Investment Moats

Explaining Quantitative Easing and its Effect on Commercial Banks

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To liquify the financial markets and the main economy, a lot of money was pumped into the financial system.

The straight forward deduction is that if you create money from out of nowhere, either your currency is going to shit or that inflation will run rampant.

We are not seeing both in the United States right now but a lot of the people are speculating it will be a matter of time.

I wonder whether that will really happen. I say this, because I can’t say I am that competent to make that deduction. Usually, we have to know to a good extent what I am talking about to make that conclusion.

I do think that from what I hear, we have created an interconnected system that will create more 2 standard deviation, 3 standard deviation volatility.

One of my favorite people on the financial blogosphere Cullen Roche of Pragmatic Capitalism explained that when the Federal Reserve infuses money, it is an exchange of very short-term liquid money with long-duration money/bonds.

In a way I understand it but if I cannot illustrate it out well, then maybe I do not understand it as well.

In any case, BCA has a good explanation about what happens when the Central Bank buys back commercial securities from the banks.

It sought to help to explain the relationship of Central banks with the monetary system.

I used to not get the relationship of Central Banks that well but the way to think about them is like the Bank of the financial institutions. They somewhat act as the lender of last resort.

If banks produce the lifeblood of the financial system, then they have to be functioning.

But what if the banks are not functioning?

That is probably the Central Bank’s job to lubricate the system.

The relationship can be best illustrated by observing the balance sheet of the Central Bank and a Commercial Bank as the Central bank announces they will buy commercial loans/bonds.

Central bank and a Commercial bank’s balance sheet before and after they decide to take on a bond purchase

In the above diagram, the top section shows the balance sheet of a Central Bank and Commercial Bank. The bottom section shows the balance sheet after they decide to purchase $100 worth of bonds that belonged was on the books of the Commercial bank.

The main operating segment for a bank is to take in your deposit by giving you an interest, and then borrowing your deposit out at a higher interest.

To ensure that you can always withdraw your deposit and not have a “run-on-the-bank”, the Central bank will mandate the commercial bank to keep a reserve with them.

If the Central bank mandate a higher level of reserve, the commercial bank can only lend less. If they mandate a lower level of reserve, the commercial bank can lend more. This is one of the ways they regulate the money system.

Now, when there is a crisis of confidence in the financial system, counter parties have a heighten distrust whether each other can honor each other’s financial obligations. What the Central bank can do is to either guarantee certain transactions.

Or they can do something novel which is to buy the securities on the commercial bank’s balance sheet. In this case, the Central bank first said they will purchase the higher quality bonds, then bonds through exchange traded funds.

To do that, they have to create money out of thin air, through money printing, which you can see as New Excess Reserves Created of $100 on the Central banks Liabilities.

In accounting double entry, the matching entry is a $100 New Bond Purchase.

This New Bond Purchase comes from buying over the existing bond held on the assets in the commercial bank. The commercial bank receives $100 in cash.

What you would notice is that

  1. The Central Banks balance sheet expanded both on the assets and liabilities
  2. The Commercial Bank balance sheet is the same
  3. The deposit in the Commercial Bank stays the same.
  4. What is different is the quality of the Commercial bank’s balance sheet. The bonds were of certain risk. Now that $100 of bonds is replaced by something of higher quality (or less risky)

Net-net the money supply was not affected by these Quantitative Easing operations.

Where money supply will be created, according to BCA, is when Central bank lends to or purchases securities from both the commercial banks and economic agents.

If instead of all deposits, the commercial bank held liabilities in pension fund deposits, then the case might be a bit different.

We introduce the before and after balance sheet of a Pension fund in the third column.

The New Excess Reserve Created at the Central bank is used to purchase additional Pension fund deposits instead of commercial bonds at the commercial banks.

What this does is that the Commercial bank’s balance sheet expands both on the asset and liabilities end.

The subtle difference is instead of improving their own balance sheet, they go get themselves more levered.

The summary is that Quantitative Easing operations put more money into circulation when Central banks purchase assets or lend to non-banks (like the Pension fund). When Central banks purchase assets from commercial banks, no new money is put into circulation.

