Wednesday, July 7, 2010
What Does Recession Mean?
A significant decline in activity across the economy, lasting longer than a few months. It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP); although the National Bureau of Economic Research (NBER) does not necessarily need to see this occur to call a recession.
What is GDP and its importance ?
The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country's economy. It represents the total dollar value of all goods and services produced over a specific time period - you can think of it as the size of the economy. Usually, GDP is expressed as a comparison to the previous quarter or year. For example, if the year-to-year GDP is up 3%, this is thought to mean that the economy has grown by 3% over the last year.
Measuring GDP is complicated (which is why we leave it to the economists), but at its most basic, the calculation can be done in one of two ways: either by adding up what everyone earned in a year (income approach), or by adding up what everyone spent (expenditure method). Logically, both measures should arrive at roughly the same total.
The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non incorporated firms, and taxes less any subsidies. The expenditure method is the more common approach and is calculated by adding total consumption, investment, government spending and net exports.
As one can imagine, economic production and growth, what GDP represents, has a large impact on nearly everyone within that economy. For example, when the economy is healthy, you will typically see low unemployment and wage increases as businesses demand labor to meet the growing economy. A significant change in GDP, whether up or down, usually has a significant effect on the stock market. It's not hard to understand why: a bad economy usually means lower profits for companies, which in turn means lower stock prices. Investors really worry about negative GDP growth, which is one of the factors economists use to determine whether an economy is in a recession.
Measuring GDP is complicated (which is why we leave it to the economists), but at its most basic, the calculation can be done in one of two ways: either by adding up what everyone earned in a year (income approach), or by adding up what everyone spent (expenditure method). Logically, both measures should arrive at roughly the same total.
The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non incorporated firms, and taxes less any subsidies. The expenditure method is the more common approach and is calculated by adding total consumption, investment, government spending and net exports.
As one can imagine, economic production and growth, what GDP represents, has a large impact on nearly everyone within that economy. For example, when the economy is healthy, you will typically see low unemployment and wage increases as businesses demand labor to meet the growing economy. A significant change in GDP, whether up or down, usually has a significant effect on the stock market. It's not hard to understand why: a bad economy usually means lower profits for companies, which in turn means lower stock prices. Investors really worry about negative GDP growth, which is one of the factors economists use to determine whether an economy is in a recession.
What is Inflation and Deflation ?
Inflation
Inflation is as an increase in the price of bunch of Goods and services that projects the Indian economy. An increase in inflation figures occurs when there is an increase in the average level of prices in Goods and services. Inflation happens when there are less Goods and more buyers, this will result in increase in the price of Goods, since there is more demand and less supply of the goods.
Deflation
Deflation is the continuous decrease in prices of goods and services. Deflation occurs when the inflation rate becomes negative (below zero) and stays there for a longer period
Effects of Deflation
During deflation the price of goods and services is falling and consumers will tend to delay their purchases until prices fall further. This will cause for a lower production, lower wages and demand which will lead to further decrease in prices. This is known as deflationary spiral.
Deflationary Spiral
It is a situation when decrease in the prices leads to lower production, lower wages and demand, which can lead to further decrease in the prices. A deflationary spiral is when decrease in prices lead to a vicious circle (a trouble leads to another that aggravates the first).
Inflation is as an increase in the price of bunch of Goods and services that projects the Indian economy. An increase in inflation figures occurs when there is an increase in the average level of prices in Goods and services. Inflation happens when there are less Goods and more buyers, this will result in increase in the price of Goods, since there is more demand and less supply of the goods.
Deflation
Deflation is the continuous decrease in prices of goods and services. Deflation occurs when the inflation rate becomes negative (below zero) and stays there for a longer period
Effects of Deflation
During deflation the price of goods and services is falling and consumers will tend to delay their purchases until prices fall further. This will cause for a lower production, lower wages and demand which will lead to further decrease in prices. This is known as deflationary spiral.
Deflationary Spiral
It is a situation when decrease in the prices leads to lower production, lower wages and demand, which can lead to further decrease in the prices. A deflationary spiral is when decrease in prices lead to a vicious circle (a trouble leads to another that aggravates the first).
Tuesday, July 6, 2010
What is SLR?
Statutory Liquidity Ratio
refers to the amount that the commercial banks require to maintain in the form of cash, or gold or govt. approved securities before providing credit to the customers.Statutory Liquidity Ratio is determined and maintained by the Reserve Bank of India in order to control the expansion of bank credit.
Statutory Liquidity Ratio or SLR refers to the amount that all banks require maintaining in cash or in the form of Gold or approved securities. Here by approved securities we mean, bond and shares of different companies.
Statutory Liquidity Ratio
is determined as percentage of total demand and percentage of time liabilities. Time Liabilities refer to the liabilities, which the commercial banks are liable to pay to the customers on there anytime demand. The liabilities that the banks are liable to pay within one month's time, due to completion of maturity period, are also considered as time liabilities. The maximum limit of SLR is 40% and minimum limit of SLR is 24%.In India, Reserve Bank of India always determines the percentage of Statutory Liquidity Ratio. There are some statutory requirements for temporarily placing the money in Government Bonds. Following this requirement, Reserve Bank of India fixes the level of Statutory Liquidity Ratio. At present, the minimum limit of Statutory Liquidity Ratio that can be set by the Reserve Bank is 25%.
The main objectives for maintaining the Statutory Liquidity Ratio are the following:
- Statutory Liquidity Ratio is maintained in order to control the expansion of Bank Credit. By changing the level of Statutory Liquidity Ratio, Reserve bank of India can increase or decrease bank credit expansion.
- Statutory Liquidity Ratio in a way ensures the solvency of commercial banks.
- By determining Statutory Liquidity Ratio, Reserve Bank of India, in a way, compels the commercial banks to invest in government securities like government bonds.
