Dumb economics question!

[cj.23]

OK, I am pretty dumb when it comes to economics, in fact completely clueless. I have never studied th subject at all, and know nothing, but I'm sort of interested, and I have recently read hundreds of newspaper articles when my ignorance is beginning to niggle, so I thought I'd ask here!

1. What is the relationship between Interest Rates and the Stockmarket?
My guess would be that if Interest Rates rise people withdraw money from the stockmarket to take advantage of the higher interest rates available, causing stocks to fall, and conversely if you cut interest rates the market picks up for that reason? Is that true? I'm sure it's far more complex, but as a rough guide?

2. Does loan size available effect the Housing Market?
I had assumed for the last few years there would be a problem in the UK housing market as prices were rising at about 10% a year or even more, but there is a cap on lending as I understand of three times income, or twice joint income. Once people could no longer borrow money as the price was greater than available loans from banks, I assumed house prices would fall?

My thought experiment was what if you could not borrow more than 5 times your annual income. At that point surely house prices would drop drastically, to meet money available? That suggested to me that high house prices were not in any way related to the bricks and mortar value of a property, but simply how much cheap credit is available?

Is this what the "credit crunch" is, people not being able to borrow so house prices drop to meet the available cash, a pricing correction to the lack of money availbility? That seems like a simple supply & demand issue. If so why was thsi not obviously a problem, and why has anyone I have suggested this might happen to in the last 5 years look at me like I'm a moron?

Sorry f these are relaly stupid questions. I'm running off common sense, but have very little information to go on, and know marklets anre immensely complicated things. Any help?

cj x

 

[Francesca R]

1. What is the relationship between Interest Rates and the Stockmarket?
My guess would be that if Interest Rates rise people withdraw money from the stockmarket to take advantage of the higher interest rates available, causing stocks to fall, and conversely if you cut interest rates the market picks up for that reason? Is that true? I'm sure it's far more complex, but as a rough guide?

As a textbook response--yes. A financial asset is worth (today) the present value of the future cash flows it generates, which are unknown in the case of stocks but have expected values reflecting collective opinion of all investors or would-be investors. "Present value" means "what are future receipts worth in today's money". That calculation involves DCF analysis using a discount rate. One of the components of a discount rate is the risk-free rate of return you could earn if you did not invest in stocks--which is influenced by policy interest rates. So the higher the interest rate, the less valuable are the future cash flows from a stock, hence you "should" pay less for the same stock, and it's price should fall to reflect that.

2. Does loan size available effect the Housing Market?
I had assumed for the last few years there would be a problem in the UK housing market as prices were rising at about 10% a year or even more, but there is a cap on lending as I understand of three times income, or twice joint income. Once people could no longer borrow money as the price was greater than available loans from banks, I assumed house prices would fall?

That is one mechanism, but lenders need to keep lending (to credible borrowers) to make profits and compete with other lenders, so to some extent, so the maximum they will lend is something they can and do change. In addition if interest rates are low, the affordability of borrowing increases and this also influences the aggressiveness of mortgage deals on offer. So does the rear-view-mirror trend of house prices, because if eveyone gets accustomed to them "always going up" then lenders get less bothered about being able to recover their principal through reposession/foreclosure, regardless of how creditworthy the borrower is. So there are self-reinforcing elements to the pattern of house prices and mortage lending, on the way up and the way down.

My thought experiment was what if you could not borrow more than 5 times your annual income. At that point surely house prices would drop drastically, to meet money available? That suggested to me that high house prices were not in any way related to the bricks and mortar value of a property, but simply how much cheap credit is available?

Well the "bricks and mortar value" is nothing more than where "what the next buyer is likely to pay" intersects with "what the next seller is happy to accept". But yes, as above, it is related to the ease of borrowing.

Is this what the "credit crunch" is, people not being able to borrow so house prices drop to meet the available cash, a pricing correction to the lack of money availbility? That seems like a simple supply & demand issue. If so why was thsi not obviously a problem, and why has anyone I have suggested this might happen to in the last 5 years look at me like I'm a moron?

It tends to get triggered by people borrowing but this being followed by the surprise discovery that many of them can't make the payments. It can be a "dead cert" that it will transpire that way but without any certainty about when. May people have been forecasting a downturn in UK house prices--but since the late 1990s.

