.05
3.24
Book value ($)
414.75
414.75
367.00
TABLE 8.2 Expected Earnings Growth of S&P Indexes as of March 17, 2004
Index
1 Q 2004Earnings GrowthForecast
2 Q 2004Earnings GrowthForecast
3 Q 2004Earnings GrowthForecast
S&P 500
15.1%
14.2%
11.4%
S&P Mid Cap 400
20.4%
20.3%
18.6%
S&P Small Cap 600
18.5%
26.1%
33.3%
In short, expectations about future earnings growth will have animportant impact on the performance of the stock market. Index traderswill want to keep this in mind and trade on the right side of the market.For instance, when the S&P 500 Index ($SPX) is expected to show solidstrong earnings growth for several quarters, bullish strategies with six- tonine-month time horizons (such as bull call spreads, call calendars, and
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ratio backspreads) make sense. Several sources provide earnings outlooks, including Standard & Poor’s (www.standardandpoors.com) andZacks Investment Research (www.zacks.com).
INTEREST RATESEarnings are not the only factors that influence stock prices. According toone school of thought, the value of a stock depends on both earnings andinterest rates. Why do interest rates affect stock prices? On one hand,higher rates mean that interest-bearing securities will be more competitive assets and will appeal to investors. Money will move out of stocks. So,as returns from other investments improve, these alternatives become attractive on a relative basis when compared to stocks. All else being equal,higher interest rates will lead to lower stock prices; lower interest rateswill boost the value of stocks.There is a formula used to measure the impact of rising rates on valuations of the stock market as a whole. It is computed as the reciprocalof the government’s benchmark 10-year note yield multiplied by the expected earnings of the S&P 500 companies. The 10-year note is the mostactively traded government bond today. Its yield, which moves oppositeto the bond’s price, is a key gauge of long-term rates. This rate can befound at any time using the ticker symbol for the CBOE Ten-Year RateIndex ($TNX).In order to compute the expected value of the SPX, the projectedearnings of the S&P 500 (found at Standard & Poor’s web site, www.spglobal.com) is multiplied by the reciprocal of the yield on the 10-yearnote. To illustrate, if the yield on the 10-year is 4.1 percent and earningsfor the entire S&P 500 during the next four quarters is expected to be$67.40, the formula yields:1× 67.40 = (24.40 × 67.40)0.041= 1, 645Therefore, if the SPX is trading near 1,220, it is 36.50 percent undervalued according to this formula. However, if the SPX is near 2,000, itis 21.5 percent overvalued. This is the so-called Fed model and is usedby many institutional investors today. It helps explain why suddenchanges in rates often lead to an opposite reaction in the stock market.That’s why we keep an eye on the TNX. There will be more on this topiclater.
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THE ECONOMYEconomic data is extremely important to index traders. On one hand,stock prices tend to perform well when the economy is booming. During asolid economic expansion, business is strong and corporate profits are increasing. So when the economy is expected to perform well, it makessense to trade the market on the long side.On the other hand, a strong economy can trigger concerns about theprospect of inflation, which has historically led to higher interest rates(bearish for stocks). This prospect creates a concern due to its adverseimpact on corporate profits. Therefore, for investors, the ideal situationis an economy that is not too hot and not too cold. This is sometimesreferred to as a Goldilocks economy.Given the importance of the economy, several pieces of economicnews can move the market over time. For instance, the “Prices” elementof the monthly Institute for Supply Management (ISM) manufacturing report can serve as a guide for gauging inflation. If prices paid are toostrong, stocks and bonds might react negatively to the news.When inflation fears hit the market, the index strategist also pays attention to any indicator that might point to rising or falling prices. For instance, the Consumer Price Index (CPI) measures prices on consumergoods and services and the Producer Price Index (PPI) gauges prices onvarious goods such as commodities, capital items, automobiles, and textiles. Both are reported monthly and should be watched for signs that inflationary pressures in the economy are mounting.Some traders also watch trends in the commodities market for signsof inflation. The Commodity Research Bureau provides an index of commodity prices known as the CRB. A rising CRB is a sign of rising commodity prices and mounting inflationary pressures for many companies. Theemployment cost index (ECI) is also watched to determine the current inflation outlook for wages.The monthly unemployment report from the Labor Department,sometimes called the “un-enjoyment” report, is considered to be one ofthe most important pieces of economic data. It is usually released on thefirst Friday of every month. Going back to the Goldilocks economy, lowunemployment is good for the overall economy since more consumershave the ability to save and spend dollars. However, as employment levelsrise, a rise in wages may follow, creating higher costs for a core portion ofa company’s budget.Data on retail sales, housing, motor vehicle sales, and consumer sentiment numbers can also cause a reaction in the index markets. Table 8.3lists some of the key economic indicators worth watching.
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TABLE 8.3 Important Government ReportsComponent
Release Dates
Advancing Numbers
Declining Numbers
EmploymentReport
First Friday ofthe month.
A rise inunemployment rateis often seen as anegative for stocks,but positive forbonds.
