plus the difference between the strike priceand the price of the underlying stock at initiation.• The maximum potential risk is unlimited to the downsideand requires margin to place.• Calculate the breakeven by subtracting the short callpremium from the price of the underlying stock at initiation.• Choose an exit strategy before placing the trade.• Watch the market closely as it fluctuates. The profit on thisstrategy is limited—an unlimited loss occurs if and when theunderlying stock falls below the breakeven point.Understand how to • Choose a lower-strike put no more than two months out tocreate a coveredsell against short shares of the underlying stock.put trade.• The maximum potential profit is the credit received from theshort put option, plus the difference between the strike priceof the put and the price of the underlying stock at theinception of the trade.• The maximum potential risk is unlimited to the upside andrequires margin to place.• Calculate the breakeven by adding the short put premium tothe price of the underlying stock at initiation.• Choose an exit strategy before placing the trade.• Watch the market closely as it fluctuates. The profit on thisstrategy is limited—an unlimited loss occurs if and when theunderlying stock rises above the breakeven point.Option-SpecificWeb Sites
CoveredCall.com (www.coveredcall.com): Strategy advice oncovered calls, credit spreads, LEAPS, and stock splits.Financial Web (www.strikeprice.com): Offers fundamental dataand historical prices of options and stocks.INO (www.ino.com): This well-organized site features futuresand options.Optionetics.com (www.optionetics.com): Check out the link toan in-house section called Platinum, a comprehensive optionsanalysis software.OptionsInvestor.com (optioninvestor.com): One of the fastestgrowing options advisory sites on the Net.Options Industry Association (www.optionscentral.com): TheOptions Industry Council (OIC) is the educational arm of severalexchanges.OptionSource.com (www.options-iri.com): Bernie Schaeffer’sexcellent options web site.Stricknet.com (www.stricknet.com/index.htm): Options andcovered call picks, pure plays, and naked puts.
6Broad Market Analysis
Since three out of four stocks move in tandem with the general trend of the market,determining the general direction of the marketplace is vital to your success. To assess the general movement of the market—up, down or sideways—you need toknow how to use the tools that provide clues to the nature of general market performance. Broad market analysis offers traders the tools to assess the marketplace as awhole, monitor specific exchanges and industrial sectors, and examine an individual stock’s performance in comparison to its competitors.Broad market analysis: Analysis techniques that accurately identify markettrends by reviewing the flow of money, analyzing index performance, keepingtabs on industry group leadership, scanning changes in the advance-declineline (A/D line), and monitoring the release of government reports.
If you want to become involved in the stock market, you’re literally betting yourfinancial well-being on market performance. In order to meet this challenge, Istrongly urge you to begin watching it and not just the sound bite on the eveningnews. Actively monitoring everything from seasonal changes to scheduled and unscheduled news that affects the markets will help you to keep up with what’s goingon in the business world. You even need to monitor domestic and global economiesto gauge future market direction.But studying the markets is just part of the picture. You also have to take into account that the market will change course when it suspects the economy is heatingup or slowing down. This chapter is designed to help you get a handle on how theeconomy works and how certain events influence market performance.If you study the U.S. economy, you’ll find it expands (grows) and contracts(shrinks). In the old days, this inevitable cycle would mean terrific boom times158
INFLATION, INTEREST RATES, AND THE FED
159
followed by recessions, even depressions. These days the cycle has been evened outto a great extent; but it still cycles. If the economy grows too quickly, inflation results. If it shrinks too dramatically, productivity drops, and we have layoffs, bankruptcies, and widespread unemployment.Stock movement tends to precede these cycles because investors are always looking forward, anticipating the direction of a company. Anything that puts a strain on acompany’s ability to maintain their profit ratio can send a stock south. Likewise, anyfactor that increases a stock’s ability to make a profit can make a stock advance. Thisis because we invest in things that grow, and we close out our investment when weanticipate growth is ebbing.Without a crystal ball, investors practically have to grow antennae when it comes toforecasting market performance. Luckily, there are a variety of reports, indicators, andgeneral tools that enable investors and traders to keep their fingers on the pulse of thestock market. The Internet has made this information easily available, further enablingthe investor to track and interpret data as it’s released. These tools come in the form ofmonetary policy (such as interest rates and the value of the dollar), scheduled government reports, index analysis, sector comparisons, market indicators, seasonal factors,and changes in the political climate. Some of these factors have an immediate or shortterm effect on stock market activity while others come to fruition over the long term.You don’t have to become an expert in economics to gauge market performance;but you do need to know what you’re looking for and how to use the informationthat’s out there. Part of a trader’s learning curve depends on his or her ability to integrate an understanding of the big picture with the multitude of details that tradingindividual stocks requires. Since money is the lifeblood of the stock market, understanding how it moves and where it moves is a major key to financial success.Events not only move the markets, but also the international flow of money as investors seek the highest possible rate of return. The thought of international moneyflow may be incomprehensible to many of us; but it is an important part of the bigpicture. So put on your high waders—the water’s just fine.
