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The money movement strategy works if one uses it appropriately (1)
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In “More Wealth Without Risk”, Charles Givens proposed a money movement strategy based on the prime rate. If the prime rate is below a critical value (PR_c), put the money into the stock funds; if the prime rate is reaching or above PR_c, put the money into the money market or bond funds.

The economic (or physical) reason for such a strategy is as follows: business needs to borrow money from banks or investors in order to operate and to make money. To look the problem from the interest rate viewpoint, to operate efficiently, all companies make money by taking the profit margins between the money they get after selling their products as income and the money they have to pay to their workers and banks as expense.

The amount of the money a company pays to its bank is closely tied to the interest rate. In other words, generally speaking, company’s profit margin is closely tied to the interest rate of the loans the company receives from the bank. The more interest a company has to pay to the bank due to its higher interest rate, the less profit margin the company will have.

There are all kinds of different interest rates for different types of loans. However, almost all those interest rates are related to, either explicitly or implicitly, to the prime rate. Though there is a technical definition on the prime rate that one can find it easily, the important thing about prime rate is that it does not fluctuate at a short term such as daily or weekly basis.

To this point, one should have been convinced that:

When the prime rate is low, business makes big money and grows. When the prime rate is high, business losses money and dies.

People put their money into companies’ stocks to make money. If companies cannot make money it makes no sense for people to invest money into those companies. When more people want to take the money out of companies’ stocks, i.e., to sell the stocks, the values of those stocks drop. Therefore, we can also say:

“When the prime rate is low, stocks will grow. When the prime rate is high, stocks will die.”

But what is the value of PR_c? What should one do when the prime rate is near PR_c?

Well, ........ (to be continued)

The money movement strategy works if one uses it appropriately (2)
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Well, before suggesting an appropriate value for PR_c, it is important to say a few words about bond funds. If the prime rate is above PR_c, one should put the money into the money market or bond funds, but which one, the money market or the bond funds?

Money market funds are very similar to the bank saving accounts that are safe but with very little return. Their main function in financial investment is to provide a safe heaven for one’s money when one is somewhat quite sure that both the stock funds and bond funds are risky and they most likely are in downturn for a seeable period.

Why will the bond funds go down? Government or cooperation issues bonds at fixed terms and interest rates. People hold the bonds and collect the interests until the maturity dates of those bonds and then get the principles back. It sounds that the bond funds are safe too.

It is safe only if one holds the bonds until their maturity dates, say after 3 years, 5 years, or 30 years. But we are not planning to do so. We are going to take the money out of the bond funds and put it back to the stock funds when the prime rate is below PR_c again later. Other people are doing similar things. In other words, hardly anyone would hold the bonds from the beginning all the way to the maturity dates.

People trade the bonds. People buy and sell the bonds all the time for all kinds of reasons. When people are planning to buy bonds they have two options. They can either buy directly from the government or cooperation based on the interest rate that is available at the time or buy indirectly from others who want to sell their bonds at the time.

If the future interest rate is expected to go up, people who are planning to buy bonds would wait a little while to buy bonds from government or cooperation later in hoping to get a better deal. Under such a circumstance, to attract buyers, people who like to sell their bonds right away would provide a discount to their bonds, i.e., they will sell their bonds at the prices less than the face/principle values of the bonds. To the buyers who bought the bonds at the discount prices, the price discount compensates their loses of buying bonds with the lower interest rates than if they waited for a little while to get the higher rate bonds. It is noted that the value of a stock, a bond, a house, a bicycle, or anything is realized only when that thing is traded, i.e., when that thing is changed the hands of its ownership. Therefore, the end/net result of all this bond stuff is that the value of that traded bond has been reduced.

Therefore, if the future interest rate is expected to go up, the value of the bond funds will go down. Likewise, if the future interest rate is expected to go down, the value of the bond funds will go up.

Now, after the prime rate reaches and passes PR_c, it may continue to increase to reach its maximum value (PR_mx). It then starts decreasing and comes back to PR_c and passes it.