If any Indian Bank fails to maintain the required level of Statutory Liquidity Ratio, then it becomes liable to pay penalty to Reserve Bank of India. The defaulter bank pays penal interest at the rate of 3% per annum above the Bank Rate, on the shortfall amount for that particular day. But, according to the Circular, released by the Department of Banking Operations and Development, Reserve Bank of India; if the defaulter bank continues to default on the next working day, then the rate of penal interest can be increased to 5% per annum above the Bank Rate. This restriction is imposed by RBI on banks to make funds available to customers on demand as soon as possible. Gold and Government Securities (or Gilts) are included along with cash because they are highly liquid and safe assets.
The RBI can increase the Statutory Liquidity Ratio to contain inflation, suck liquidity in the market, to tighten the measure to safeguard the customers money. In a growing economy banks would like to invest in stock market, not in Government Securities or Gold as the latter would yield less returns. One more reason is long term Government Securities (or any bond) are sensitive to interest rate changes. But in an emerging economy interest rate change is a common activity.
What is CRR, Repo Rate and Reverse Repo Rate
CRR
Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method (increase of CRR rate), to drain out the excessive money from the banks.
Repo Rate
Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.
Reverse Repo Rate
Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money are in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system.
Due to this fine tuning of RBI using its tools of CRR, Bank Rate, Repo Rate and Reverse Repo rate our banks adjust their lending or investment rates for common man.
Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method (increase of CRR rate), to drain out the excessive money from the banks.
Repo Rate
Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.
Reverse Repo Rate
Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money are in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system.
Due to this fine tuning of RBI using its tools of CRR, Bank Rate, Repo Rate and Reverse Repo rate our banks adjust their lending or investment rates for common man.
Monday, July 5, 2010
Common mistakes in trading
Common mistakes in trading
- Trading for excitement & thrill Not for profits.
Many traders consider stock market as casino and trade for thrill and
fun only. As soon as one has a losing trade, he wants to quickly make back
the lost money. He thinks about the other things he could have done with the
money, regret taking the trade and want to recover as quickly as possible.
This in turn leads to further mistakes. Be patient and wait for the next
high probability opportunity. Don't rush back in.
- Trading with a high ego.
Many individuals who have remained highly successful in other business
ventures have failed miserably in trading game. Because they have a fairly
big ego and thought they couldn't fail. Their egos become their downfall
because they can not except that they would be wrong and refuse to get out
of bad trades. Once again, whoever or wherever has any one come from does
not concern the markets. All the charm, powers of persuasion, number of
degrees & diplomas of business management on the wall or business savvy will
not budge the market when you are wrong.
- Four 4-letter words that will kill you! HOPE--WISH-- FEAR--PRAY
If you ever find yourself doing one or more of the above while in a
trade then you are in big trouble! Markets has own system of moving up &
down. All the hoping, wishing and praying or being fearful in the world is
not going to turn a losing trade into a winning one. When you are wrong just
use a simple 6-letter word to correct the situation-GET OUT!
- Trading with money you can't afford to lose.
One of the greatest obstacles to successful trading is using money
that you really can't afford to lose. Examples of this would be money that
is supposed to be used in any other business, money to be paid for
college/school fee, trading with borrowed money etc. Ultimately what happens
is that when someone knows in the back of their mind that they are risking
the money they can not afford to lose, they trade out of fear and emotion
versus logic and no emotion. If you are in this situation It is highly
recommend that you stop trading until you earn enough to put into an account
that you truly can afford to lose without causing major financial setbacks. - No Trading Plan
If you consider yourself a trader, ask yourself these questions: Do I
have a set of rules that tell me what to buy, when to buy and how much to
buy, not just for the next trade, but for the next 10 trades? Before I enter
a trade, do I know when I will take profits? Do I know when I will get out
if I am wrong? These questions form the first part of a trading strategy.
There simply cannot be any expectation of success if we can't answer these
questions clearly and concisely.
- Spending profits before you make them.
Nothing is more exciting then getting into a trade that blasts off and
puts you into a highly profitable situation. This can cause major problems
however, because this type of trade puts you in a highly euphoric state and
leads to daydreaming about the huge profits still to come. The real problem
occurs as you get caught up in the daydream and expectations. This causes
you to not be prepared to get out as the market reverses and wipes off all
your profits because you have convinced yourself of the eventual outcome and
will deny the reality of the situation. The simple remedy for this is to
know where and how you will take profits once you enter the trade.
- Not Cutting Losses or letting Profits run
One of the most common mistakes made by traders is that they let their
losses grow too large. Nobody likes to take a loss, but failing to take a
small loss early will often result in being forced to take a large loss
later. A great trader is not someone who has never had a loss. Great traders
have made many losses. But what makes them great is their ability to recover
quickly from a string of losses. Every trader needs to develop a method for
getting out of losing trades quickly. Research and learn to apply the best
methods for placing protective stoploss orders. The only way to recover
from many (small) losing trades is to make sure the winning trades are much
larger. After a series of losing trades, it becomes difficult to hold a
winning trade because we fear that it will also turn into a loss. Let your
profitable trades run. Give them room to move and give them time to move.
- Not Sticking to your plans & Changing strategies during market hours
If you find yourself changing your strategy during the day while the
markets are still open, be mindful of the fact that you are likely to be
subject to emotional reactions of fear and greed. With rare exception, the
most prudent thing to do is to plan your trading strategy before the market
opens and then strictly stick to it during trading hours.
- Not knowing how to get out of a losing trade.
It's amazing that most of the traders don't have any clear escape plan
for getting out of a bad trade. Once again they hope, pray wish and
rationalize their position. It must be kept in mind that market does not
care what you think. It does what it does and when you are wrong you are
wrong! The easiest way to keep a bad trade from going really bad is to
determine before you get in, where you will get out.