INFLATION, INTEREST RATES, AND THE FEDIf preservation of capital is at the heart of the investment battle, inflation is the firstline drawn in the sand. Even though the media would like to be able to classify inflation using a glib number pulled from the teeth of some influential government report, the rate of inflation is an ever-changing presence. It’s at the gas pump and the7-Eleven. It’s waiting for you online. Inflation is always nipping at our heels in oneway or another. Staying ahead of it is the task at hand—a cause taken up by many ababy-booming investor.When we speak about inflation, we are specifically talking about the increase in theannual cost of living. As long as the rate runs at about 3% to 4%, inflation is said to beheld in check. But looking back over the past 20 years, we’ve seen rates of inflation top15%. The outcome is grim: Inflation means less profits, and less profits mean lower
160
BROAD MARKET ANALYSIS
stock valuations. Why? High inflation triggers a rise in interest rates. An increase in interest rates slows the economy down by putting the reins on lending and business expansion, increasing home mortgage rates, and scaling back consumer spending. Lowinflation and low interest rates keep money flowing into the stock market.Figure 6.1 shows the rate of inflation since 1994. Between 1994 and 1999, theinflation rate has risen 2.5%. This may not seem like much, but every increase in inflation eats away at the strength of a dollar’s purchasing power. In fact, the threat ofinflation alone can move the market. The market likes inflation reports to show thatinflation is under control. If the economy shows signs of continued future growth,company management will be more confident that consumers will be able to buynew cars, finance them at reasonable interest rates, and retain a positive consumerattitude that encourages heavy spending.If inflationary pressures become increasingly worrisome, look out! Enter the Fed,or the Federal Reserve Board to be exact. The Fed is a conglomerate of 12 separatedistrict banks governed by a seven-member Board of Governors that works morelike a government agency than a corporation. The Federal Reserve System is chargedwith fostering national growth without generating inflation. It accomplishes this featby holding a Federal Open Market Committee (FOMC) meeting every six weeks(eight times a year) to balance the amount of money in circulation and keep the economy prosperous without creating inflation. If the members decide that the economyneeds a boost, they tell the Federal Reserve Bank of New York to speed up the creation of dollars to keep the economy running smoothly. If they think inflation is onthe rise, they may decide to use their secret weapon: interest rates.Money supply is the key to keeping the economy expanding or contracting.
Annual Inflation Rates4.00%
3.50%12 Month MovingAverage3.00%
2.50%
2.00%
1.50%
1.00%
Figure 6.1
Apr-00 –
Jun-00 –
Feb-00 –
Oct-99 –
Dec-99 –
Apr-99 –
Jun-99 –
Aug-99 –
Feb-99 –
Oct-98 –
Dec-98 –
Aug-98 –
Apr-98 –
Jun-98 –
Oct-97 –
Feb-98 –
Dec-97 –
Aug-97 –
Apr-97 –
Jun-97 –
Feb-97 –
Oct-96 –
Aug-96 –
Dec-96 –
Apr-96 –
Jun-96 –
Feb-96 –
Oct-95 –
Dec-95 –
Aug-95 –
Apr-95 –
Jun-95 –
Feb-95 –
0.00%
Dec-94 –
0.50%
Annual Inflation Rates (1999–2000) (Courtesy of Economagic.com)
INFLATION, INTEREST RATES, AND THE FED
161
When the economy shows signs of faltering, money is pumped into the economy,done so by the easing of interest rates and the redemption of government paper(Treasury notes, bills, and bonds). Money that was formerly out of circulation reenters the economy. Money becomes cheaper (because there’s more of it), meaningbusinesses will borrow more to expand, which creates new jobs and higher wages;and if left unchecked, inflationary pressures begin to build. This is when the FederalReserve says “Enough!” and begins to restrict the availability of money. The Fedauctions more paper and raises interest rates, both of which work in unison to reduce the monetary supply. When you see the M1, M2, and M3 reports, they are measurements of money in the system.M1: Money that can be spent immediately. Includes cash, checking accounts,and NOW accounts.M2: M1 plus assets invested for the short term. These assets include money market accounts and money market mutual funds.M3: M2 plus big deposits. Big deposits include institutional money market fundsand agreements among banks.