 

[drkitten]

1. What is the relationship between Interest Rates and the Stockmarket?
My guess would be that if Interest Rates rise people withdraw money from the stockmarket to take advantage of the higher interest rates available, causing stocks to fall, and conversely if you cut interest rates the market picks up for that reason? Is that true? I'm sure it's far more complex, but as a rough guide?

Yes. Another way to look at it -- courtesy of the Motley Fool (q.v.) -- is in terms of our old standby for stock evaluation, price to earnings ratio. A cash account paying 5% gives you one dollar back for every 20, so you "earn" 1 dollar by spending 20. This is equivalent to a P/E ratio of 20.

On the other hand, a cash account paying 2.5% has a P/E ratio of 50. So a stock with a P/E ratio of 30 is not a good (income) investment when the bank interest is high, but is when the bank interest is low.

2. Does loan size available effect the Housing Market?
I had assumed for the last few years there would be a problem in the UK housing market as prices were rising at about 10% a year or even more, but there is a cap on lending as I understand of three times income, or twice joint income. Once people could no longer borrow money as the price was greater than available loans from banks, I assumed house prices would fall?

The "cap" isn't as hard as you think --- nor is income as much a barrier as you think; lots of people make more money than you do, and lots make less.

But, yes,... the availability of cheap credit is one of the main things that has been driving the housing boom in the States recently; in particular, there's a rather infamous type of loan that does not even pay attention to the buyer's income (on the assumption that the house itself will continue to increase in value --- so even if you bought a million-pound house, the bank "knows" that by the time you default, the house will be worth 1.2 million, so they'll walk away with a house worth more than the loan anyway).

As soon as house prices started to fall, for whatever reason, this line of thought came unstitched, for the simple reason, as Capt. Blackadder put it, that "it was bollocks."

Is this what the "credit crunch" is, people not being able to borrow so house prices drop to meet the available cash, a pricing correction to the lack of money availbility? That seems like a simple supply & demand issue. If so why was thsi not obviously a problem, and why has anyone I have suggested this might happen to in the last 5 years look at me like I'm a moron?

Because people are dumb.

 

[Jaggy Bunnet]

OK, I am pretty dumb when it comes to economics, in fact completely clueless. I have never studied th subject at all, and know nothing, but I'm sort of interested, and I have recently read hundreds of newspaper articles when my ignorance is beginning to niggle, so I thought I'd ask here!

1. What is the relationship between Interest Rates and the Stockmarket?
My guess would be that if Interest Rates rise people withdraw money from the stockmarket to take advantage of the higher interest rates available, causing stocks to fall, and conversely if you cut interest rates the market picks up for that reason? Is that true? I'm sure it's far more complex, but as a rough guide?

Another factor that impacts it is that most companies on the stock market will have borrowings on which they will have to pay a higher interest cost, leaving less cash for the shareholders. This is in addition to the reduced net present value of the cash available to the shareholders due to the higher interest rate which others have mentioned.

2. Does loan size available effect the Housing Market?
I had assumed for the last few years there would be a problem in the UK housing market as prices were rising at about 10% a year or even more, but there is a cap on lending as I understand of three times income, or twice joint income. Once people could no longer borrow money as the price was greater than available loans from banks, I assumed house prices would fall?

My thought experiment was what if you could not borrow more than 5 times your annual income. At that point surely house prices would drop drastically, to meet money available? That suggested to me that high house prices were not in any way related to the bricks and mortar value of a property, but simply how much cheap credit is available?

Is this what the "credit crunch" is, people not being able to borrow so house prices drop to meet the available cash, a pricing correction to the lack of money availbility? That seems like a simple supply & demand issue. If so why was thsi not obviously a problem, and why has anyone I have suggested this might happen to in the last 5 years look at me like I'm a moron?

Sorry f these are relaly stupid questions. I'm running off common sense, but have very little information to go on, and know marklets anre immensely complicated things. Any help?

cj x

All perfectly reasonable points. However as you correctly observe the market is extremely complex so you have to remember that any models are just that.

Long term trends say that house prices rise at a broadly consistent rate over long periods of time - recent rises have been well above that rate. This could mean that the recent rises are unsustainable or it could be due to a fundamental change in the market - for example some argued that the reason house price growth was sustainable was that it was due to demand for housing units (increasing rapidly due slightly to immigration but far more to the lower average number of people per house) exceeding supply (due to planning constraints etc.) Looks like they were wrong, but there is little sign, yet, of the sort of correction that would take house prices back to their "long term" trend.