What actually put more money into circulation, outside of Quantitative Easing is when commercial banks purchase securities from or loans to economic agents (like the Pension fund in the example).

Can We forecast How Much Money is Created Through QE Operations?

One conclusion we may draw from the previous discussion is that we may not know if the money buys back from the commercial banks or from non-bank entities.

Basically, there are no easy way of predicting the percentage of which.

We do know that the Central Banks may just be getting bigger and bigger.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

  1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
  2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
  3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
  4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
  5. Free Stock Portfolio Tracking Google Sheets that many love
  6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
  7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works

Speculation, Price Earnings Expansion and Expanding Yield Curve

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I had the kind of “no-day-no-night” week due to studying five days a night for a certain work class. This does not include the work in the morning.

It is a good thing that two of the days include a Professional Image & Etiquette for Effective Communication course.

So on two days, I had lessons in the day time, and then at night.

I think I had enough of studying.

It has been some time since I put out something about investments so here are some short notes.

10 Year Government Bond Yield Moderate Upwards

My investment head noted that the 10-year US Treasury Yield seems to have risen in a gradual manner. If he didn’t mention it, I would not have noticed.

A rise in 10-year government bond yield can be a result of a cause or it could be the cause of something else. Sometimes, we do not know whether it is chicken before the egg or the egg before the chicken.

But I think the longer term rates do correlate with the GDP. This may indicate that the economy is on a gradual road to recovery.

It may also indicate that the demand for long term bonds is relatively lower versus other assets. This may indicate greater appetite for risk taking.

The Impact to Different Types of Stocks

The first thing you might subtly noticed is that the REITs seemed weak. I think we noticed the weakness before we notice the 10-year rate changed.

Folks just could now find out why but I think highly it is due to this.

The second thing is that some of the banks are running. Bank of America, Hang Seng Bank, HSBC Bank. Not so much the Singapore banks.

Higher interest hurts the REITs because this is their cost of debt. A steepening of the yield curve helps banks because they can borrow and lend out with better margins.

There are also some other kind of businesses that requires a steeper yield curve to function well.

These are the insurance companies and brokers. A broker such as Interactive Brokers or Charles Schwab make part of their profits from investing the cash of their users that was not deployed. These are typically invested in reasonably safe bond instruments.

When the yield curve is flat and the interest rate is near zero, this really make it very challenging for them.

How much is the Market Driven by Speculation?

In this recent months, we have seen a lot of individual companies really move. What I mean is that, if there are positive news, whether it is a positive guidance, beating a guidance, the share price would really jump.

If Salesforce can jump 25% in a day, I do wonder if there were far too much speculation compared to in the past.

The image above shows that there might be a relationship between Tesla’s share price and the number of holders on Robinhood. Looks cool but I also noticed that in Jan to Sep 2019, Robinhood holders were also increasing, but Tesla’s share price did not have the same level of moves.

We are always trying to put the blame on the young Robinhood traders but I think not all of these things can be attributed to them.

Still, the volatility can be a bit crazy. There are strong holders of stocks and weak holders of stocks. If there are bad news, it is likely the strong holders would be holding.

I observed billion dollar capitalization stocks go up suddenly by 30%, only to see it go down 30% when news disappoints. This does not seem normal.

But what is normal if more people got introduced to the stock market? This might become the new normal.

When Great Growth is Embedded in Today’s Price

In the past, I explained that you could use a high growth rate in your forward price earnings, or EV/EBITDA estimation.

It will make the share price that you are willing to buy at look fair or cheap.

This indirectly means that, the current share price factored in some high growth rate.

This is an assumption.

If the growth rate disappoints, this invalidates that assumption. It also means that the price today already priced in a sizable growth.

If the stock lives up to that growth, there are no surprises. But if the growth disappoints, then the share price would likely take a beating.

We observe that with some companies like Fastly and Alteryx. The financial results were OK for the quarter, but the guidance indicates cautiousness.

And that killed the share price.

The share price would only move upwards if

  1. Growth rate surprises higher than an already high growth rate
  2. Growth is over a longer period than what the market anticipate

Would growth rate never disappoint? I don’t think so. There will be periods where guidance disappoints or company misses earnings.