You don’t really need to fully understand every last little detail, but you need toknow how these indicators work and if they are likely to prompt the Fed to raise orlower interest rates. The amount of reserves a bank has to hold changes as its deposits and transactions change. When a bank needs additional reserves on a shortterm basis, it can borrow them from other banks that happen to have more reservesthan they need. These loans take place in a private financial market called the federal funds market. The interest rate on the overnight borrowing of reserves is calledthe federal funds rate or simply the funds rate. It adjusts to balance the supply ofand demand for reserves. For example, an increase in the amount of reserves supplied to the federal funds market causes the funds rate to fall, while a decrease in thesupply of reserves raises that rate.Federal funds rate: Set daily by the market, this rate is the most sensitive indicator of the direction of interest rates. It is the interest rate at which banks lend andborrow federal funds among themselves.
Figures 6.2 and 6.3 point to the strong influence interest rates hold over stockprices. The first graph shows interest rate levels as measured by the fed funds rate,and the second shows how the market performed, as measured by the S&P 500 overthe same period. In the first half of 1998, rates were running between 5.4% and5.6%. When the Fed began lowering interest rates—partially to allay fears createdby the financial crises in South America and Russia—the market began a rally thatsurprised many. Even in 1999, when rates began rising again, the market seemed toshrug off the hikes, but still staggered a bit when the rate hikes were enacted.
162
BROAD MARKET ANALYSISFederal Funds Rate
5.60 –5.50 –5.40 –5.30 –5.20 –5.10 –5.00 –4.90 –4.80 –4.70 –Economic Chart Dispenser
4.60 –
1997
Figure 6.2
http://www.Economagic.com
1998
1999
2000
Federal Funds Rate 1997–1999 (Courtesy of Economagic.com)
S&P 500 Total Return; Monthly Dividend Reinvest '97–'994500. –4250. –4000. –3750. –3500. –3250. –3000. –2750. –2500. –2250. –2000. –
Economic Chart Dispenser
1997
Figure 6.3
http://www.Economagic.com
1998
1999
2000
S&P 500 1997–1999 (Courtesy of Economagic.com)
The Federal Reserve Board controls interest rates by moving the discount rateup or down. Banks key off the discount rate to set interest rates they charge to customers for loans, because the discount rate is the cost of funds to a bank. Banks borrow money from the Fed, and then lend it out as loans at a slightly higher rate. Thisis one of the ways they earn profits. Interest rates are the cost of money that businesses and consumers alike must pay. When this cost goes up, the economy and cor-
INFLATION, INTEREST RATES, AND THE FED
163
porate profits go down. This is why the stock market abhors rising interest rates andloves falling rates. Figures 6.2 and 6.3 show this inverse relationship. In 1998, theFed began lowering interest rates in the middle of the year. The stock market, as reflected in the S&P 500, began to rally almost immediately, a clear example of thestrong influence interest rates have over the stocks.
Discount rate: The interest rate charged by the 12 Federal Reserve banks forshort-term loans made to member banks.