- Falling in love with a stock (Just Flirt).
Many traders get fascinated by just a stock or two and look for
opportunities to trade in those stocks only ignoring the other profitable
trading opportunities. It is because they have simply fallen in love with a
stock to trade with. Such tendencies can be suicidal as far as trading is
concerned. It may cost any one dearly.
- Trading for excitement & thrill Not for profits.
Many traders consider stock market as casino and trade for thrill and
fun only. As soon as one has a losing trade, he wants to quickly make back
the lost money. He thinks about the other things he could have done with the
money, regret taking the trade and want to recover as quickly as possible.
This in turn leads to further mistakes. Be patient and wait for the next
high probability opportunity. Don't rush back in.
- Trading with a high ego.
Many individuals who have remained highly successful in other business
ventures have failed miserably in trading game. Because they have a fairly
big ego and thought they couldn't fail. Their egos become their downfall
because they can not except that they would be wrong and refuse to get out
of bad trades. Once again, whoever or wherever has any one come from does
not concern the markets. All the charm, powers of persuasion, number of
degrees & diplomas of business management on the wall or business savvy will
not budge the market when you are wrong.
- Four 4-letter words that will kill you! HOPE--WISH-- FEAR--PRAY
If you ever find yourself doing one or more of the above while in a
trade then you are in big trouble! Markets has own system of moving up &
down. All the hoping, wishing and praying or being fearful in the world is
not going to turn a losing trade into a winning one. When you are wrong just
use a simple 6-letter word to correct the situation-GET OUT!
- Trading with money you can't afford to lose.
One of the greatest obstacles to successful trading is using money
that you really can't afford to lose. Examples of this would be money that
is supposed to be used in any other business, money to be paid for
college/school fee, trading with borrowed money etc. Ultimately what happens
is that when someone knows in the back of their mind that they are risking
the money they can not afford to lose, they trade out of fear and emotion
versus logic and no emotion. If you are in this situation It is highly
recommend that you stop trading until you earn enough to put into an account
that you truly can afford to lose without causing major financial setbacks. - No Trading Plan
If you consider yourself a trader, ask yourself these questions: Do I
have a set of rules that tell me what to buy, when to buy and how much to
buy, not just for the next trade, but for the next 10 trades? Before I enter
a trade, do I know when I will take profits? Do I know when I will get out
if I am wrong? These questions form the first part of a trading strategy.
There simply cannot be any expectation of success if we can't answer these
questions clearly and concisely.
- Spending profits before you make them.
Nothing is more exciting then getting into a trade that blasts off and
puts you into a highly profitable situation. This can cause major problems
however, because this type of trade puts you in a highly euphoric state and
leads to daydreaming about the huge profits still to come. The real problem
occurs as you get caught up in the daydream and expectations. This causes
you to not be prepared to get out as the market reverses and wipes off all
your profits because you have convinced yourself of the eventual outcome and
will deny the reality of the situation. The simple remedy for this is to
know where and how you will take profits once you enter the trade.
- Not Cutting Losses or letting Profits run
One of the most common mistakes made by traders is that they let their
losses grow too large. Nobody likes to take a loss, but failing to take a
small loss early will often result in being forced to take a large loss
later. A great trader is not someone who has never had a loss. Great traders
have made many losses. But what makes them great is their ability to recover
quickly from a string of losses. Every trader needs to develop a method for
getting out of losing trades quickly. Research and learn to apply the best
methods for placing protective stoploss orders. The only way to recover
from many (small) losing trades is to make sure the winning trades are much
larger. After a series of losing trades, it becomes difficult to hold a
winning trade because we fear that it will also turn into a loss. Let your
profitable trades run. Give them room to move and give them time to move.
- Not Sticking to your plans & Changing strategies during market hours
If you find yourself changing your strategy during the day while the
markets are still open, be mindful of the fact that you are likely to be
subject to emotional reactions of fear and greed. With rare exception, the
most prudent thing to do is to plan your trading strategy before the market
opens and then strictly stick to it during trading hours.
- Not knowing how to get out of a losing trade.
It's amazing that most of the traders don't have any clear escape plan
for getting out of a bad trade. Once again they hope, pray wish and
rationalize their position. It must be kept in mind that market does not
care what you think. It does what it does and when you are wrong you are
wrong! The easiest way to keep a bad trade from going really bad is to
determine before you get in, where you will get out.
- Falling in love with a stock (Just Flirt).
Many traders get fascinated by just a stock or two and look for
opportunities to trade in those stocks only ignoring the other profitable
trading opportunities. It is because they have simply fallen in love with a
stock to trade with. Such tendencies can be suicidal as far as trading is
concerned. It may cost any one dearly.
Some concepts important to understand
Fundamentals
Economic indicators are valuable and reliable reports assembled by the government, universities, and private-sector businesses. They measure the economic health of the overall economy. Most are monthly reports but some are weekly. Generally, the market as a whole and traders in particular listen very carefully to economic results to determine whether they are "net buyers" or "net sellers" for the day. Whenever a report is released, you need to be aware of the time and the information given. It can dramatically change price direction, depending on how the market interprets it.
There are many different indicators. Below are some of the most common ones used by traders. You must understand that not all indicators are equally important. You must learn about all of them, observe reactions to them, and then form an opinion on which ones help you in your specific style of trading. And to make it even more interesting, their importance changes with time and market perception.
Consumer Price Index (CPI)
The Consumer Price Index is a measurement of the cost of living as determined by the U.S. Bureau of Labor Statistics. The CPI is a widely followed inflation indicator. It compares relative price changes over time for a fixed basket of goods and services used by consumers. The CPI has the potential to overstate inflation because it does not adjust for the substitution of goods and the rapidly changing prices of new technology. Release schedule: monthly, around the 13th at 8:30 a.m. EST.
