Countdown to Extinction, Part 2: What They're Doing About It and What It Means For Us

From Abtruse Goose

The short term solution to this predicament is for the US to borrow more; the problem is that additional debt would push borrowing beyond the current debt ceiling or limit of US$ 14.3 trillion, and the only workaround is to legislate an increase in the debt ceiling. To improve the US's financial situation in the medium to long term, spending cuts and/or tax increases would also have to be enacted by Congress. Seems straightforward enough, right? So why have these things not been done yet? Two words: partisan politics. The only way a solution could be legislated is if Democrats and Republicans work together and agree on a solution; unfortunately, to this date, the two parties continue to bicker, pontificate, push for their own agendas and refuse to compromise.

As the deadline draws near and an agreement still nowhere in sight, many of us rightfully wonder what this might mean for us, both as investors and ordinary Filipinos. Might as we want to believe that we are immune to the effects of the stupidity of *some* Americans, the 2008 financial crisis has shown us that we are not. I repeat here some of the ways I think we could be affected by a US default that I have already stated in the comments section of the previous post.

• A default would trigger a rating downgrade on US debt, and this will raise interest rates on future borrowings. I've read somewhere that a 1% increase in interest rate will result in an additional US$ 100 billion in interest payments; this additional financial strain could trigger a recession/depression in the US. 
• The US is our number one trading partner; a decline in US demand due to the contraction of their economy will lead to a drop in our exports to the US, and this, in turn, will negatively affect both our general economy and the revenues of specific export-reliant industries and firms. 
• US demand for services in the Philippines will decline and related industries like call centers will also be hit.
• As soon as the phrase "financial crisis" gets out to mainstream media, people will start to panic and take their money out of the stock market, causing a substantial drop in stock prices.

Given these dire possible effects of a US default on our economy, how concerned should we be? Is now the time to panic? The consensus that a US default would lead to disastrous global economic consequences is matched only by the widespread agreement that a US default will not happen and that eventually these stubborn US representatives will realize the folly of their actions and finally act for the interests of their constituents, as they should have done from the very beginning. Everyone is saying that one way or another, the US government will not default on its debt, so there's no real reason to panic. But that doesn't mean that we should not prepare ourselves for what could happen.

Countdown to Extinction, Part 1: Wanna See How Screwed the US's Finances Really Are?

It's hard to imagine how the the biggest economy in the world--and since time immemorial what we Filipinos have considered as the land of promise and endless opportunity--would find itself facing a very real and imminent financial shit fest (for lack of a more suitable term, please pardon my French). For those who don't know yet, the US is broke: broke, not figuratively but for real, broke as in it does not have enough money to pay for stuff it needs. Yes, broke broke. Wait, let me correct that, I'm getting ahead of myself: at least according to Slate, the US will officially run out of money on August 3 (that's one, two... seven days from today, US time), that is unless the US Congress gets its act together by August 2, but that's a story for another post (the last post of July, to be exact). For now, let's just see how screwed up the US financial situation really is with these graphs from the same article from Slate.

First, the state of the US's cash reserves, which shows how money could dry up by August 3.

And finally, a look at the US's debt position, which illustrates a Catch-22-like situation: the US is running out of money to pay its bills and debt obligations, so it needs to borrow more, but the more it borrows, the more money it needs to pay it's existing and new creditors.

All this makes the next few days both scary and exciting for investors like you and I as all eyes are on how the US Congress will handle the situation. And while now is not the time to panic, it is definitely time to act. What we all can do is hedge our bets by cashing in our paper gains now and build up an ample hoard of cash that we can use to take advantage of a buying opportunity if the shit does hit the fan next week.

UPDATE: 7/29/2011, 4:30 PM

Something that will help us better understand how it came to this.

An additional US$ 4.3 trillion in two years brings us up to speed.

Greek Tragedy

I'm sure many of you have heard of how Greece has been in financial trouble recently, especially with today's financial headlines centering on Moody's downgrading of Greece's credit rating by three notches. Ever wondered what all the hullabaloo is about? Here's what, in my opinion, is the best take on the matter out there.

Part 1

Part 2

So, in a nutshell, it's all about how Greece found itself heavily in debt by spending way more than it could earn (on generous retirement benefits and the 2004 Summer Olympic Games in Athens, for example), how it needed to borrow more to service its old debt and finance necessary expenses, how it had to assure lenders that it would be capable of paying off new debt by legislating significant reductions in government expenses (through the so-called "austerity" measures), how the Greek people would fight tooth-and-nail for the quality of life that they had been accustomed to and expected (something that they would have to give up with the passage of the austerity measures), and finally how we again find the usual suspects (e.g., investment banks like Goldman Sachs) and known modus operandi (e.g., credit default swaps) at the heart of the issue, just as we did three years ago.