We are in an environment where a great deal of attention is focused on monetary policy changes, especially those contemplated by Alan Greenspan, the current chairman of the Federal Open Market Committee. He and the other Fedgovernors are in charge of setting interest rates in order to curb inflation, whilemaintaining a sustainable level of growth in our nation’s economy. Twice a year,the Federal Reserve chairman officially speaks to Congress at the HumphreyHawkins Testimony (www.bog.frb.fed.us/boarddocs/hh), and stocks rally or descend in anticipation of what he’ll say. In the wake of his testimony, the bearingof the economy may be adjusted with an increase or decrease of interest rates.This kind of information has a powerful effect on the markets, which is whywhenever Alan Greenspan speaks, the stock market hums with volatility. However, if the market expects the Fed to raise interest rates, as long as the hike is inline with expectations the market will not experience too much of a correction,and may in fact rally—called a relief rally.Interest rate decisions have far-reaching effects on companies as they make decisions about raising capital to build plants or purchase equipment. Additionally,companies have to monitor their own respective customers’ financial condition,need for their products and services, and future growth. For example, Boeing (BA)is a large aerospace firm in Seattle that does very well when the economy is expanding. A healthy economy means new orders for planes, which leads to the hiring ofadditional employees; but when the economy slows down, the number of jets beingordered drops, and the company is forced to lay people off. People, in turn, buyBoeing stock when the outlook is good, and sell it when the new orders slow down.In good times, people spend more because they’re more confident. This leads to arise in spending, so companies that benefit directly from this spending increase become attractive investments.
Even the least market-savvy person in your office is probably awarethat the market is watching interest rate policy carefully. Interest ratesare the price of money and have an inverse relationship with the stockmarket. An increase in interest rates has a negative effect on stockprices, while an interest rate decline is good for stock prices.
164
BROAD MARKET ANALYSIS
Interest RatesUpDownSidewaysFigure 6.4
Dollar
Bonds
Stocks
UpDownSideways
DownUpSideways
DownUpUp
Typical Relationships of Interest Rates versus Dollar, Bonds, and Stocks
Figure 6.4 illustrates the typical relationship a change in interest rates has tobonds, the stock market, and the value of the dollar (i.e., the normal expected actiongiven the theory behind the economics). But keep in mind the word typical, becausethere are times when a divergence from this chart happens.It is interesting to note that a rise in interest rates can lead to an increase in thevalue of the dollar. If the Fed wants the value of the dollar to go up, it accomplishesthis by raising interest rates so that investors will put money in dollars. It is the natural law of financial physics that money always flows to the highest return on capital (i.e., you always want to get the highest return on your money relative to risk).For example, if a foreign government wants a safe place to invest cash, it’ll look tobuy the bonds with the highest interest rates. Therefore, one of the ways to firm upthe U.S. dollar is to raise interest rates.An inverse relationship exists between bond prices and interest rates. If interestrates go up, bond prices go down; and if interest rates go down, bond prices go up.Why? An increase in interest rates discourages loans and slows the economy down,while a decrease encourages loans in order to jump-start the economy. Let’s say youdecide to lend me $1,000 for a five-year period of time. I agree to pay you 8% interest charges ($80 per year interest). If interest rates suddenly jump to 10%, you couldhave lent the same $1,000 and received $100 per year interest. Therefore the valueof the first loan went down with the rise in interest rates.Since interest rates have an inverse relationship to the stock market, the correlation can be made that bond prices and the stock market move in tandem. This relationship is easy to explain. Let’s say your company has to buy $10,000 worth ofequipment and you don’t want to pay cash for the equipment. If you want to financethe purchase, you have to pay interest. Let’s say you have to pay 8% interest or$800 per year on $10,000. Interest is an expense that gets subtracted from earnings.Therefore, if you earn $20,000 before interest expenses, you will have earned$19,200 after interest is paid. Now what if interest rates are at 10%? The same$10,000 loan now requires you to pay $1,000 per year in interest decreasing earnings to $19,000 ($20,000 – $1,000 = $19,000). These examples show that an inverse relationship exists between interest rates and earnings—the higher yourinterest rate, the less money flows to your earnings. A decline in earnings can have asignificant (negative) effect on a stock’s price. Therefore, if interest rates go up,bond prices fall and stock prices decrease.This inverse relationship does not always hold. There are periods when a divergence will occur—a company’s earnings will increase even though interest rates goup. However, these divergences are generally short-term in nature. You can usuallycount on the market coming back, reacting to the change in interest rates.
