September 19, 2022
Notable:
- Home-flipper Opendoor lost 42% on its resales in August. I thought you knew what you were doing, Chamath!)
- Taiwan experienced a 6.9 earthquake over the weekend. A 7.5 earthquake hit Mexico today. Puerto Rico was completely out of power over the weekend from a hurricane.
- Central bank activity this week: Japan, Sweden, Turkey, Brazil, Indonesia, the Philipines, and of course the 800-lb gorilla, the USA.
- Rising bond yields change the calculus for stocks. Huh?
What it might mean:
Home-flipper Opendoor is a company that flips houses. When house values go up, they make a profit. When house values go down, sadness. Because mortgage rates hit 6%, August was sadness for Opendoor (and Chamath). There may be much more sadness to come.
Earthquakes, tsunamis, and hurricanes! Oh my! It’s not just Putin who’s raising hell, eh? And whether it’s natural or named Putin, disasters have plenty of negative economic effects: supply chain, insurance, commodity prices, etc. Whatever shall we do? We take the Vectorspace brick road to…the Portfolio Protector! See below.
The 800-lb gorilla and the rate increase. The Fed is raising rates this week, and the question is 0.75% or 1.0%? The EXPECTATION (very very important) is 0.75%. However, if the Fed decides to raise by 1.0% (an unpleasant surprise — like when you thought mom was taking you to get ice cream but actually it was to the doctor to get a shot and you wet your pants), the market will need more clean pants.
Bond yields. YES!!! You hear about these all the time, but what are they really? I’m glad you asked! The simplest answer is that a bond is debt, and the most basic bond is for $1,000 of debt. What is a yield? That’s the interest rate — like what you pay on your mortgage or your car loan — and typically a yield payment is made twice a year. Now here’s the tricky part — a bond can CHANGE in value because of what people pay for it, and that makes the yield CHANGE. Let’s see what this means.
You buy a $1,000 bond from Putin with a 5% yield that’s repaid in 10 years. (For the sake of this discussion we’ll use dollars instead of rubles because I bet none of you know the symbol for a ruble. But I know it. Maybe.) Here’s how it works.
Putin owes you a principal amount of $1000.
He pays you $50/year ($25 x 2 per year).
Over 10 years he pays you $500.
At the end he gives you back the original $1000.
Since he paid you $500 and you gave him $1000, your overall return is 50% after 10 years.
However, earlier I said that things can change. Though initially a bond might be worth $1000, people might change what they’re willing to pay for it. That’s because things can happen that make people think Putin might not be able to pay down the bond. Let’s say Ukraine annihilates the Russian army and besieges Moscow and it looks like Putin might end up in the gulag. The value of the bond will totally tank because no one will think that Putin can pay off the bond. What happens if it drops all the way from being worth $1000 to $50, a loss of 95%? (This is what is known as a junk bond because the default risk is so high.) Here’s the thing, the amount of money the bond has to pay out each year DOESN’T CHANGE with the new perceived value of the bond. So, no matter what, the bond pays out $50/year. That means that if you buy the bond when the value is perceived to be only $50 (perception is dependent on context, which is what you come to me for), you’ll be making a yield of 100% because you bought it for $50 and are earning $50 every year (if Putin stays gulag-less.) Therefore:
Putin owes you a principal amount of $1000.
He pays you $50/year ($25 x 2 per year).
Over 10 years he pays you $500.
At the end he gives you back the original $1,000.
Since he paid you $500 interest and $1,000 principal and you gave the previous owner of the bond $50, your overall profit is $500 + $950 = $1450. Since you only paid $50, your overall return is 2900%. Wow!
Of course, it’s possible that Putin and his head go separate ways which means you don’t get paid anything and you lose your entire investment of $50, a 100% loss. (oof) Still, the original bondholder sold it to you for $50 but bought it for $1000, so they took a 95% loss because they lost $950. (really big oof) It’s also possible that Putin’s secret ninja force takes out the Ukraine army and Russia absorbs Ukraine, in which case the bond might become worth MORE than the original $1000.
So what do bond yields have to do with stocks? Bonds and stocks are both investments. Treasury bonds (which we won’t discuss this time to your great disappointment) are seen as being extremely safe. Stocks? Much less so. However, both give a return. Stocks change in value over time — hopefully up — and also pay dividends. Bonds also change in value over time — slowly — and pay a yield. When the Fed raises interest rates, bond yields go up (because a yield is an interest rate). That makes bonds a better investment, so money moves from stocks to bonds. That hurts the stock market. Just one more way that higher rates from the Fed is a negative for [screws] the markets.
tl;dr
Fed rate up. Bond yield up. People sell stocks and buy bonds. Stock market down.
Btw, many other things affect the prices of bonds, but this gives you a very general understanding of how they work. You can also categorize bonds as sovereign bonds, high yield bonds (fancy way of saying junk), investment-grade bonds, convertible bonds, etc., but we’ll ignore all that because I know you’ve fallen asleep and aren’t reading this anymore.
Remember how we said nobody understands The Big Short? Replacing the words “subprime mortgage” with “junk bonds” still doesn’t mean you’ll understand it, but you’ll get a little closer.
This bit down here is a plug. Ignore at your peril. I’m a huge fan of Vectorspace AI. They use AI/ML (everyone says that, right?) to help you make money in the markets (stocks and crypto) and then help manage risk to keep the money. Check it out! Full disclosure, I’m an investor.