It should be very clear now that within the period between PR_c and PR_mx when the prime rate is still increasing, one should put the money into the money market. When the prime rate reaches PR_mx and starts decreasing, i.e., within the period between PR_mx and PR_c, one should put the money into the bond funds.

(to be continued)

The money movement strategy works if one uses it appropriately (3)
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One may ask an interesting question while reading the above explanations about the prime rate:

“When the prime rate is low, business makes big money and grows. When the prime rate is high, business losses money and dies.”

Then, why do we or the banks or why does the government have to raise the prime rate? Is that great to let the business continuously make money, let the economy uninterruptedly grow, and let people’s lives steadily improve?

Well, the resources are limited! The resources in a broad sense are limited. If the economy grows much faster than the general resources can afford, it will lead to an inflation, that is, things in general will get much more expensive in a relatively shorter time period. Under such a circumstance, the additional money the business and the workers are making as a result of the quick growth of the overheated economy can barely catch up with the inflation. Such a cancellation of making more money with a bigger inflation, i.e., big increase in general price, will not lead to a net improvement of people’s lives. The situation may get worse because the price of the general product usually increases with time, either at a slow rate or at a fast rate, but not decreases with time. If someday, the economy is cooled, the business growth is slowed or becomes negative, and people are making less money, the raised general price usually will not go back to the old ones. As a result, people will feel a much worse living condition for the adjustment from good to bad is always much harder to accept than from bad to good. Of course, inflation also erodes people’s savings because the money was saved at the time when the general price was low.

So the government controls the growth of the economy to confine the inflation by controlling/raising the interest rate.

What if the resources are unlimited? Ha! Then, the economy can grow at a fast rate in a very long, long time period without or with little harmful inflation. This is the situation of the so-called emerging market to some small countries and/or developing countries. Within certain time period, the economy of a developing country is so small that it has no or little effect on the economy of the big, reservoir countries from which they get their (relatively unlimited) resources and also sell their products to. In this situation, there are two issues one has to worry and watch: (1) the currency exchange rate because the condition of unlimited resources is closely tied to the dominant form of the export-import economy and (2) the interest rates of the reservoir countries because investors like to make money and to make money only. Without government interferences, the currency exchange rate will be determined by the capital flow toward and from those small/developing countries. Also, if the interest rates in the reservoir countries get very high, the international investors will pull their money out of everywhere including the emerging markets and put it into the bond funds of the reservoir countries that have the high interest rates/yields to have a high return. The return will get even (much) higher if the interest rates later drop again, as I explained in the previous post. Therefore, it is not coincidental that several economic crises, i.e., market crashes, in emerging markets all occurred when the prime rate in USA was high.

In conclusion, increase of prime rate is for the purpose of confining the inflation. It may also have a side effect on the economy of emerging markets.

Ok, I have described enough the importance of prime rate and PR_c. Now, let me tell you the value for PR_c that I think, based on the current economic environment, is reasonable ………

(to be continued)

If I purchase textbooks here, I'd be broke! That is called Lose Wealth Without Risk:(

Stargazer, are you implying that you are currently at an oversea university? That is very good! I know that textbooks or professional books in general are expensive oversea because the copyright laws are more strictly implemented than in China and the living standard is also much higher. When I was a graduate student, I photocopied some parts of the secondary textbooks to save money but I still purchased the primarily textbooks for the reasons of easy to read, carry, make notes, etc.. Believe it or not, I personally believe that the productivity of study is much higher if one studies with a well printed and bonded textbook than with some loosely bonded papers.........

Good luck to you!

I photocopied some parts of the secondary textbooks to save money but I still purchased the primarily textbooks for the reasons of easy to read, carry, make notes, etc.. ----- nod, nod, nod...