Producer Price Index (PPI)
The Producer Price Index measures the average change over time of wholesale prices received by domestic producers for their output. This index has several components: commodity, industry sector, and stage of processing. The U.S. Bureau of Labor Statistics produces the PPI. Release schedule: monthly, around the 11th at 8:30 a.m. EST.
Gross Domestic Product (GDP)
The Gross Domestic Product provides the total value of goods and services produced within the borders of the United States. Real GDP is the most comprehensive measure of U.S. economic activity. The change in output is measured in real
terms (inflation has been removed). The U.S. Department of Commerce, Bureau of Economic Analysis releases this information. Release schedule: quarterly, during the third or fourth week of the month following the previous quarter at 8:30 a.m. EST.
M2 Money Supply
This is a measure of the United States' supply of money, including M1 (currency in circulation, demand deposits, non-blank traveller's checks, and other checking deposits) plus money market funds, savings accounts, overnight euro dollars, and time deposits under $100,000. The Board of Governors of the Federal Research System provides this information. Release schedule: weekly and monthly.
Employment Reports
The employment reports are the most timely and broad indicators of economic activity. They provide results for two separate sectors. A household survey generates an unemployment rate and a business survey determines non-farm payrolls, average work week, and average hourly earnings figures. The U.S. Department of Labor, Bureau of Labor Statistics provides these reports. Release schedule: first Friday of the month at 8:30 a.m. EST.
Institute of Supply Management (ISM)
The Institute of Supply Management provides the results of a national survey of purchasing managers that includes data on items such as new orders, production, employment, inventories, prices, import orders, and delivery times. A reading above 50 percent indicates expansion and below 50 percent, contraction. This particular report now contains two sections. The first reports on goods and raw materials and the second reports on the purchases of services. Release schedule: first business day of the month for the prior month at 10:00 a.m. EST.
The following measurement tools will help you evaluate a company and determine the value of its stock.
Price-Earnings Ratio
The price-earnings ratio is the most popular measure. It consists of finding a company in which the price-earnings (P/E) ratio is low when compared to similar companies. To find the price-earnings ratio, divide the stock's current price by its earnings per share:
Price-earnings Ratio = Current Stock Prices/Earnings per Share
Therefore, if a stock is selling for $35 now and its earnings last year were $7.00 per share, the P/E ratio would be 5 ($35 Ö $7.00 = 5). This means that for every $1.00 the stock earns, investors are currently willing to pay $5.00. However, investors also pay for future earnings. If the same $35 stock is expected to earn $9.00 per share next year, then the P/E ratio would be 3.89 ($35 Ö $9.00 = 3.89).
The idea is to find stocks with a significantly lower P/E ratio than other stocks in their sector. The P/E ratio cannot always be calculated if the company suffers a loss or breaks even, as there would be no earnings to compute. Expectations of popular stocks can be so high that they may sell for prices way above the market value.
Cash Flow
Cash flow is an important measure of a business for investors because it is a way of determining a company's ability to pay dividends and more. Generally, cash flow is defined as the net income of a business plus depreciation and the value of other non-cash assets.
Companies must have cash to keep going. They need money to pay for all the goods and services they use, as well as making capital improvements and paying operating costs (wages, raw materials, gas for company cars, electricity, etc.). Companies with a high-level debt have to pay a significant amount in interest to service that debt. If an opportunity suddenly appears, perhaps to buy a strategically located piece of land or another firm that would help the business, cash-poor companies may not have the money to make the deal.
Most important, perhaps, is that during hard times, a company with a cash cushion is likely to have a higher probability of making it through. Companies that have enough cash to survive the down periods are in a good position to make clearheaded judgments and keep their enterprise afloat.
Price-Earnings- to-Growth Ratio
The price-earning- to-growth (PEG) ratio is used to determine a stock's value while taking into account earnings growth. The calculation is as follows:
PEG Ratio = Price/Earnings Ratio
Annual EPS Growth
PEG is a widely used indicator of a stock's potential value. Many consider it to be a stock's potential value. It is favoured over the price-earnings ratio because it also accounts for growth.
Keep in mind that the numbers used are projections so they can be less accurate. Also, there are many variations when using earnings from different time-periods (for example, one year versus five years). Be sure you know the exact definition your source is using.
Beta
Beta is a measure of a stock's relative price volatility to the S&P 500. For example, a beta of 1 indicates that for every one-point move in the S&P 500, the stock would move 1.0. A beta of 1.5 indicates that a one-point move in the S&P 500 would move your stock 1.5.
Book-to-Bill Ratio
The book-to-bill ratio describes the technology industry's demand to supply, or the number of orders on a firm's "book" compared to the number of orders filled.
This ratio measures whether the company has more orders than it can deliver (greater than 1), the same number of orders that it can deliver (equals 1), or fewer orders than it can deliver (below 1). This monthly figure is used frequently for companies in the technology and chip (semiconductor) sector.
Price-to-Book Ratio
The price-to-book ratio is used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value. (Book value is simply assets minus liabilities) .
A lower price-to-book ratio could mean that the stock is undervalued. It could also mean that something is fundamentally wrong with the company. As with most ratios, however, be aware that it varies considerably by industry.
This ratio also gives some idea of whether you are paying too much for the stock, when the amount that would remain if the company went bankrupt immediately is considered. This is also known as the price-equity ratio.
Economic indicators are valuable and reliable reports assembled by the government, universities, and private-sector businesses. They measure the economic health of the overall economy. Most are monthly reports but some are weekly. Generally, the market as a whole and traders in particular listen very carefully to economic results to determine whether they are "net buyers" or "net sellers" for the day. Whenever a report is released, you need to be aware of the time and the information given. It can dramatically change price direction, depending on how the market interprets it.