And that might present an opportunity to buy.

But how long do we have to wait? After 10 more quarters or 2 more quarters?

I think that is the tough part about speculation. Perhaps the right way is to be really better in your valuation model. In that way, you would know this price is to buy but not buy too much, buy and buy a lot, or not buy at all.

Price Earnings Expansion

Since the Dimensional Funds are tilted towards value and small we tend to look at some reference index to have a quick check of the performance of value and growth.

The Russell 1000 represents the largest companies in the United States. If you split them to Value versus Growth, you can evaluate the performance of those cheap companies versus expensive companies based on book value or some traditional metric.

In this chart, they deconstruct what the return of these two index is attributed to. So we can see that the total return of the value index is much lower in the past 4 years versus growth (16.7% vs 117.5%)

Of the return, dividend return was largely the same, but take a look at EPS growth and multiple expansion.

I think traditionally, if your earnings per share grow it is healthy. If you did all the right things, and the market priced you with the right price earnings multple, it is healthy.

But the returns from PE expansion is pretty big. Perhaps part of it is that there isn’t much alternative.

Let me keep this short. Be back tomorrow.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

  1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
  2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
  3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
  4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
  5. Free Stock Portfolio Tracking Google Sheets that many love
  6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
  7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works

Negative Real Bond Yields Impact on the 4% Safe Withdrawal Rate

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A couple of years ago, I played with this Software-as-a-service called Timeline.

It allows an adviser to put their client’s case throught the system and give an idea whether the client’s resources is enough for them to have a conservative retirement.

They allow the adviser to model based on both Monte Carlo and Historical Withdrawal Rates.

You can read Making a Portfolio of $500,000 last 60 years on a 5% Initial Withdrawal Rate and The Permanent Portfolio Might Do Worse in Retirement than the Traditional Equity Bond Portfolio to see Timeline in action.

The CEO of Timeline, Abraham Okusanya, from time to time writes well written research articles on retirement planning.

This week he published a post called No , QE didn’t break the 4% rule.

One of the fears that we have is that with very low bond yields, many smart folks commented that the 4% rate is no longer safe.

Perhaps the reason Abraham took an interest in this narrative now is that the Glit is currently having a negative real yield.

The withdrawal rate study is figuring out the highest you can spend, in the worst-case scenario.

Abraham’s point is that for the UK, 4% is not the worst-case, to begin with. He replicated a 30-year retirement through 1915 to now with a 50% equity 50% bond portfolio, factoring 1% in advisory + total expense ratio fees and this is what he has gotten:

Initial withdrawal rates for various 30-year periods from 1915 to today

Abraham did not mention this, but I think this is a 1 million pound portfolio.

Every bar on this chart shows the highest withdrawal rate that a retiree can spend on.

For example, in 1915, the highest a retiree can spend in the initial year so that he or she can have inflation-adjusted income that last for 30 years is close to 26,000 pounds a year. That is like 2.6%.

Another example is that if the retiree decide to retire in 1922, he or she could start with a 124,000 pounds a year spending instead. That is like 12.4%.

With this table you can see in the past 106 years which are the tough periods in the UK.

Abraham’s point is that in the worst year, which is the 30-year starting in 1948, the highest safe rate that you can spend is closer to 25,000 a year or 2.5%.

The past 106 years in the UK contains periods of Negative Interest Rates

The important point is that, during this 106 years, there were already many periods of negative interest rates.

This is not new.

Abraham layered the US and UK government bond yields out.

This chart is a gem because… if you tried looking for these yield data and you could not find it, it means this is just that valuable.

There are a lot of periods of negative yields and you realize that they occured during the World War 1 and Spanish flu period, the World War 2 period, the 1970s oil embargo high-inflation period, the European crisis after the GFC.

The 2.5% safe rate factored in these periods of negative bond yields, but also the periods where bond yields hit 45% a year in 1922.

Abraham also published some of the worst calendar year real returns for UK bonds in history:

We can be worried about negative bond returns, but UK have like 100 years of history and they have had some really challenging years of negative bond yields.

This is not something new.