Thank you, that sounds like a good idea. :)

The money movement strategy works if one uses it appropriately (4)
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Reading to this point, an intelligent reader may have already guessed correctly what was the PR_c I was trying to suggest. The current value of the prime rate is 8.25%, which was realized about two months ago on June 29, 2006. The title of this writing is “The money movement strategy works if one uses it appropriately” and the key for the strategy to work is to correctly identify PR_c. Therefore, an intelligent reader may easily conclude that the guy should have identified PR_c of 8.00% or 8.25% to make a big move and have made tons of money this time [say, enough to buy quite a few expensive textbooks :)] to reveal the secret.

The USA prime rate has been steadily increasing in the last two years from 4.00% to the current value of 8.25%. In “More Wealth Without Risk”, Charles Givens, based on the historical data, suggested PR_c to be 9.00% at the time (1991) and also indicated that PR_c may vary with time. Note that the value of PR_c is determined by the profit margin averaged over all or most of the business in USA. Therefore, it should not change dramatically though the profit margins of individual business may vary greatly. Furthermore, the globalization of the world economy enhances the competition, especially the competition from the developing countries, which should lead to a decrease in its value of PR_c. Therefore, I believe the most likelihood value of PR_c under the current economic condition should be 8.00% or 8.25%.

It is always more exciting to put a newly discovered idea or theory into practicing than to hypothetically thinking or talking about it. Therefore, I started slowly moving my investments that were almost all in stock funds into the money market and bond funds after the prime rate reached 8.00%. On the day of June 29 when PR_c became 8.25% I sold the rest of my stock funds and my position on June 29 was that 2/3 of my investments were in the money market funds and the rest 1/3 was in the bond funds. I had no money in any stock funds right after June 29.

According to Charles Givens’ theory, I was supposed to put everything into the money market funds when the prime rate just reached or passed PR_c. Why did I put 1/3 into the bond funds? The physical reason of my action is as follows: the discussion in Charles Givens’ book and also in my previous post implicitly assumed that (PR_mx – PR_c) was approximately equal to (PR_c – PR_mn), where PR_mn is the minimum prime rate within a cycle, i.e., 4.00% in the current situatioin. But what if PR_mx is only slightly greater than PR_c or is approximately equal to PR_c? What if it takes very long time to slowly reach RP_mx from PR_c? The current money market funds give an annual return of about 3% but the bond funds with the fixed prime rate should give on average an annual return of about PR_c or about 10%. So, briefly, the reason that I put 1/3 of my investments into bond funds is that I do not know what the value of PR_mx is and when it will be reached.

Once the prime rate reaches, passes or is hovering around its critical value of PR_c, one would expect that the stock funds will be down by about, say, 5% to 10% within the following six months to one year, or the stock funds will be hovering around the values when PR_c was reached. However, we had some unusual bad news of the war between Israel and Lebanon and the related oil crisis. The stock funds dropped by about 8% within three weeks, a significant short-term correction. Of course, I was still confident that the overall stock funds should be down by about 5% to 10% within six months to one year. Since the correction was realized within three weeks and the fundamental character of the stock market is that it fluctuates, therefore, the market would not quietly stay low by 8% for the rest 5 months to one year. So I put all my money from the money market funds, i.e., 2/3 of my total investments back into the stock funds only about three weeks since I pulled out, half into the growth funds that were down significantly and the other half into the international funds that also dropped due to the war and oil crisis. The market rebounded and recovered the most of its correction in the last month and I partially came back to my original/planned position at the end of the last week. It should be obvious that the reason that I did not move those bond funds also into the stock funds at the time was that I was not sure at the time whether the short-term correction was only 8% or it could be 20%.

My current position: 1/3 in bond funds, 1/3 in money market funds, 1/3 in international stock funds.

The biggest gain this time for me was that I COMPLETELY escaped the correction happened about two months ago. One may argue that it was mostly due to the accidental event of the war but I still believe that the high interest rate played a significant role. Though the prime rate has been remaining the same since June 29, 2006 the bond funds, for which I have been holding 1/3 of my investment, have since been up by about 5% because people EXPECTED that the interest rate may not go up that much or that soon. The 2/3 that were re-invested into the stock funds made on average 8% return within about one month. The US part was cashed in last week when the money was moved back to the money market funds.

(End)