THE FLOW OF CAPITAL
165
There are a multitude of web sites that offer sound economic information,including:• Briefing.com (www.briefing.com): Offers a number of graphs that cantell you in an instant which direction rates are going.• Cleveland Federal Reserve (www.clev.frb.org): Helps to explain everything about economics.• Economic Indicators.com (www.economic-indicators.com/EconomicNews.html): Provides a tremendous number of links that will assist youin understanding how the economy is performing.• Financial Trends.com (www.fintrend.com/ftf): Offers useful informationabout inflation.
THE FLOW OF CAPITALLike a stream transforming and mutating, money controls the economies of nationsand the quality of life for individuals all over the world. Electronically controlledand extremely sensitive, its worth depends on the agreement of all participants.Since the success of a company’s stock depends on money, it is essential to have abroad understanding of this unique raw material.Flow of money sometimes becomes flight of capital. What drives capital totake flight? As previously stated, it is the nature of investors to constantly seek thehighest reward for the least risk. If interest rates in one country are lower thanrisk-adjusted rates in other countries, capital flows out of that country in search ofhigher rates abroad. This causes the foreign exchange rate of the low-interestcountry to fall. On the other hand, if interest rates in one country are higher thanother countries, capital will then flow into the country with the higher rates. Thiswould cause the foreign exchange rate of the higher-interest country to rise.This is one reason money moves rapidly between countries; between investmentcategories such as bonds, equities, and commodities; and between individual stocks,commodities, and bonds. It is helpful to understand that a flight of capital from a particular investment (more sellers than buyers) results in falling prices, while capitalflowing to an investment (more buyers than sellers) results in rising prices.The mere fact that money has moved and prices have changed results in a shiftin the risk/reward ratio of any investment. Fluctuations in the perceived risk/reward ratio can trigger the flight of capital from one investment opportunity tothe next. Countries with high inflation seek financial stability for their money. Ifthe investing public believes that the best reward for the risk lies in the U.S. equity markets, capital will flow from all over the world, and from bonds and commodities, into the U.S. stock markets. Conversely, if the general sentiment of theworldwide investing public is that there is about to be a significant degradation ofthe U.S. equity market (major tax increases, profit warnings, interest rate hikes,adverse political/judicial climate, etc.), capital will flee from the U.S. stocks intoany and all other types of investments—bonds, commodities, foreign stocks, and
166
BROAD MARKET ANALYSIS
so on. This capital flight will result in a reduction of individual U.S. stock pricesand a subsequent increase in price of other assets. These kinds of trends usuallycontinue until investors believe that the potential reward of stocks is higher thanother assets.It is the general tendency of all stocks to follow the market. In fact, various studies attribute as much as 70% of a stock’s performance to the movement of the market as a whole. In other words, if money is flowing into the market, most stockswithin the market will increase. After all, the market is made up of the sum of all thestocks. In order for the market to increase, most of these stocks will have to increase. Conversely, if the market is declining, then any particular stock is likely todecrease in value as well. While this sounds self-evident, many investors fight thetrend by taking a contrarian stance.Contrarian: A contrarian fades the trend by going against the majority view ofthe marketplace.
What tends to happen in the stock market is a mini-version of the flow of globalcapital. Just as money will flow from country to country and from commodities tohard assets to stocks, so too does money flow within the stock market as a whole,always searching for the best reward-to-risk ratio. In fact, money tends to seek outthe hottest sectors or groups of related stocks. This is why, regardless of overallmarket direction, not all sectors go up or down at the same time.
ECONOMIC TURNING POINTS AND GOVERNMENT REPORTSSince capital flow is based, at least partially, on interest rates, what does the Fedlook at to measure our economy? The Fed collects data from a number of sources,uses this data to judge whether the economy is expanding or contracting, and mostimportantly the pace at which it is doing so. Investors also key off this rate ofchange, for they understand that unusually high or low readings will have a directeffect on interest rates and thus the flow of capital. There are a number of government reports that enable the Fed and investors to keep tabs on the nuts and bolts ofour economy. Keeping abreast of these reports is a big priority for investors—theyknow the market’s direction ultimately depends on the severity of inflation.
