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Principles of Finance: Unit 2, Practical Examples of Inflation: Part II 4 Views


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In this video, we're going to hit you with some more practical examples of inflation. Everyone get your balloons ready.

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English Language

Transcript

00:00

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

00:07

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

00:13

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

00:17

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

00:23

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

00:27

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

00:32

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

00:37

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

00:41

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

00:46

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

00:53

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

00:58

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

01:02

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

01:07

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

01:12

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]

01:19

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

01:24

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

01:27

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

01:33

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

01:38

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]

01:44

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

01:48

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

01:52

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

01:57

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

02:02

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

02:07

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

02:11

married to a long term bond with low interest rates

02:14

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]

02:18

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

02:23

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

02:27

bonds were trading at a hundred cents on the dollar

02:29

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]

02:35

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

02:39

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

02:43

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

02:48

to sixty cents got it at six hundred bucks for that

02:51

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

02:57

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

03:02

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]

03:08

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

03:12

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

03:16

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

03:21

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

03:24

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

03:30

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

03:35

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

03:40

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

03:46

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

03:51

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

03:56

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

04:00

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

04:03

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

04:06

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]

04:12

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

04:16

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

04:19

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

04:24

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

04:28

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

04:32

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

04:35

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

04:39

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

04:45

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

04:49

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

04:54

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

04:58

happens to Joe Sixpack if quotes safe unquote rates backed by

05:02

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

05:06

yield pays and twelve percent well then Joe pay something like

05:09

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

05:14

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

05:20

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

05:24

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

05:28

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

05:33

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

05:38

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

05:43

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

05:48

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

05:51

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

05:55

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

05:59

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

06:02

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

06:07

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

06:11

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]

06:15

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

06:19

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

06:22

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

06:26

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

06:33

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

06:38

bottom half the country really didn't pay anything

06:40

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

06:44

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

06:48

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

06:52

country goes bankrupt well everything else is considered riskier than that

06:56

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

07:02

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

07:06

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

07:12

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

07:17

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

07:22

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

07:27

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

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