 

[lomiller]

1. What is the relationship between Interest Rates and the Stockmarket?[/B]
My guess would be that if Interest Rates rise people withdraw money from the stockmarket to take advantage of the higher interest rates available, causing stocks to fall, and conversely if you cut interest rates the market picks up for that reason? Is that true? I'm sure it's far more complex, but as a rough guide?

What you suggest is largely true of the rates available in the bond market, but not so much bank interest rates. The way the fed controls interest rates is to tighten/loosen the money supply. When the fed pumps more money into the economy interest rates will drop, but the availability of that cash will generally drive stock prices up.

Is this what the "credit crunch" is, people not being able to borrow so house prices drop to meet the available cash, a pricing correction to the lack of money availbility? That seems like a simple supply & demand issue. If so why was thsi not obviously a problem, and why has anyone I have suggested this might happen to in the last 5 years look at me like I'm a moron?

Remember that banks can’t lend out money if they don’t have cash on hand. When the housing market dropped their assets were devalued, and the risk on their debt increased thus reducing their ability to raise cash. Without this cash they need to be much more selective about what loans they give out, so they charge higher rates and only lend to lower risk customers. This, however, has the effect of deflating the housing market further.

 

[balrog666]

There were several more issues in addition to the above explanations for the "credit crunch" and subprime mess.

First, the explicit pressure from bank regulators to get banks to issue more mortgages to minorities, which led to reduced (sometimes non-existent) qualifications for mortgages for precisely the people who couldn't afford (or wouldn't pay for) a house in the first place. The proliferation of heavily discounted subprime mortgages to meet the arbitrary quotas followed, especially as passed through Freddie and Fannie where they could be easily offloaded from the lender's books.

Second, the increasing separation of mortgage brokers from mortgage holders led to significant fraud at every level, with lack of income verification for mortgages and inflated appraisals (and rings) to bundled securities sold to multiple parties within the banking system, all with government-backed Fannie and Freddie standing in the middle to take the (financial) fall for everyone.

 

[Francesca R]

There were several more issues in addition to the above explanations for the "credit crunch" and subprime mess.

First, the explicit pressure from bank regulators to get banks to issue more mortgages to minorities, which led to reduced (sometimes non-existent) qualifications for mortgages for precisely the people who couldn't afford (or wouldn't pay for) a house in the first place. The proliferation of heavily discounted subprime mortgages to meet the arbitrary quotas followed, especially as passed through Freddie and Fannie where they could be easily offloaded from the lender's books.

Second, the increasing separation of mortgage brokers from mortgage holders led to significant fraud at every level, with lack of income verification for mortgages and inflated appraisals (and rings) to bundled securities sold to multiple parties within the banking system, all with government-backed Fannie and Freddie standing in the middle to take the (financial) fall for everyone.

Parodied here (FNMA and FHLMC are not involved with "sub-prime" mortgage securitisation though)

 

[cj.23]

I'd just like ot thank everyone very much for answering my questions which must be irritatingly naive so generously and clearly! I felt rather ashamed to admit my colossal ignorance, but I figure that is the fastest wayy to learn, and the links were very helpful, so thank you. I have wikipedia'd a few terms i was not familiar with, and bought a book on Economics (Economics Made Easy, 1974 I think). I have not read it yet though!

I did have one more question - I saw a mentionof a Price/Earnings ratio of 20??? I vaguely recall my father mentioning 20 odd years ago that the ratio of a dividend to share price was normally 14 for a sound investment, and he advising me not to invest in BT shares as they were overvalued following the sell off, at least not as a long term investment. Assuming that is what Price/Earnings means, and I think it might, has that changed? Is 20 now the guiding figure?

Thanks!
cj x

 

[Jaggy Bunnet]

I did have one more question - I saw a mentionof a Price/Earnings ratio of 20??? I vaguely recall my father mentioning 20 odd years ago that the ratio of a dividend to share price was normally 14 for a sound investment, and he advising me not to invest in BT shares as they were overvalued following the sell off, at least not as a long term investment. Assuming that is what Price/Earnings means, and I think it might, has that changed? Is 20 now the guiding figure?