There are many different indicators. Below are some of the most common ones used by traders. You must understand that not all indicators are equally important. You must learn about all of them, observe reactions to them, and then form an opinion on which ones help you in your specific style of trading. And to make it even more interesting, their importance changes with time and market perception.
Consumer Price Index (CPI)
The Consumer Price Index is a measurement of the cost of living as determined by the U.S. Bureau of Labor Statistics. The CPI is a widely followed inflation indicator. It compares relative price changes over time for a fixed basket of goods and services used by consumers. The CPI has the potential to overstate inflation because it does not adjust for the substitution of goods and the rapidly changing prices of new technology. Release schedule: monthly, around the 13th at 8:30 a.m. EST.
Producer Price Index (PPI)
The Producer Price Index measures the average change over time of wholesale prices received by domestic producers for their output. This index has several components: commodity, industry sector, and stage of processing. The U.S. Bureau of Labor Statistics produces the PPI. Release schedule: monthly, around the 11th at 8:30 a.m. EST.
Gross Domestic Product (GDP)
The Gross Domestic Product provides the total value of goods and services produced within the borders of the United States. Real GDP is the most comprehensive measure of U.S. economic activity. The change in output is measured in real
terms (inflation has been removed). The U.S. Department of Commerce, Bureau of Economic Analysis releases this information. Release schedule: quarterly, during the third or fourth week of the month following the previous quarter at 8:30 a.m. EST.
M2 Money Supply
This is a measure of the United States' supply of money, including M1 (currency in circulation, demand deposits, non-blank traveller's checks, and other checking deposits) plus money market funds, savings accounts, overnight euro dollars, and time deposits under $100,000. The Board of Governors of the Federal Research System provides this information. Release schedule: weekly and monthly.
Employment Reports
The employment reports are the most timely and broad indicators of economic activity. They provide results for two separate sectors. A household survey generates an unemployment rate and a business survey determines non-farm payrolls, average work week, and average hourly earnings figures. The U.S. Department of Labor, Bureau of Labor Statistics provides these reports. Release schedule: first Friday of the month at 8:30 a.m. EST.
Institute of Supply Management (ISM)
The Institute of Supply Management provides the results of a national survey of purchasing managers that includes data on items such as new orders, production, employment, inventories, prices, import orders, and delivery times. A reading above 50 percent indicates expansion and below 50 percent, contraction. This particular report now contains two sections. The first reports on goods and raw materials and the second reports on the purchases of services. Release schedule: first business day of the month for the prior month at 10:00 a.m. EST.
The following measurement tools will help you evaluate a company and determine the value of its stock.
Price-Earnings Ratio
The price-earnings ratio is the most popular measure. It consists of finding a company in which the price-earnings (P/E) ratio is low when compared to similar companies. To find the price-earnings ratio, divide the stock's current price by its earnings per share:
Price-earnings Ratio = Current Stock Prices/Earnings per Share
Therefore, if a stock is selling for $35 now and its earnings last year were $7.00 per share, the P/E ratio would be 5 ($35 Ö $7.00 = 5). This means that for every $1.00 the stock earns, investors are currently willing to pay $5.00. However, investors also pay for future earnings. If the same $35 stock is expected to earn $9.00 per share next year, then the P/E ratio would be 3.89 ($35 Ö $9.00 = 3.89).
The idea is to find stocks with a significantly lower P/E ratio than other stocks in their sector. The P/E ratio cannot always be calculated if the company suffers a loss or breaks even, as there would be no earnings to compute. Expectations of popular stocks can be so high that they may sell for prices way above the market value.
Cash Flow
Cash flow is an important measure of a business for investors because it is a way of determining a company's ability to pay dividends and more. Generally, cash flow is defined as the net income of a business plus depreciation and the value of other non-cash assets.
Companies must have cash to keep going. They need money to pay for all the goods and services they use, as well as making capital improvements and paying operating costs (wages, raw materials, gas for company cars, electricity, etc.). Companies with a high-level debt have to pay a significant amount in interest to service that debt. If an opportunity suddenly appears, perhaps to buy a strategically located piece of land or another firm that would help the business, cash-poor companies may not have the money to make the deal.
Most important, perhaps, is that during hard times, a company with a cash cushion is likely to have a higher probability of making it through. Companies that have enough cash to survive the down periods are in a good position to make clearheaded judgments and keep their enterprise afloat.
Price-Earnings- to-Growth Ratio
The price-earning- to-growth (PEG) ratio is used to determine a stock's value while taking into account earnings growth. The calculation is as follows:
PEG Ratio = Price/Earnings Ratio
Annual EPS Growth
PEG is a widely used indicator of a stock's potential value. Many consider it to be a stock's potential value. It is favoured over the price-earnings ratio because it also accounts for growth.
Keep in mind that the numbers used are projections so they can be less accurate. Also, there are many variations when using earnings from different time-periods (for example, one year versus five years). Be sure you know the exact definition your source is using.
Beta
Beta is a measure of a stock's relative price volatility to the S&P 500. For example, a beta of 1 indicates that for every one-point move in the S&P 500, the stock would move 1.0. A beta of 1.5 indicates that a one-point move in the S&P 500 would move your stock 1.5.
Book-to-Bill Ratio
The book-to-bill ratio describes the technology industry's demand to supply, or the number of orders on a firm's "book" compared to the number of orders filled.
This ratio measures whether the company has more orders than it can deliver (greater than 1), the same number of orders that it can deliver (equals 1), or fewer orders than it can deliver (below 1). This monthly figure is used frequently for companies in the technology and chip (semiconductor) sector.
Price-to-Book Ratio
The price-to-book ratio is used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value. (Book value is simply assets minus liabilities) .
A lower price-to-book ratio could mean that the stock is undervalued. It could also mean that something is fundamentally wrong with the company. As with most ratios, however, be aware that it varies considerably by industry.