The austerity measures have since been passed by the Greek legislature, and the Eurozone has since approved a EUR 109 billion bailout plan to save the Greek economy. It remains to be seen if these efforts would be enough to stem the tides of economic malaise that continues to plague Europe and finally give our equity investments some room to breath and grow.

5 Ways This Free Excel Budget Planner Can Help You Manage Your Finances

Disclaimer: I came across this tool several years ago, I can't remember from where or from whom. So WHOEVER you are, thank you.

Budget Planner (download here) is a simple budget planning and expense tracking tool based on Excel. It's easy to use (you don't need to be an Excel expert) and is packed with all the features you'll need to effectively manage your income and spending. It fits our guide for beginner investors perfectly, right where you're supposed to generate enough positive cash flows to pay off your debt and build up your emergency fund.

Here are some of the things you can do with Budget Planner:

1. Create a Quick Budget. Roughly set how much you want to spend every period (e.g., monthly, quarterly, yearly, etc.) and see how much you can save each year if you stick to your budget.

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2. Create a Monthly Budget. This is a more detailed version of the Quick Budget, and is more appropriate if your income and/or expenses vary month by month. The Monthly Budget also lets you identify months when you'll have positive cash flows and months when you'll have cash shortfalls (if any), and plan accordingly.

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3. Track your actual income and expenses. The only way to find out if you successfully meet your budget is if you track how much you actually make and spend.

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4. Compare your actual income and expenses to your budget. Are you able to successfully follow your budget? Do you need to adjust your spending downwards to meet your target savings, or do you have room to spend a bit more? Budget Planner's Comparison feature let's you answer these questions, and more.

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5. Track your daily spending. I understand how recording each and every expense you make could be a tedious exercise, but I suggest that you do this for at least for a month so that you'll have a pretty accurate idea of how much you actually spend on any given month and set a more realistic budget based on that.

Pricing Bonds

In a previous post, we discussed the key characteristics of bonds, one of the two primary investment alternatives available to investors (the other one being equity or stocks). In that post, we discussed the following features:

• Par or face value - the amount paid by the bond issuer (borrower) to the bond holder (lender or investor) on the bond's maturity date, when the bond expires or is redeemed
• Coupon rate - the percentage of the par value that is annually paid by the issuer to the bond holder as interest
• Price - how much a bond sells for
• Yield to maturity - the percentage return an investor would earn every year if he or she holds on to the bond up to maturity

Typically, investors would be interested in periodic price quotations of outstanding bonds in the market since price is the primary indicator of how well an existing investment is doing and how attractive available bonds are for potential investment. Unfortunately, some data sources quote yield to maturity in lieu of price, as what one of our readers, Zeny, discovered browsing the government securities board of the Philippine Dealing and Exchange Corporation (PDEX). Fortunately, all is not lost since we can easily convert yield to maturity to price given the available information.

First, we need to understand the relationship between these bond features by redefining yield to maturity as the discount rate which equates the present value of future cash flows of a bond to its price. A bondholder is entitled to future cash flows in the form of coupon payments and the par value; the price of the bond owned by the bond holder, given the bond's yield to maturity (YTM), is therefore

Price = PV(coupon payments at YTM) + PV(par value at YTM)

Where PV means present value, from the time value of money concept we discussed before.

We can easily compute for the price of a bond using Excel, specifically the "PV" function and the formula for the present value of a single cash flow. To illustrate, let's use the FXTN 25-05 bond quoted on the government securities board of PDEX. We find the following relevant details of the bond on the board:

• Coupon rate = 8.5%
• Years to maturity = 21.38
• Yield to maturity = 8%

Assuming a par value of 100, we use the following Excel expression to compute for the price of the bond

=PV(8%/2,21.38*2,(-8.5%/2)*100)+100/(1+8%/2)^(21.38*2)

and get 105.05. 