Thanks!
cj x

Investment is too complex to boil down to one single statistic. Investing in companies with very high P/E ratios can be just as rational a decision as investing in those with very low P/E ratios. You need to understand WHY the company is valued at X times its current earnings - for example it may be that a pharma company has several highly promising drugs about to come onto the market and current earnings of 100. A rival company has no such drugs in the pipeline and its most valuable drug is about to come out of patent. It also has current earnings of 100. You would expect the P/E of the former to be far higher than the latter, because the expectation of future profits is much higher, therefore the discounted cash flow value is higher. Does that make it a better investment? Maybe, maybe not.

Efficient market theory assumes that the price reflects all known circumstances, so there is no reason to assume that a high P/E share is more likely to rise or fall in price than a low P/E share.

 

[drkitten]

I did have one more question - I saw a mentionof a Price/Earnings ratio of 20??? I vaguely recall my father mentioning 20 odd years ago that the ratio of a dividend to share price was normally 14 for a sound investment, and he advising me not to invest in BT shares as they were overvalued following the sell off, at least not as a long term investment. Assuming that is what Price/Earnings means, and I think it might, has that changed? Is 20 now the guiding figure?

Apologies for the length, but this is a detailed question and deserves a detailed answer.

The simplest answer is that intelligent investment is not simply a question of numbers, as JB pointed out. In general, there are two different "schools" of investment, though, which can be summarized as "growth" vs. "income." The idea behind income investment is that you buy a company that gives you a steady income (usually through dividends) for a low price, which P/E ratios approximate. The historical return on such investment is usually around 7-8%, which corresponds roughly to a P/E of 14 --- but with the stock market tanking and earnings down all around, this is not necessarily a time when we should be looking for normality.

The other school of thought involves buying stocks whose earnings are expected to rise; i.e. paying today's price to buy tomorrow's income -- which in the case of a stock that's expected to have a sudden rise in income can result in a hefty bonus. The problem is that if YOU expect a stock to have a sudden rise in income, probably so does everyone else, so such stocks tend to trade at a high P/E ratio already. (Similarly a stock whom everyone expects to crash may be trading at a low P/E ratio, because the E represents the past, while the P represents the future.)
Motley Fool (and I) prefer the slightly more sophisticated PEG ratio, which is the P/E ratio divided by the expected growth -- i.e. a stock trading at a P/E ratio of 10 that is expected to grow at 5% per year has a PEG ratio of 2.0, while a stock trading at P/E 10 expected to grow at 10% a year has a PEG ratio of 1.0. "Obviously," the second stock is a better investment -- except that that's another vast oversimplification.

JB's post was made from the standpoint of a growth investor -- he wants his stocks to rise in price. (Who wouldn't?) That's not really the position from which you want to analyze a pure cash investment like a bank account, though. The price of a dollar is and will always remain a dollar. But the question is how many dollars you get back per dollar invested -- P/E. And, historically, cash investments have been lousy growth investments, but so-so income investments. And when interest rates are high, they are even better income investments.

Of course, very few people are pure growth or pure value investors (although people tend to lean one way or another depending upon whether they need money NOW (income) or can wait an indeterminate while for it (growth)). Certainly, I just want my investments to make me more wealthy. But I'm young enough -- and draw enough in salary -- that I can afford to take the higher risk that growth investments usually carry.

 

[Jaggy Bunnet]

JB's post was made from the standpoint of a growth investor

It was? In what way?

 

[cj.23]

Thanks to both of you for your excellent answers. I am not in a position to invest in anything, and have no mortgage nor will I ever be able to get one I suspect (no credit history worth speaking of as have never had any personal debt or for that matter excess income), but it does interest me, not least because many of my friends are in the categories where they have to make a more important financial decisions than my baked potatoes or pasta for tea!