This ratio also gives some idea of whether you are paying too much for the stock, when the amount that would remain if the company went bankrupt immediately is considered. This is also known as the price-equity ratio.
Sunday, July 4, 2010
Stock Market Basics
Introduction
There are some concepts you must clearly understand in order to learn market timing principles. Many of you can probably just scan this section because it is rather basic. However, please don't skip it altogether because you will miss information that is built upon later in the tutorial.
The Stock Market
The stock market is where shares of stock are traded. A share of stock is an ownership share in a corporation. For example, assume XYZ Inc. has issued 100 shares of stock. If you own one share, you actually own a 1.0% stake in XYZ Inc. Shares of stock issued by large U.S. corporations are publicly traded at stock markets or stock exchanges. The prices of these shares are constantly changing as they are determined solely by supply and demand. Anyone with money can buy shares in these corporations by simply setting up an account with a stock broker and submitting a purchase order. The order is electronically transferred to the stock exchange, where the order is executed.
Stock Market Indexes
A stock market index is a number computed from the prices of a group of stocks. It is computed daily to gauge the movement in the market for that day. Here are some examples:
Dow Jones Industrial Average (DJIA)
The DJIA is computed by adding all the daily stock prices of a group of 30 major U.S. corporations and dividing that total by a number called the divisor; this is called a price-weighed method. This divisor will change whenever one of the 30 companies declares a stock split. A company will split its stock when the price becomes high, making it more affordable. By changing the divisor, the index value is unaffected by stock splits.
The DJIA has two disadvantages as compared to other types of indexes:
The S&P 500 doesn't have the disadvantages of the DJIA. It is made up of 500 stocks. The total market value of each company is computed and summed. A company's market value is simply the share price times the total shares outstanding. The sum of all 500 companies' market values is then divided by a divisor. The result is that each company influences the index based on its total market value rather than its share price. This type of index is a capitalization- based index.
NASDAQ 100
Like the S&P500, the NASDAQ 100 is capitalization- based. It consists of 100 high tech, financial, and other growth companies that are traded on the NASDAQ Stock Exchange.
Stock Mutual Funds
A stock mutual fund is a portfolio of stocks that has been purchased by a fund manager using money that has been invested by many individual investors. At the end of each trading day, the total value of the portfolio is determined and divided by the total number of outstanding shares, resulting in the current share price. All new investments the fund has received prior to that market close (4:00 p.m. EST) are exchanged for shares in the fund using the share price. The fund manager then invests the new investment capital.
For example, assume that before the market close on Thursday, November 10, 1991, you invest $1000 in a mutual fund called XYZ Fund. At the close on this day the fund has the following portfolio:
There are some concepts you must clearly understand in order to learn market timing principles. Many of you can probably just scan this section because it is rather basic. However, please don't skip it altogether because you will miss information that is built upon later in the tutorial.
The Stock Market
The stock market is where shares of stock are traded. A share of stock is an ownership share in a corporation. For example, assume XYZ Inc. has issued 100 shares of stock. If you own one share, you actually own a 1.0% stake in XYZ Inc. Shares of stock issued by large U.S. corporations are publicly traded at stock markets or stock exchanges. The prices of these shares are constantly changing as they are determined solely by supply and demand. Anyone with money can buy shares in these corporations by simply setting up an account with a stock broker and submitting a purchase order. The order is electronically transferred to the stock exchange, where the order is executed.
Stock Market Indexes
A stock market index is a number computed from the prices of a group of stocks. It is computed daily to gauge the movement in the market for that day. Here are some examples:
Dow Jones Industrial Average (DJIA)
The DJIA is computed by adding all the daily stock prices of a group of 30 major U.S. corporations and dividing that total by a number called the divisor; this is called a price-weighed method. This divisor will change whenever one of the 30 companies declares a stock split. A company will split its stock when the price becomes high, making it more affordable. By changing the divisor, the index value is unaffected by stock splits.
The DJIA has two disadvantages as compared to other types of indexes:
- It consists of only 30 stocks
- Higher priced stocks affect the index more than lower priced stocks.
The S&P 500 doesn't have the disadvantages of the DJIA. It is made up of 500 stocks. The total market value of each company is computed and summed. A company's market value is simply the share price times the total shares outstanding. The sum of all 500 companies' market values is then divided by a divisor. The result is that each company influences the index based on its total market value rather than its share price. This type of index is a capitalization- based index.
NASDAQ 100
Like the S&P500, the NASDAQ 100 is capitalization- based. It consists of 100 high tech, financial, and other growth companies that are traded on the NASDAQ Stock Exchange.
Stock Mutual Funds
A stock mutual fund is a portfolio of stocks that has been purchased by a fund manager using money that has been invested by many individual investors. At the end of each trading day, the total value of the portfolio is determined and divided by the total number of outstanding shares, resulting in the current share price. All new investments the fund has received prior to that market close (4:00 p.m. EST) are exchanged for shares in the fund using the share price. The fund manager then invests the new investment capital.
For example, assume that before the market close on Thursday, November 10, 1991, you invest $1000 in a mutual fund called XYZ Fund. At the close on this day the fund has the following portfolio:
At this time the fund has sold 20,000 total shares. This results in a share value of $9.50 per share. Therefore, your $1000 investment will buy 105.263 shares of the fund and there will now be 20,105.263 total shares outstanding. Note that 105.263 new shares were created, but the value of each share is still $9.50 per share ($191,000 / 20,105.263 shares). The next day the fund manager will invest the new $1000 as he so chooses. When you decide to sell your shares, the price per share you will receive is the computed share price at the next market close.
