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principles of finance a la shmoop practical examples of inflation part 2

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all right well remember our punch-drunk friend inflation well he's back [Two people fighting in the UFC]

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yeah we're investors in the stock market in one form that is we only own one [People wearing suits appear]

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thing its ticker SPY which is a huge ETF which basically tracks the

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performance of the S&P 500 it pays a three percent dividend which is a

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mash-up amalgamation of all of the dividends of the stocks contained in the [List of all the stocks in the S&P 500]

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SP 500 some pay no dividend others pay huge dividends like six seven eight [High dividend paying stocks are highlighted]

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percent you know that historically the market goes up in eight or nine percent

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a year over long periods of time and these investments are long-term in [S&P 500 chart showing price going up over time]

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horizon so you expect 8% minus the 3 percent dividend to produce about 5% a

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year growth of the actual value of ticker SPY well the market trades at

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about 20 times earnings a pretty high multiple on its own by historical

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standards but at 20 times investors are getting a quote 5 percent yield unquote [Long term return points written on a whiteboard]

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on earnings that is if a company will earn $1 a share investors are paying $20

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a share for it hmm interesting that's a 5% earnings yield plus the 3% [Company holds up 1 dollar and an investor holds up 20 dollars]

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yield from dividends they add up to 8% magic well all the sudden some old white

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guy in a suit in front of the mic at the White House [Guy with a beard stood at a podium]

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stands there and announces that frozen concentrated orange juice is now $4 a

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case instead of 3 and that milk prices are skyrocketing and that inflation is

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suddenly a big fat deal and that the new president doesn't want to see old ladies [Woman with all her belongings next to her car]

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living in their Lexuses because they bought bonds in their retirement funds

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and had never taken this course immediately the bond market reacts it [Newspaper article about inflation]

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predicts that inflation will grow fast from its current 2 to 3% levels

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- well pundits talking about 5 to 6 percent meaning inflation is about to

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hit in a really big way well guess what long-term bond prices collapse why long [The newspaper article is punched away by inflation]

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term because inflation is something that goes on and on and on and if you're [Gravestone for long term bond prices]

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married to a long term bond with low interest rates

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predicted that rates will go up a lot in the future and the value of your current [Guy speaking next to a presentation about bonds collapsing]

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low yielding bonds is worth a lot less a given bond used to have to yield 6% to

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clear the market or get bought given its duration and risk well those

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bonds were trading at a hundred cents on the dollar

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got it yielding 6% but now that same bond must pay 10% to clear the market or [The 6% on the bond certificate is crossed out]

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get bought or that's its market price the piece of paper bond investors are [10% is written on the bond]

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holding however only pays sixty dollars a year for the thousand dollars invested [Woman holding up 60 dollars looks sad]

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so that bonds market price now has to drop from a hundred cents on the dollar

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to sixty cents got it at six hundred bucks for that

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piece of paper which pays $60 a year the bonds now yields the 10 percent it has

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to yield to reflect these new market conditions so what is the stock market [The changes in bond price are written onto the whiteboard]

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do well we're clearly in a booming economy for inflation to be hitting us [Guy in a suit is punched in the face by inflation]

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so hard but it's clear that the federal government wants to cool things off and [Government building on fire]

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they have some real tools in their pocketbook to do so they also have some [Firefighter arrives with a hose]

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financial tools to cool off the economy so the market adjusts what are those

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tools well remember the Fed that can raise rates but here we go

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if bond rates are going up and investors can get guaranteed returns of 5% on very

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safe things like backed by the US government and corporate bonds return 8% [Whiteboard listing other securities]

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like semi risky corporations and high-yield ie riskier bonds from risky

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corporations return 10 11 12 % well why would investors cling to their stocks [Woman holding onto her stocks]

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they won't they'll sell them down to a given level where they yield plus the

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growth prospects corrects to reflect these new market conditions like if you [Woman trades some of her stock for cash]

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get guaranteed rates from bonds of a certain level of appreciation you've got

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to get a whole lot more that from equities to warrant the risk you're

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taking right so think about it a different way the price to earnings

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ratio of the market will fall and the dividend yield of that S&P 500 will go [Arrows showing P&E ratio falling and yields increasing]

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up because the dividends don't change nearly as fast as the market prices do

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right corporations aren't suddenly cutting their dividends because there's [Dividends being cut with a corporation saw]

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inflation so numerically think about it like instead of 20 times earnings the

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market might fall to being only 16 times earnings and its yield

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all else being equal well dividend yield go from about three percent to about

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four percent is twenty five percent ish correction and it's about where

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they go so it's 16 times earnings investors are getting an earnings yield

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of 1/16 or 6.25% investors are now getting up four percent cash dividend [Yield calculations are shown on a whiteboard]

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plus the earnings yield to total ten point two five percent compared with the

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eight percent before that inflation crisis yep the market just got a little

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cheaper thank you fed well when interest rates go really high think about what [Joe Sixpack clinging to his beer]

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happens to Joe Sixpack if quotes safe unquote rates backed by

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the US government are four percent corporate bonds pay six percent and high

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yield pays and twelve percent well then Joe pay something like

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eighteen percent interest on his credit cards and remember that Joe carries a [Joe holding his credit card that says debtor's balance]

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debtor's balance all the time on his credit cards because he likes beer now [Joe in the liquor store]

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if safe bonds go up a lot like eight percent ten percent well then everything

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else moves in lockstep as well and Joe wakes up with thirty percent interest on

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his credit cards and while this change is probably good for his waistline it [Liquor store goes out of business]

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destroys the economy in a way that is such high rent prices of money make a [Joe looks upset]

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lot of people who had adjustable rate mortgages go up or have to evacuate

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their homes because well they never imagined that interest rates would go so [Couple looks upset as their house starts to flood]

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high and you're like well then why did you buy an adjustable rate mortgage

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why'd you take all that risk yeah they really didn't know consumers plead [The couple are washed away]

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ignorance all the time at six percent they could afford their mortgage but at

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ten percent no not so much well this situation creates an even

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wider spread between the haves and the have-nots the wealthy have investments [Gate with a sign that says 'poor wet people keep out]

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like stocks and bonds and homes and custom fish tanks which they can use as

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collateral to get low-interest loans if they want them or they can just spend [Guy cashing in his fish tank at a pawn shop]

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less which they would likely do and many of the wealthy don't have mortgages they [Guy holding a big pile of money]

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just pay cash for everything so how did all this start where is the foundation

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of interest rates well in the modern economy everything starts at whatever is

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at the time perceived as quote most safe and today that most safe thing is the US

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government's ability to tax its upper half of taxpayers because remember the [Taxed stamp on the upper bracket]

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bottom half the country really didn't pay anything

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taxes the bet that borrowers are making is that the upper half will continue to [Someone betting chips in a card game]

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work hard and pay their taxes and not Greece like you know where they all [Someone putting bundles of cash on the table]

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leave the country or just become very corrupt and nobody pays any taxes in the [Taxes vanish in Greece]

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country goes bankrupt well everything else is considered riskier than that

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base case US government backed bonds situation so a risk premium is stacked [Least risky stamp on government bonds]

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on top of it whenever other debt or investment opportunities are considered

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for a well positioned large corporation rates are a bit higher but only maybe by [Stack of cash outside 'Large Co.']

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a percent or two then as you get into the less well-positioned riskier players [Risk Co. floating on the sea]

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obviously the risk premium gets higher and you build a stack of premiums added [Stacks of money labelled premiums]

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on to the base rate foundation of the most safe fed and let's hope Uncle Sam

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continues to be most safe [Uncle Sam wearing boxing gloves]

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