So the value of a stock clearly fluctuates with expectation of future growth, independently of past history? Makes perfect sense. A start up company might not have much in the way of a dividend, but may one day do very well. Some of my friends "invested" in getting me a pc and on the web a few years back, confident I would then be able to make some money wrting or working, and sure enough I have, and I have been able to offer them a good return on their kindness. ( I quickly ended up making documentaries for British TV and wrtiing books. Unfortunately the returns are not spectacular, and I would be significantly better off at times (like now f'r instance) on benefits, but average out higher. )

Right, so if perception is an important aspect, then surely all the journalism concerning impending Recession (negative growth for two quarters?) could become a self fulfilling prophecy, by driving the market down, and making people unwilling to invest or act as venture capitalists, resulting in further economic stagnation? How do you get round that? I'm just tempted to think of all the "middle class homeowners may as well top themselves" Mail & Express headlines I read and laughed at in the 90's, which were obviously had no effect on market confidence - but now confidence appears key to the the future? Presumably a low market si an ideal time to invest though, so if stocks drop sharply, then people buy in and the market rises, correcting itself?

Hence my question about P/E. The only reason I can see for a real problem would be if a) people were unable to take advantage of a low market for some reason like high unemployment or a massive hike in cost of living (but that would simply mean those with excess money would invest, and the rich would get richer?) or B) the stocks were massively overvalued, and the prices bore no resemblance to the actual earning expectation of the stocks?

I'm stiill getting my head round all this, it's a long way from the few things I do know about, but once again sincere thanks for your patience. And may you prosper in the current adversity, and grow wealthy and enjoy it! I rather like people making money and looking after themselves, as despite being in the lowest few income percentiles personally (underclass, me!) I'm content enough with what I do and see no reason to try and drag everyone down to my level.

j x

 

[Tippit]

Yes. Another way to look at it -- courtesy of the Motley Fool (q.v.) -- is in terms of our old standby for stock evaluation, price to earnings ratio. A cash account paying 5% gives you one dollar back for every 20, so you "earn" 1 dollar by spending 20. This is equivalent to a P/E ratio of 20.

On the other hand, a cash account paying 2.5% has a P/E ratio of 50. So a stock with a P/E ratio of 30 is not a good (income) investment when the bank interest is high, but is when the bank interest is low.

No. The reciprocal of 2.5% is 40, not 50, and comparing the earnings yields of stocks with interest bearing securities is a very crude method of valuation to say the least. Stocks are typically valued according to the discounted present value of expected future free cash flows, so it is growth and not necessarily prevailing interest rates that can make one stock a bargain at 30x earnings, and another extremely overvalued.

 

[drkitten]

It was? In what way?

Your concern for stock price as opposed to dividend yield, and your apparent concern for future cash flows without regard to the time window in which they appear.

Nothing wrong with that, of course. As I said, no one is purely a growth or a value investor. But since P/E tends to be much more directly meaningful to an investor concerned with next quarter's cash flow as opposed to stock price an indefinite number of quarters from now, the analysis of stock price vs. interest rates is more easily presented from an unreasonably and unrealistically pure value investment standpoint. Think of it as the financial equivalent of "neglecting air resistance" in a physics problem.

 

[drkitten]

No. The reciprocal of 2.5% is 40, not 50, and comparing the earnings yields of stocks with interest bearing securities is a very crude method of valuation to say the least.

Yes, that was a typo.

And you're absolutely right, that's an extremely crude method of valuation -- but pedagogically useful for that reason. I'm educating here, not giving investment advice. The James Randi Investment Foundation can be found on the next floor up.

 

[drkitten]

So the value of a stock clearly fluctuates with expectation of future growth, independently of past history?

Absolutely. Hence Amazon.

Right, so if perception is an important aspect, then surely all the journalism concerning impending Recession (negative growth for two quarters?) could become a self fulfilling prophecy, by driving the market down, and making people unwilling to invest or act as venture capitalists, resulting in further economic stagnation?

Absolutely. Just like all the irrational press fueled the dot.com boom via "irrational exuberance."

How do you get round that?

Critical thinking and rationality. On an individual basis, it can actually be helpful to have everyone else be dumb-as-a-brick; I'm reminded of Buffett's dictum to "be greedy when others are fearful; be fearful when others are greedy." There's even a term for the school of investment that says "do what everyone else says NOT to" -- "contrarian" investing.

On the other hand, if the market is being driven by irrationality one way or another, it can also be quite profitable to follow the herd for a while with the intention of riding it for a bit and then getting off before everyone tips wise. If you had bought Amazon -- or any dot.com -- in 1998 and sold it in early 2000, you would have made a fortune. Just don't get caught with the potato at the end. I'm not confident enough in my ability to time; I don't play that game. The risk is too great. But I've seen fortunes made that way.