Summary

My suspect is that many still don’t understand how withdrawal rate study really work and the significance of its study.

Morgan Housel mentioned that we learn the wrong things from history. The lesson may not be “don’t buy internet stocks”, or “don’t buy Tulip bulbs”.

The lesson here to me is that in the body of history that we have, there were many adversities such as wars, high inflation, negative bond yields, low returns. These are not new.

The link to the safe withdrawal rate is that, it is a historical study that factors in all these evidence of history.

With that, hopefully, you understand what does that 2.5% withdrawal rate signifies.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

  1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
  2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
  3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
  4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
  5. Free Stock Portfolio Tracking Google Sheets that many love
  6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
  7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works

The Safe Retirement Spending Rate can be as high as 5% in Today’s Low-Inflation Environment: Bill Bengen

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A good rule-of-thumb to estimate whether you have accumulate enough to retire or not is based on a magical 4% Safe Withdrawal Rate.

This percentage was first came out based on the research of Bill Bengen in the 1990s. Back then, he became a financial planner not too long ago and his client have a problem of figuring out

  1. How much they need to accumulate so that they can retire?
  2. How much they can spend monthly or yearly so that they would not run out of money?
  3. How to structure their portfolio?

His research was borne out of necessity but it became a rule of thumb that many in the Financial Independence Early Retirement (FIRE) space use to determine how much they need to build up towards.

This week, there were two good interviews on this subject.

Bill Bengen, now having sold off his financial planning practice, happily retired, spoke to Michael Kitces on his podcast. Karsten from the great blog Early Retirement Now spoke to Morningstar’s The Long View.

If you are someone who is accumulating towards FIRE, or financial independence, or retirement, you can gain good insights from these two interviews.

I treat these interview as a quick way to gain concise thoughts from thought leaders who have done either a lot of research, or are very experience practioners.

While they cannot go too in-depth as compared to their writings, you can hear certain important things that they emphasize on that would have been lost in the many articles they have written over the years.

Some interesting points I gathered:

  1. Bengen held the view that in today’s low-inflation environment, we might be able to withdraw as high as a 5% initial withdrawal rate and things would be OK
  2. Both Karsten and Bengen highlight the strong correlation between market valuation and what is a safe initial withdrawal rate to withdraw
  3. Bengen highlighted that you could withdraw more if you have pension sources
  4. Bengen is quite an active manager for his client’s portfolio
  5. Karsten specifically talks about what made portfolios fail to last long in negative sequences
  6. While he is an advocate of a diversified, index portfolio, Karsten also dabbles in uncorrelated investments such as private equity real estate and options writing

Here are my notes from the two interview, with time stamp. Let me know your takeaway.

Listen to the podcast Karsten Jeske: Cracking the Code on Retirement Spending Rates here on Player.FM.