There are some big advantages to investing in mutual funds:
Stock Market Movement
Most stocks move with the market. For example, if the general market is in a downtrend (a bear market), even stocks that are fundamentally excellent values, will trend downward. In fact, aggressive growth mutual funds whose portfolios consist of professionally selected stocks get absolutely devastated in bear markets. Many investors, who are not able to sit by and watch their funds lose 40-50% of their value actually end up selling out at exactly the wrong time. Whether you invest in stocks or funds, it is absolutely necessary to know when to be very conservative about your stock market investments.
Positions
Your position is based on which way you are betting the market will go. We refer to these positions as long, short, and cash.
Long Positions
If you buy stock or mutual fund shares hoping they will increase in value, you have taken a long position.
Short Positions
If you believe the market will fall, you can profit by selling short. This is referred to as a short position. Selling short is selling borrowed shares of stock or shares of a mutual fund, hoping to some day buy them back at a lower price and return them to their owner. For example, assume you borrow 100 shares of XYZ Corp. and sell them for $5 per share. You will receive $500 proceeds from the sale. At some later date, XYZ Corp.'s stock has dropped to $3 per share and you decide to buy the shares and return them to the person you have borrowed them from. This is called short covering. To repurchase the shares you will have to pay $300. Since you received $500 on your short sale, and paid $300 to cover your short, you have gained a $200 profit on the trade. This is a very common transaction. A stockbroker who will charge you a commission handles all of the details.
Cash Positions
If you are not short selling when you believe the market is going to fall, you will simply sell your long position and place the proceeds in an interest bearing account. This is a cash position.
Buying On Margin
If you buy stocks or mutual fund shares from a broker, you can leverage your purchases. That is, you can borrow money from your broker and buy more shares using your cash and the cash you have borrowed. The amount of cash you must provide is governed by the margin requirement that the U.S. Federal Reserve sets. For example, currently the margin requirement is set at 50%. Therefore, whenever you buy stock or funds you can borrow an additional 100% from your broker bringing your maximum invested position to 200% instead of 100%. When you purchase shares on margin, you must pay your broker interest on the borrowed capital.
Mutual Funds can be purchased on margin at most discount brokers such as Jack White & Company.
Beta
Beta is a measure of volatility of a trading vehicle such as a mutual fund. The general market as measured by the S&P 500 is considered to have a beta of 1.0. Stocks or funds that gain more than the general market in bull markets and lose more in bear markets have betas of greater than 1.0. Conservative funds and stocks may also have betas that are less that 1.0. For example, assume you invest your money in an aggressive growth fund that has a beta of 1.5. If the S&P 500 gains 10%, this fund should gain 15% (1.5 X 10%). If the S&P 500 loses 10%, this fund should lose 15%.
Stock and Mutual Fund
Picking Rarely Works. In 1997, most investors believe that the market will always go up with only very minor corrections of less than 10%. This would eliminate the need for timing the market and would make an investors only job deciding which fund or stock will go up the most. Pick up a copy of any high circulation investment magazine. Month after month they have headlines that read, "10 Stocks that will go up..." or "The 5 Best Funds..." The entire investment industry is built on analysis that attempts to reveal the next Microsoft. There are some big problems with this approach:
Time Magazine summed up the dilemma well in their January 15, 1996 issue:
"86% of the most popular mutual funds did worse than the Standard and Poor's 500 index in 1995. This is more proof that the national pastime of picking the winning mutual fund is a wasted effort. Most people would be better off buying the so-called index fund that give them a guaranteed average return."
The only problem with this advice is that an "average return" can be very negative. Bear markets can easily cause SP500 index funds to drop 30-40% in value. Investors cannot emotionally handle riding out losses like these.
Spend Most of Your Time Deciding WHEN to Buy Instead of What to Buy.
Do you really think that the wealthiest and smartest investors in the world are actually buy-and-hold investors? Individuals who have built multi-million dollar fortunes are not big on losing money. Sure, they may ride out losses on venture capital type investments just as a business owner wouldn't sell his business because of temporary losses. But, the majority of their portfolios are protected from bear markets with hedging strategies which is simply market timing.
Your goal should be to incrementally move from a 100% cash position to a margined 200% invested position based on the probability that the market will rise. Until you have a developed a sound strategy for doing this, don't spend time deciding what to invest in. Simply invest in an index fund.
There are some big advantages to investing in mutual funds:
- If you invest in "no-load" funds, there is no commission on your purchase or sales of fund shares. As the fund manager buys and sells shares, the fund is charged commissions, but they are charged at a smaller institutional rate and absorbed by the entire fund.
- Small investments are properly diversified in many different stocks.
- You have a professional manager who is highly skilled at picking individual stocks and managing the fund. In exchange for this management, the fund is charged a fee, usually around 1-2% per year. This is how the mutual fund company makes money.
- You can easily determine how much risk you are taking based on the type of mutual fund you have invested in. For example: aggressive growth funds, will go much higher in rising markets and much lower in falling markets than conservative stock funds.
- With a single phone call, you can transfer money between different types of funds within the Mutual Fund Family. Most families contain aggressive growth stock funds, conservative stock funds, bond funds, money market funds, and many other types of funds.
Stock Market Movement
Most stocks move with the market. For example, if the general market is in a downtrend (a bear market), even stocks that are fundamentally excellent values, will trend downward. In fact, aggressive growth mutual funds whose portfolios consist of professionally selected stocks get absolutely devastated in bear markets. Many investors, who are not able to sit by and watch their funds lose 40-50% of their value actually end up selling out at exactly the wrong time. Whether you invest in stocks or funds, it is absolutely necessary to know when to be very conservative about your stock market investments.
Positions
Your position is based on which way you are betting the market will go. We refer to these positions as long, short, and cash.
Long Positions
If you buy stock or mutual fund shares hoping they will increase in value, you have taken a long position.
