BUFFETTS BOOKS ACADEMY: BASIC COURSE
LESSON 11: WHAT IS THE FED
LESSON OBJECTIVES
- Understand what the FED is.
- Understand what the mission of the FED is.
- Understand how the FED changes market conditions with interest rates.
- Understand what the FED tells us about Mr. Market.
LESSON SUMMARY
In this lesson, we learn that the FED is short for the U.S. Federal Reserve. The mission of the FED is to care for the U.S. economy, which is done in a variety of ways.
For the investor, the FED is an interesting institution because one of the main goals is directed at the stabilization of the financial system. The main instrument to do that is by adjusting the interest rates. To illustrate, we look at the stock market before, under, and after the financial crisis. What can be seen is that the FED actually anticipated a bubble that would burst. The way that anticipation can be expected is by looking at the interest rate.
- High stock prices and booming economy = High interest rates (think 2007 and prior to that)
- Low stock prices and a depressed economy = Low interest rates (think 2009-2010)
To help you understand this, we will use an example of a car here. We learn that when the interest rate is high, the car becomes more expensive, while a low interest rate makes the car cheaper in relative terms. The implication of this is that the FED is controlling our spending habits. By controlling our spending habits, it is also controlling the economy.
So if the FED can see that the economy is overheated, it begins to increase interest rates. While this does not always prevent a bubble, it will, under all circumstances, slow down the economy making the bubble less severe. The way we, as investors, can benefit from this is to buy quality bonds that have high coupon rates. In overheated economies, we will usually get a very nice Yield to Maturity on our bonds. Stocks on the other hand are usually expensive.
The opposite scenario of a depressed economy occurs when the FED lowers the interest rates. While this does not always kick start the economy, it is a strong method for giving people the incentive to spend money, which is beneficial for future growth. The way we can benefit from this as investors, is to sell our bonds as we have accumulated them while the interest rates were high. Since you hold on to a higher coupon, your current bonds have now increased in value. Another great thing about a depression is that the stocks are usually very cheap. This means that you can accumulate stocks at a very good price selling well below the value.
Obviously, now you’re wondering how you can benefit from the fluctuating interest rates. In order, to do that, you can consider an interest rate to be high or low. The method is surprisingly simple. You compare the return you can expect to get from stock to bonds, to see if you are on the right side of the fence. For instance, if you expect to get 5% from stocks and 5.5% from bonds you should invest in bonds. In that sense, the FED is actually displaying a clear picture as to how Mr. Market is acting at the moment.
NEW VOCABULARY
FED
Short for “The United States Federal Reserve” that among other objectives, secures that the American financial system is stable.
Interest Rates
There are many different interest rates, however, when we talk about the “interest rate” we usually talk about the “price of money” the FED has determined is appropriate.
LESSON TRANSCRIPT
A lot of people have no idea what the FED really is. The FED is nothing but a short term for the United States Federal Reserve. The FED manages the U.S. Currency and ultimately controls the U.S. Economy.
Before 1913, the United States had over 30,000 different countries in circulation. It can bring stability to a volatile economy. Local governments could issue currencies. Well, pretty much anyone could issue whatever type of currency they wanted, so sometimes the currency would become quickly worthless. Sometimes also it would hold its value, which led to a lot of unrest throughout the country, because there was no regulation or any standards for the rules for creating currency.
After 1913, there was one federal currency – the dollar. The dollar brought some stability to the country, and that was the FED’s main goal. There are lots of different reasons and interesting things you can read about the Federal Reserve, but the primary purpose is to bring stability to the country.
FED is a private institution. Although the directors are appointed by the president and informed by the congress, once people attain their positions, they stay there for 12 years and never answer the president and the congress ever again. They are now on their own entity. After the nomination process, the people running the FED could do anything they want.
The FED is a private institution owned by 12 regional Federal Reserve banks, commercial banks, and even individuals. Especially if you went back to when the FED was created, very wealthy people set it up. An interesting book called Creature for Jekyll Island gives a different perspective on the FED.
The FED prints money, but where do those come from? Some people are really surprised to know that the FED has the ability to simply print more and more money from thin air whenever they want to.
That’s’ what happened in 2008 and 2009 –people in the FED issued out orders to put more money in the system, so people would spend it. Much of the FED’s activity was not made public, so they held closed-door meetings where people could not go in. After the meeting, they would just give general ideas like, “Hey, interest rates are not going to rise/not not going to rise.”
People debate whether the FED is constitutional. That is not the point of this video, I just highlighted to just throw out some intriguing facts to make you read some more about it.
FED tries to accomplish these 4 things:
- Maximize employment and stabilize prices
- Supervise and regulate banks
- Maintain the stability of the financial system
- Service debts for the U.S. Federal Government
Their focus is maintaining the stability of the financial system. How does the FED stabilize the financial system? The FED has very smart people running it. In 2006-2008, Mr. Market was screaming, “Everybody, join me!” The Federal Reserve absolutely knew that there was a bubble coming in the economy and there was a recession to follow. They were trying to affect that. To prevent that bubble from happening, whenever the market was climbing and getting really high, they were trying to raise the interest rate to slow it down. When it crashed, they tried to lower the interest rate so people to spend. Here’s an example:
It’s Christmas time and you’ve got $5,000 bonus for your job. You’ve been wanting a new car. You have an agreement with yourself that no matter what, you’re not spending $35,000 on a car. The value of the car you want is $35,000. You use your $5,000 as a down payment. You go to the dealership and see that the car price is perfect at $30,000. I’m going to use a really extreme interest rate here just to highlight and exemplify something for you. Assume that the best interest rate on this car is 15%. Your monthly payment for a 5-year loan would be $495,000 a month. The total interest you will pay over that 5-year period will be $40,684. The adjusted price on the car is not a 30,000-dollar car; it’s actually a 40,684-dollar car. The price is higher than what you valued that car being $35,000. You don’t buy it because it’s too expensive. That monthly payment is way too high.