  • 2:30: “We cannot diversify our career as much as our portfolio.”
  • 3:40: There are people taking a slower approach to FIRE but Karsten also have friends that like their normal lives but now are reaching out to find out more about this FIRE movement
  • 6:20: There is some truth that 4% Safe Withdrawal Rate is too optimistic
  • 8:10: At the same time, the withdrawal rate study factors in some seriously poor sequence such as 1929 and 1960s. If you reduce your withdrawal slightly from 4% to 3.2%, things will turn out okay.
  • 9:20: If you have a longer spending period, your initial withdrawal rate needs to be lower. It is just amortization math. But the surprising thing is how little lower you need to move it. It is not like instead of a 30-year retirement, you have a 60-year retirement, you would need to move your initial withdrawal rate from 4% to 2%. It will be around 3-3.3%.
  • 11:20: Using Shiller CAPE or Earnings yield and use market valuation to time the initial withdrawal rate to use. There is a strong correlation that those lowest safe initial withdrawal in history are also periods where market valuations are high
  • 15:15: What if markets stayed overvalued for a prolonged period of time? By withdrawing based on a CAPE earnings yield percentage, if the markets remain overvalued, your portfolio value goes up, the absolute amount also goes up, which means that you could spend more money. It is more flexible compared to a static 4% safe withdrawal rate.
  • 17:10: Is there a concern over low bond yields? Bond yields have been low before in the 1960s (and this is part of the safe withdrawal rate study)
  • 19:30: Why Karsten does not like the Required Minimum Distribution approach. The main reason is that it is very rigid and not a very scientific approach. Nothing in life is as linear. In contrast, the Boglehead’s Variable Percentage Withdrawal (VPW) is a good tweak.
  • 23:30: How to tackle a sequence of return risk for people with long retirements. If you have a longer period, the period of vulnerability to sequence risk also increases. Typically you can wait 10-15 years in a 30-year retirement to know your portfolio is able to survive well. For a 60-year retirement, you have to wait until 45 years later to know you are out of the woods. Some solutions
    • Just be flexible. Jobs and side gigs.
    • Have enough diversification in asset type at the start of your retirement so that it diversifies the volatility at the start of your retirement e.g. short-term cash, bonds. Sequence risk is selling volatile assets at the worst possible time and if you have enough uncorrelated assets that you can sell and get cash flow instead of selling the volatile assets, then it helps.
    • Micheal Kitces’ Bond-tent or Rising Equity Glidepath. Don’t use Target Date Fund. The glide path is so that your equity allocation is at the lowest during the lowest point in the bear market and then you pick it up.
  • 28:00: It may be tough for clients at 80 years old to remain in high equity allocation. Karsten explains that you might want to use the rising equity glide path or take your equity allocation up only if you face a bear market or a negative sequence at the start of your retirement. If not, don’t rely on it so much, just have a normal allocation. Don’t do these blindly.
  • 31:45: Why holding a basket of dividend stocks do not work. When you go high yield, you are being concentrated and you lose traditional high-quality safer bonds. Your dividends don’t hold up forever. Just focus on total return.
  • 35:50: What kind of assets does Karsten recommend as passive assets for retirement. Private equity multifamily real estate. Sell very short-dated S&P 500 put (not passive). His majority would be passive unit trust.
  • 39:00: Tackling US Health Plan and social security
  • 44:00: Having an active network in retirement.

Listen to How The Creator Of The 4 Percent Rule Applied It For His Clients And His Own Retirement with Bill Bengen here on Player. FM.

  • 7:30: Why Bill Bengen choose to be a Fee-Only adviser when it was not fashionable to do it (the 1990s)
  • 19:00: Why did Bengen start researching on the 4% withdrawal rule. No one could answer him the question of how much to save for retirement, how much to spend in retirement.
  • 22:43: How did he get close to the magical 4% number
  • 25:00: People criticizing his 4% rate was too low in a 7% a year balance fund return world. Now people are criticizing his 4% is too high.
  • 27:30: Bengen emphasizes that people need to be aware that the 4% withdrawal rate is a worst-case scenario and you cannot just rely on the worst-case. Given what he knows now, instead of the 4%, he would recommend a 5.25 – 5.50% withdrawal rate today in a low-inflation environment.
  • 29:50: When Bengen introduced small-cap stocks, he realizes the safe withdrawal rate is close to 4.50%
  • 33:30: How Bengen implements 4% with clients. It was ideal for him because they have a massive bull market during that period.
  • 36:10: He wishes that financial planning software can benchmark a client’s current withdrawal rate against some historically poor sequences and warn clients before this.
  • 37:40: Opinions on Monte-Carlo vs 4% withdrawal rate
  • 42:00: Bengen explains how he implemented different withdrawal rates for clients. Start at 4.2%. For some with inheritance, he may start at 5.25%
  • 45:00: Did September 11 affect things? (answer no. The 1960s and 70 sequence was worst)
  • 49:00: What are the reasons for him to retire?
  • 51:00: Bengen got his clients successfully out of the GFC. But he was unsuccessful in getting clients back in.
  • 62:40: How Bengen looks at the 4% rule today and how tactically he will shift his portfolio. Bengen believes that we should look at the relative inflation and market valuation at the time you retire to judge what is a safe initial withdrawal rate for yourself. At this moment we believe is closer to 4.75 to 5%.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

  1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
  2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
  3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
  4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
  5. Free Stock Portfolio Tracking Google Sheets that many love
  6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
  7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works