Hence my question about P/E. The only reason I can see for a real problem would be if a) people were unable to take advantage of a low market for some reason like high unemployment or a massive hike in cost of living (but that would simply mean those with excess money would invest, and the rich would get richer?) or B) the stocks were massively overvalued, and the prices bore no resemblance to the actual earning expectation of the stocks?

Both are factors. A third factor might be that the stocks are accurately valued, but that the public fear will persist long enough to drive the stock prices down to massively UNDERvalued. Even if you're right and eventually they return to sensible prices, that might be too far away (if you are saving for college tuition for your 15-year old, for example).

The problem is that it's hard to tell which is which, or which factor is dominant today. If you have long enough, it doesn't really matter. But on the short-term, you need to have an idea of what kind of return you will make NOW, which brings us back to P/E ratios.

 

[cj.23]

Thanks again. I've just been reading about Bonds - you can convert them to discounted shares at a future date, but have not got the hang of this yet. I'll keep reading! I assume the advantage of companies issuing them is that they don't have to pay interest on the cah raised, but surely they will devalue your shares when cashed in???

Last foolish question for now -- What is a stock split? It looks to me like you double the shares and halve their value, diluting them massively. Why would you do this?

cj x

 

[cj.23]

Actually don't stress about answering that -- I think my book will reveal all, and Google is good if not. Now I have a few vague concepts I'm capable of looking stuff up, but thanks again to everyone who has been so patient.

cj x

 

[Tippit]

Last foolish question for now -- What is a stock split? It looks to me like you double the shares and halve their value, diluting them massively. Why would you do this?

cj x

A stock split is a purely cosmetic action where the aggregate shares outstanding of a business are increased by some amount so as to reduce the price per share. Unlike public equity offerings, or the Federal Reserve diluting the purchasing power of our money, it is not dilutive because the ratio of the split is applied to each shareholder equally.

The purpose is to create demand for the stock by reducing it's apparent price to naive investors, or to keep share prices in line with convention.

 

[Miss_Kitt]

On the general question of What Is Wrong with the Housing Market / Mortgage Mess? I'd like to chip in some non-technical observations.
Contrary to what a prior poster suggested, a lot of "bad" loans were not made to minorities and low-income, but to middle-income folks who wanted to buy more house than they could afford--or to those who bought houses as investments that they planned to "flip" (resell after primping) before the cheap initial rates changed. Then when the conventional belief that "Real estate never loses value" was proved wrong, a lot of people got a harsh lesson in reality.
This is not to say that converting mortgages into other forms of tradeable assets was not also part of the problem. Basically, a lot of ultimately mortgage-backed investments were not regarded as being backed by mortgages...and so financial institutions and some individual investors got caught being much more exposed than they had realized.
Another aspect of this, at least in the US, was that people took out new mortgages as interest rates dropped--and used this as a chance to take out their equity in the property as spending money. (Often, sadly, used to pay off credit cards, which were promptly run up again.) So instead of having some value in the property that would survive a small price downturn, they mortgaged to a value that included the rosy expectation of a higher price in six months or a year. This means that 1) The homeowner is now 'upside down' (owes more than he can sell the property for) and 2) the lender is going to eat a significant loss when they foreclose.
Since the lenders made money off the refinance fees, they wanted to push a large number of large value loans through--so they used appraisers who gave high values to properties. Normally, having to risk 'eating' the property if the borrower defaults discourages the lender from doing this; but the ability to repackage the mortgages and sell the risk off to someone else removed this check on Irrational Enthusiasm.
It is also true in some markets (not all, by any means) that increasingly invasive restrictions on development raise the cost of building; since the builder needs to still make his profit, this raises the selling price. Since the minimum profitable selling price is high by historic standards, the builder helps justify the price by putting in nicer finishes, a fireplace, a bigger garage--which helps the buyer believe the house is worth the higher price. That is, if the lot used to be suitable for a $70K house with 1200 square feet, and the new price of building the same structure would raise the price to $80K, it's better for the builder to add $8K of goodies and sell the slightly larger, slightly nicer, building for $100K. What we used to call "starter homes" don't much exist anymore as new-built, because they aren't profitable for the builders.

This is a fascinating thread, I hope I have time to pop in here more often!