Let’s look at the scenario from a different angle. Go back to the dealership and price for the car which is $30,000, but this time, the interest rate is 1%. With that, your monthly payment now is $427. The total interest you pay over a 5-year period is only $641. Now the adjusted price from this car is only $30,641, which is under the $35,000 that you felt the car was worth. Therefore, you buy the car.
Let’s look at this scene side by side – same car and same market price of $30,000, but different interest rates of 15% and the other being 1%. You get a difference value in the end and therefore different spending habit. The one case you buy the car and the other case you don’t even think the car was the same price. Those interest rates change your spending habits.
The Federal Reserve understands that they can adjust the interest rates and your spending habits. Ben Bernanke is Chairman of the Federal Reserve. He makes decisions on how the Federal Reserve will adjust the interest rates. Look at the Dow Jones, the market is climbing. Mr. Bernanke is trying to make interest rates very high.
From the first lesson in Unit 1 lesson 1 with the bonds, interest rates were around 5% in 2007. This was Mr. Bernanke’s attempt in order to slow this bubble that he knew was there. His mindset was, “We need to stop this bubble from happening!” He dis that by raising the interest rates so borrowing money was expensive and people spent less. It slowed down the economy and hoping the recession didn’t happen, but what happened was a harsh recession. After that, the Federal Reserve’s reaction was ”We need to stimulate the economy. We need people to spend money.” They lowered the interest rate because they needed all that money to get out in the system. They needed people to start buying things, so the economy would grow again. The Federal Reserve knew that Mr. Market was wrong and they were trying to counteract Mr. Market by adjusting the interest rates. The FED kept raising interest rates, pretty much showing a greed cycle. When the fed was lowering the interest rates, they were showing a fear cycle.
Which asset do you want to own and when? In this scene, the interest rates are really high. What type of asset do you really want to buy at this point? Buy bonds. The reason is to have a coupon that’s paying you at very high interest rates. If you don’t understand this part, you need to go back to unit 1 and unit 2. When you but a bond at a high interest rate, you’ll receive a very good coupon which will pay you a great return. The added bonus is whenever those interest rates drop in the future which is going to happen eventually, the market price to that bond will go up. You will have the thought to sell it and then out into a stock, which really the end goal is to get that into a company.
Now look when interest rates are low. Remember this when you want to buy stocks, because when you’re in bond and you get a really low coupon, but the stocks are very heap at this point, go out and find a company with very low debt and cost of earnings and a strong price to book ratio. You will get a very strong buy that has a really good intrinsic value and end up making a lot of money on that one after the market recovers.
How do you know what’s considered a high or low interest rate? To properly value a stock or a bond, costly compare the return that you expect to get with the stock versus the return you expect to get with the bond. Assume that based off to the market price being in a greed cycle, the stocks are trading really high, and the best return you could expect to get with the stock is maybe 5% based off on a high market price. When you look at a bond, assume that the bond is at 5.5% because of the market. The bond has less risk than a stock. This is very easy decision. Buy bonds! By being able to compare a stock versus a bond, it always puts you on the right side of the fence. That’s truly the art of asset valuation.
To summarize everything, the FED is short for the U.S. Federal Reserve. The mission of the FED is to care for the U.S. economy. They do this through four different objectives. First they try to ensure maximum employment through price stabilization. Second, they supervise and regulate banks. Third, they maintain stability of the financial system by adjusting interest rates. Fourth, they service the debt obligations for the federal government.
In this lesson, we really focused on the third objective: Maintaining stability of the financial system. In order for the FED to stabilize the economy, they have to constantly adjust the interest rate at which banks can lend money to citizens and businesses. By doing this, the FED is ultimately controlling the spending habits of the U.S. economy. When the FED controls interest rates, it provides predictable investment opportunities for value based investors because they are able to capitalize on the changing market prices of stocks and bonds.
We learned that when interest rates are high, we’ll want to focus our efforts on finding quality bonds. By taking this strategy, a value investor can collect high paying coupons and also prepare themselves for a profitable venture when interest rates decrease. Since the value of a bond increases when interest rates decrease, the market value will undoubtedly increase on a long term bond when market crashes force the FED to drop interest rates.
We also learned that when interest rates are low, it’s probably a good time to find undervalued stocks. The most lucrative time to buy stocks is during a recession because scared investors are selling their shares at a discount price. Smart investors need to ensure that they always avoid buying companies with marginal levels of debt. In course two, this site conducts a thorough review of all the information you need to properly assess the intrinsic value of stocks and bonds. The key point to take away is that when interest rates are low, you want to ensure that you’re buying stocks.
In the end, we learned that the FED actually provides great clues as to the position of Mr. Market. We know that when interest rates are high, the stock market is experiencing a greed cycle. Likewise, when interest rates are low, the stock market is experiencing a fear cycle. This information proves very valuable as value investors capitalize on market movements and opportunities.