Short Positions
If you believe the market will fall, you can profit by selling short. This is referred to as a short position. Selling short is selling borrowed shares of stock or shares of a mutual fund, hoping to some day buy them back at a lower price and return them to their owner. For example, assume you borrow 100 shares of XYZ Corp. and sell them for $5 per share. You will receive $500 proceeds from the sale. At some later date, XYZ Corp.'s stock has dropped to $3 per share and you decide to buy the shares and return them to the person you have borrowed them from. This is called short covering. To repurchase the shares you will have to pay $300. Since you received $500 on your short sale, and paid $300 to cover your short, you have gained a $200 profit on the trade. This is a very common transaction. A stockbroker who will charge you a commission handles all of the details.
Cash Positions
If you are not short selling when you believe the market is going to fall, you will simply sell your long position and place the proceeds in an interest bearing account. This is a cash position.
Buying On Margin
If you buy stocks or mutual fund shares from a broker, you can leverage your purchases. That is, you can borrow money from your broker and buy more shares using your cash and the cash you have borrowed. The amount of cash you must provide is governed by the margin requirement that the U.S. Federal Reserve sets. For example, currently the margin requirement is set at 50%. Therefore, whenever you buy stock or funds you can borrow an additional 100% from your broker bringing your maximum invested position to 200% instead of 100%. When you purchase shares on margin, you must pay your broker interest on the borrowed capital.
Mutual Funds can be purchased on margin at most discount brokers such as Jack White & Company.
Beta
Beta is a measure of volatility of a trading vehicle such as a mutual fund. The general market as measured by the S&P 500 is considered to have a beta of 1.0. Stocks or funds that gain more than the general market in bull markets and lose more in bear markets have betas of greater than 1.0. Conservative funds and stocks may also have betas that are less that 1.0. For example, assume you invest your money in an aggressive growth fund that has a beta of 1.5. If the S&P 500 gains 10%, this fund should gain 15% (1.5 X 10%). If the S&P 500 loses 10%, this fund should lose 15%.
Stock and Mutual Fund
Picking Rarely Works. In 1997, most investors believe that the market will always go up with only very minor corrections of less than 10%. This would eliminate the need for timing the market and would make an investors only job deciding which fund or stock will go up the most. Pick up a copy of any high circulation investment magazine. Month after month they have headlines that read, "10 Stocks that will go up..." or "The 5 Best Funds..." The entire investment industry is built on analysis that attempts to reveal the next Microsoft. There are some big problems with this approach:
- Investors are not properly diversified. Based on bad advice, people invest too much capital into certain individual issues hoping for a big score. The bad advice did not include when to sell the issue so temporary profits eventually are closed out as losses.
- Analysts can rarely beat the SP500 with the stocks they pick. Often, throwing darts at the financial pages beats the best stock pickers in America. I'm sure you've seen articles about monkeys, widows, and children that beat the experts. It's a wasted effort. If you want to pick the next Microsoft, your best bet is to find a company in your town that is very profitable, run by outstanding people and has a fabulous potential future. When it goes public, invest a small amount of money and forget about it.
- No matter what you read in advertising material, most investment newsletters under- perform the SP500. Investment newsletters tout all the great stock picks they make. They ignore the bad ones and the total portfolio gain. The Hulbert Financial Digest tracks newsletter writers advice and very few beat the SP500. Many newsletter writers even lie about their Hulbert rankings in their advertising material.
- Growth mutual funds rarely beat the SP500. Picking the best fund is very difficult. As you add stocks to a portfolio, it becomes highly correlated with the SP500. So, a growth fund that invests in SP500 type stocks will basically replicate the SP500 over time. Since mutual funds pay commissions and are charged management fees, almost all end up under performing the SP500.
- Beating the SP500 for short periods of time is easy. So you want to beat the market. Pick a fund that has a beta greater than the market and as long as the market is rising you'll beat the SP500. An aggressive fund that invests in high-tech companies is a great example. Unfortunately, even in bull markets these funds get hit hard when the tech stocks are out of favor.
- Funds that beat the SP500 in rising markets will get hammered in falling markets. High beta funds work both ways. In a falling market high beta funds will lose more than the SP500. This is why it's so hard the beat the SP500 without market timing over longer periods of time.
- Picking funds give investors a false sense of security. The mutual fund industry has successfully convinced investors that they will become wealthy by buying their funds and holding them forever. Every mutual fund advertisement you see touts recent performance as proof. What they don't tell you is what happens to their funds in sustained bear markets. They don't tell you that the buy and hold method is emotionally impossible and that most investors bail out of their funds at exactly the wrong time. They don't tell you that their bottom line depends on the buy and hold investor. Every time someone sells out of a fund, it costs the fund company money. They certainly don't tell you that their phone system cannot handle panic selling. In a crash scenario, you will be unable to sell your funds because you won't be able to get through to a representative.
Time Magazine summed up the dilemma well in their January 15, 1996 issue:
"86% of the most popular mutual funds did worse than the Standard and Poor's 500 index in 1995. This is more proof that the national pastime of picking the winning mutual fund is a wasted effort. Most people would be better off buying the so-called index fund that give them a guaranteed average return."
The only problem with this advice is that an "average return" can be very negative. Bear markets can easily cause SP500 index funds to drop 30-40% in value. Investors cannot emotionally handle riding out losses like these.
Spend Most of Your Time Deciding WHEN to Buy Instead of What to Buy.
Do you really think that the wealthiest and smartest investors in the world are actually buy-and-hold investors? Individuals who have built multi-million dollar fortunes are not big on losing money. Sure, they may ride out losses on venture capital type investments just as a business owner wouldn't sell his business because of temporary losses. But, the majority of their portfolios are protected from bear markets with hedging strategies which is simply market timing.
Your goal should be to incrementally move from a 100% cash position to a margined 200% invested position based on the probability that the market will rise. Until you have a developed a sound strategy for doing this, don't spend time deciding what to invest in. Simply invest in an index fund.
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