Employment ReportClosely followed by the investment community, the Employment Report provides amonthly picture of the nation’s economic health. It hosts several important componentsdetailing the unemployment rate, nonfarm job growth, weekly hours, and hourly earnings. Figure 6.5 shows a brief rundown of market reaction to these components. Manyprofitable trading strategies take their cue from the release of this telltale report the firstFriday of every month. There has always been a drive to lower employment rates, butwhen employment rates drop too low, employers have to raise wages to compete for
ECONOMIC TURNING POINTS AND GOVERNMENT REPORTS
167
U.S. Unemployment Rate; Monthly 1990–1999Change from same period last year
_2
8.00
–
7.50
–
_ 1.5
7.00
–
_1
6.50
–
6.00
–
5.50
–
5.00
–
4.50
–
4.00
–1990
_ 0.5_0
Figure 6.5
_ –0.5_ –1Economic Chart Dispenser1991
1992
1993
1994
1995
http://www.Economagic.com1996
1997
1998
1999
_ –1.52000
U.S. Unemployment Rate 1990–1999 (Courtesy of Economagic.com)
the best available employees in a shrinking workforce. Wages are often the largest percentage of a company’s expenditures. Reduced unemployment has helped give rise toinflation as companies raise prices to cover increased labor costs. Less money for employment leads to lower production costs and the tempering of inflation.
Employment Cost Index (ECI)The Employment Cost Index (ECI) data are based on a survey of employer payrollsat the end of each quarter. It measures changes in labor costs of money wages andsalaries and noncash fringe benefits in nonfarm private industry and state and localgovernment for workers at all levels of responsibility. Analysts specifically look foracceleration or deceleration.
Consumer Price Index (CPI)The Consumer Price Index (CPI) measures the value of a basket of goods in the current year to the value of that same basket of goods in an earlier year. It measures theaverage level of prices of the goods and services typically consumed by an urbanAmerican family. Widely regarded as the most important inflation report, the CPIgauges retail sales by measuring consumer goods and services. Publishing information about the last month late in the next month, the CPI releases two rates: theoverall rate and the core rate (excluding the food and energy sectors).A year-to-year CPI report can give a clear picture of the rate of inflation. Thecore rate is perceived as an important inflation indicator. A rise in the CPI rate (increase in inflation) has a negative impact while a decline (a tempering of inflation)
168
BROAD MARKET ANALYSIS
Figure 6.6 1999 Dow Industrials and a Time Line for Interest Rate Hikes (Courtesy ofQCharts (www.qcharts.com))
is a positive sign for the stock market. The Fed keeps a close eye on the correlationbetween the CPI and the Producer Price Index (PPI—the costs of production), as agauge for inflation divergences. The CPI announcement can often have a volatile effect on the markets, as shown in Figure 6.6. Figure 6.7 shows what a basket ofgoods would cost during successive time periods.Inflation has a subtle effect, one you don’t really notice, unless it’sat the gas pump. To calculate the effects of inflation for any givenperiod of time, go to: Woodrow The Federal Reserve Bank ofMinneapolis (woodrow.mpls.frb.fed.us/economy/calc/cpihome.html).You’ll find a calculator there that’s easy to use, and thatgraphically illustrates the effects inflation has actually had.
Producer Price Index (PPI)The PPI is released each month about a week before the release of the CPI andhas a strong influence on the Fed’s reaction to wholesale pricing inflation and istherefore closely studied by investors and traders. Considered the first inflationreport of the month, this important index gauges the prices of commodities at
ECONOMIC TURNING POINTS AND GOVERNMENT REPORTS
169
Year
Jan
Feb
Mar
Apr
May
Jun
19901991199219931994199519961997199819992000
127.40134.60138.10142.60146.20150.30154.40159.10161.60164.30168.80
128.00134.80138.60143.10146.70150.90154.90159.60161.90164.50169.80
128.70135.00139.30143.60147.20151.40155.70160.00162.20165.00171.20
128.90135.20139.50144.00147.40151.90156.30160.20162.50166.20171.30
129.20135.60139.70144.20147.50152.20156.60160.10162.80166.20171.50
129.90136.00140.20144.40148.00152.50156.70160.30163.00166.20172.40
Jul
Aug
Sep
Oct
Nov
Dec
130.40136.20140.50144.40148.401