A few notes for the Excel formula above

• Dividing the YTM and coupon rate by 2 and multiplying the years to maturity by 2 "semiannualizes" everything, something that we need to do since coupons are paid semiannually
• The negative sign for the coupon payment argument is needed since Excel treats amortization payments as negative cash flows by default. 
• The "PV" portion of the expression gives us the present value of the coupon payments, and the latter part is for the present value of the par value
• Note that since the YTM is less than the coupon rate, the price of the bond is greater than 100, meaning the bond is selling at a premium
• Finally, the following approach does not apply to treasury bills. Unlike bonds, T-bills don't provide coupon payments; investors earn by paying a price that is lower than the par value (discount)

6 Years in the Waiting

I have waited for this for six years... and it had just been delivered to my Kindle a few minutes ago.

I'm sure that many of you are already familiar with the author and his opus, what with the recent success of the HBO series Game of Thrones. I'm also sure that more than few of you who have seen the HBO series have decided to give the books a try, and have already been pleasantly (or unpleasantly) surprised by Martin's continued masterful, savage, and unapologetic treatment of both plot and character. If you haven't seen the TV series nor read the books yet, I suggest that you give either (or better, both) a chance and I promise that you will be immensely rewarded for your time and money. 

Save that last mention of the word "money," you might have already realized that this post has nothing to do with investments or finance. I think we all could use a break from all that, and what better way to take a break than to spend many a sleepless night dancing with dragons. 

Can We Use GDP to Predict the PSEi?

A month ago, one of our avid readers ingeniously tried to perform some sort of fundamental analysis for the market as a whole using the market's total capitalization and GDP. The ensuing discussion led to a promise by yours truly to determine if there is a statistically significant relationship between GDP and the PSEi. Thanks to a timely reminder by another reader (or are you the same one?) a few days ago, here are the results of the promised analysis (pardon the mathematical/technical nature of this post, it couldn't be helped).

Getting the data

Historical PSEi prices are freely available from Yahoo! Finance, while the Philippines' historical macroeconomic data may be downloaded from the website of The World Bank.

Preparing the data

To facilitate the statistical comparison between frequently quoted data (i.e., the PSEi, which is quoted daily, weekly, or monthly) and annual data (i.e., GDP), we would need to annualize the former. One way to do this is to get the annual average of monthly PSEi prices, which, in my opinion, is better than just using end-of-year prices since the average approach smooths out price fluctuations within the year; of course, the downside of any attempt to annualize the PSEi data is significant loss of detail, an issue that cannot be avoided, however.

For the purpose of our analysis, I have decided to use both GDP and per capita GDP in constant US dollars (which is the same as "in current pesos"). Finally, I also computed for the annual growth in GDP, per capita GDP, and average PSEi for an alternative approach in the analysis. You may download the data set and the results of the analysis by clicking this link.

Processing the data

Plotting the data series across time, we see a general  increasing trend in all series from 2000 to 2009. To determine if the relationship between the series (GDP vs. PSEi, PCGDP vs. PSEi) are statistically significant, we would have to perform simple regression analysis, a statistical analysis tool that is available in Excel (by installing the Data Analysis toolpack).

Analysis results

Let's start with GDP vs. PSEi: how strongly is GDP correlated with PSEi, if at all? The regression analysis output from Excel is shown below.

If you recall your college statistics, these highlighted values are the ones that matter the most in regression analysis.  A high "R Square" or coefficient of determination, like what we have here, tells us that we have a "good" model, or that there is a strong relationship between our independent variable (i.e., GDP) and the dependent variable (i.e., PSEi). Another indication of the strength of the relationship between GDP and PSEi is the low p-value of the coefficient of GDP in our model; specifically, the results of our analysis tell us that the coefficient of GDP is significant at the 0.01 level of significance (which means that there's a 99% chance that we are right).

The analysis results of our other models are also significant, as shown below, although less so for the relationship between GDP growth and PSEi growth.

Using the results and limitations of the analysis

So, can we use GDP to predict the PSEi? Even if the results of our analysis seem to indicate that we can, I would not recommend it.Our analysis suffer from very important limitations that limit the usefulness of the results: first, having a limited number of observations casts doubt on the persistence of the observed trends; second, our findings are limited to how the stock market could behave on average in a span of one year and so do not capture daily, weekly, or even monthly fluctuations in the market, which renders the results irrelevant for short term plays. What good is it to have "good" results and models, then, if we cannot even apply them to real world decision making? Well, even with its limitations, our analysis is not completely useless. At the very least, the results tell us that if the economy is expected to grow the following year, then the stock market, as represented by the PSEi, is likely to follow suit. Also, these findings are a sign that long-term trends in the stock market have some fundamental basis, and that investors may be rational in the sense that they drive prices up (or down, as the case may be) when there is valid reason to do so.