# The Magic of Compound Interest

There was the King who held a chess tournament among the peasants and asked the winner what he wanted as his prize. The peasant, in apparent humility, asked only that a single kernel of wheat be placed for him on the first square of his chessboard, two kernels on the second, four on the third – and so forth. The King fell for it and had to import grain from Argentina for the next 700 years. Eighteen and a half trillion kernels, or enough, if each kernel is a quarter-inch long, to stretch to the sun and back 391,320 times. That was nothing more than one kernel’s compounding at 100% per square for 64 squares.

… The Money Angles, by Andrew Tobias

When compound interest works in your favor, it is a blessing. When it works against you, it’s a curse! That is a “Jeffreism” I learned the hard way back in the bear market of the early 1970s when I was working for a \$100 per week in this business and consequently had my credit cards levered to the “max.” The interest rate at the time was 18%. Now consider this from the same Money Angles book:

Say you borrowed \$1000 from a friend and paid it back at the rate of \$100 a month for a year. What rate of interest would that be? A lot of bright people will answer 20%. After all, you borrow \$1,000 and pay back \$1,200, so what else could it be? FORTY percent? No, MORE! If you’d had use of the full \$1,000 for a year, then \$200 would, indeed, have constituted 20% interest. But you had full use of it for only the first month, at the end of which you began paying it back. By the end of the 10thmonth, far from having use of the \$1,000, you no longer had the use of ANY money. So you were paying \$200 in the last 2 months of the year for the right to have used an average of \$550 for each of the first 10. That comes to a bit more than 41.25% effective rate of interest. (Trust me).”

I was reminded of Mr. Tobias’ musings from 1989 as I read various newspapers over the weekend that were talking about sequestration and our nation’s gross debt of \$16.6 trillion (see the debt clock here: (http://www.usdebtclock.org). In a rising interest rate environment, with the government linking much of its debt to the short-end of the interest rate spectrum, this is not a pretty picture; and yes, Virginia, interest rates are rising. To wit, the yield on the 10-year Treasury has risen from last July’s yield yelp low of 1.394% to 1.853% currently. While that may not sound like much of a rise, in percentage terms it is a 33% increase. Of course Wall Street is replete with gurus saying the Fed’s zero interest rate policy (ZIRP) will be maintained until at least 2015, but I am not so sure the bond market vigilantes are not already at work. Indeed, when the cost of money (aka, interest rates) is dictated by the Federal Reserve it is a better idea to look at the underlying measures of the funding cost. As the good folks at the GaveKal organization write:

“The best proxy I know for the true cost of money is the Wicksell long run equilibrium rate, which is linked to the economy’s structural growth rate. This non-manipulated measure can be calculated using the 7-year moving average of US nominal GDP growth. And when the Wicksell rate is compared to the current yield offered by BAA credits, the spread on offer shrinks to about two percentage points—a threshold, which dating back to the early 1960s, has offered a clear sell signal (see chart on page 3).”

To be sure, when compound interest works in your favor, it is a blessing. When it works against you, it’s a curse! Yet despite the Wicksell model’s “sell signal,” and my sense that the yield “lows” were made last July, it is doubtful rates are going to skyrocket in the short to intermediate term because given the nation’s debt any severe rate ratchet would be onerous to the government’s balance sheet. As Stan Druckenmiller noted on CNBC , “If you normalize interest rates to where they were before quantitative easing (QE), and use a 5.7% funding cost for this debt, that’s \$500 billion a year in increased interest expense. Because of this the central bank can’t raise rates; it has to keep printing money.”

Obviously something has to give. The Democrats believe raising taxes is the answer and the Republicans think cutting spending is the answer. The truth is both sides are right, spending has to be reduced and taxes need to be raised. With the passing of the “fiscal cliff” taxes were indeed raised, but now spending needs to be addressed. However, with politicians unwilling to compromise like they did on the “cliff,” the sequestration process has begun; and the dateline looks like this. March 1 – The Sequester: Large spending cuts are set to begin. About half would be in defense. This is set to subtract 0.7 percentage point from GDP growth this year absent any multiplier effects. However, it’s unclear when the cuts to spending will be made (if they are not postponed again) and exactly what will be cut. March 27 – The Continuing Resolution: Without a real budget (last seen in 2009), federal spending has been authorized through a series of CRs. Most likely, we’ll see another one. May 19 – The Debt Ceiling: Treasury reported that the ceiling was breached on December 31, but (through “extraordinary measures”) the drop dead date was expected to be in the second half of February. There was not enough time for the new Congress to work on a possible budget deal. Lawmakers now have until mid-May to achieve a plan to reduce the deficit over the long term.

As I understand it, the spending cuts, well actually they are not really cuts but simply a reduction in the rate of spending increases, will not actually “bite” until March 27th when the government officially runs out of money unless rescued by another continuing resolution. Yet, I remain steadfast in the belief there will be a solution. One solution would be to place a “cap” on all tax deductions of say 2%. That would mean at a marginal tax rate of 25% a 2% cap would limit deductions/exclusions to 8% of an individual’s adjusted gross income. According to Martin Feldstein, such a cap on tax deductions would reduce the national debt by \$2 trillion over a decade (for more, see the Wall Street Journal’s article dated 2-21-13 here: (http://online.wsj.com/article/SB10001424127887324880504578296920278921676.html).

Consistent with these thoughts, I think you need to be very careful with the fixed income allocation of your portfolio. The three bond mutual funds I favor, where I have spent time with the portfolio managers and think they are positioned for the type of interest rate climate I think is coming, are Putnam International Diversification Fund (PDINX/\$7.89) managed by Bill Kohli, Lord Abbett Bond Debenture Fund (LBNDX/\$8.22) managed by Chris Towle, and the Van Eck Unconstrained Emerging Markets Bond Fund (EMBAX/\$9.75) managed by Eric Fine.

As for the stock market, last Thursday the D-J Industrial Average (INDU/14089.66) came within 15 points of hitting a new all-time high, but failed to accomplish that. Subsequently, in Friday’s verbal strategy comments I stated not only did the Industrials fail to make a new all-time high, but the S&P 500 (SPX/1518.20) likewise failed to make a new reaction high above its February 19, 2013 closing high of 1530.94. Therefore, we should look for the equity markets to flop/chop around with attempts to sell stocks off that don’t gain much downside traction. Such action should allow the SPX, and the INDU, to rebuild their internal energy, leading to an upside breakout due by mid-month. Consistent with that outlook, I remain a buyer of stocks on pullbacks.

The call for this week : Well, it was close, but no cigar, last Thursday as the Industrials got within 15 points of their all-time high of 14164.53 made on October 9, 2007. Given that upside failure, it would not be surprising to see some downside attempts this week that don’t gain much traction. That said, we still have not seen three consecutive Downside Days for the Dow, which is what is required to break the back of the current Buying Stampede. Accordingly, today is session 43 in that upside skein, making this the second longest stampede chronicled in my notes of some 50 years (the longest is 53 sessions). Meanwhile, Raymond James’ 34th Annual Institutional Conference is in full swing here in Orlando. There are more than 300 companies presenting, and nearly 800 portfolio managers in attendance. Given the theme of American energy independence, I will be attending a number of the energy company presentations.