A decrease inunemployment numbersis a positive sign for theeconomy.
WholesaleTrade
Second weekeach month.
Wholesale tradeinventories:A rising numberindicatesconsumption isslowing.Inventory to salesratio: Rising numbersagain reﬂecta slowdownin the economy.
Wholesale tradeinventories: If inventoriesare falling, consumptionon the rise.Inventory to sales ratio:If this number begins tofall, an increase inconsumer spendingindicates moreconﬁdence.
Import andExportPrices
Aroundmidmonth.
Imports constitute15% of U.S.consumption. Theyalso directly affectthe proﬁtability ofU.S. companies.Higher prices fromimports translate tohigher prices ofdomestic goods.Good news forbusiness; bad forthe consumer.
If import prices fall, U.S.companies must lowerprices to compete. Badfor businesses, good forconsumer.
EmploymentCostIndex (ECI)
Once a quarter,toward end ofmonth, forprecedingquarter.
Analyzes wages andfringe beneﬁts.Rising wages alonehave less meaningbut are used inconjunction withother reports, likehousingstarts.
Lower wages mean aslowing economy, andwill be used inconjunction with othereconomic measurementsto gauge the economy’sstrength.
(Continued)
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TABLE 8.3 (Continued)Component
Release Dates
Advancing Numbers
Declining Numbers
ConsumerPriceIndex (CPI)
Data releasedaround 15thof eachmonth.
Since the CPIdescribes the pricechanges of a basketof consumer goods,a rising numbermeans inﬂationarypressures at work.Bad for the marketbecause inﬂation isheld in check withrising interest rates.
A drop in prices isgenerally considered agood sign for consumersand good for the market.Too much of a drop is anegative, or a sign ofpossible deﬂation.
ProducerPriceIndex (PPI)
Previousmonth’s dataare releasedduringsecond fullweek ofcurrentmonth.
Increases may ormay not be goodnews. If interest ratesare declining then arising number meansthe economy isreacting to the ratecuts. If rates areincreasing, this isbad because furtherrate hikes may berequired.
Decreases mean theeconomy is slowing. Bestto look at trends.Prolonged slowing maylead to deﬂation and arecession.
Institute forSupplyManagementIndex (ISM)
First of month.
Above 50% indicateseconomic expansion.
Below 50% suggestseconomic contraction.
Retail Sales
Midmonth.
People are spendingmore and conﬁdenceis high; it’s a goodsign for the market.
People spend less andconﬁdence shrinks; it’s abad sign for the market,especially retail stocks.
GrossDomesticProduct(GDP)
Released onemonth afterend ofquarter.
Takes into accountconsumer demand,trade balance, etc.Economy expandingis good news, but nottoo fast—the Fedraises rates whenthat happens.
Economy slowing. If itcontinues the Fed will(possibly) lower interestrates; good for market.
Housing:HousingStarts andSales of Newand ExistingHomes
Third week ofmonth.
Increasing startsindicate conﬁdence—a good sign for themarket.
Economy slowing. Redﬂag for Fed to be onlookout for downturn ineconomy. Market reactionis anybody’s guess.
146
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TABLE 8.3 (Continued)Component
Release Dates
Advancing Numbers
Declining Numbers
ConstructionSpending
First of month.
Lagging indicator.Report comes inonly after building isﬁnished. An increasein numbers is agood sign.
Since it’s a laggingindicator, may serve toconﬁrm the economy isslowing and rates needto be lowered. Good forthe market.
IndustrialProductionIndex
Midmonth.
This would indicatethe slack is beingtaken out of theeconomy; we’remaxing out.
Factories are slowingdown. Might beconsidered bad for themarket, is consideredbad for the economy.
PersonalIncomeandConsumptionExpenditures
Third or fourthweek after themonth itreports on.
Doesn’t indicatemuch. It reports afterother key data(employment andretail sales).
Prolonged decrease inconsumer demand isdeﬁnitely bad forconsumer stocks.
FactoryOrders:DurableGoods andNondurableGoods
Four weeksfrom end ofreportingmonth.However,everyone keysoff of theadvancerelease oneweek prior.
Leading indicator ofindustrial demand.Numbers going upis generally apositive sign forthe markets.
Slowing demand means aslowing economy, if itstays in a declining modefor several months.Might adversely affectmarkets, but if it promptsinterest rate reductions itcould be good.
THE FEDERAL RESERVEEconomic reports are not the only influences on the market; decisions bythe Federal Reserve also have an impact. Created by Congress in 1913, theFederal Reserve (“the Fed”) is a conglomerate of 12 separate districtbanks governed by a seven-member Board of Governors that works morelike a government agency than a corporation. The Federal Reserve Systemis charged with fostering national growth without generating inflation. In2006, Ben Bernanke replaced Alan Greenspan as the Chairman of the Federal Reserve, America’s economic top dog.The primary goals of the Federal Reserve are to stabilize prices,
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promote economic growth, and strive for full employment. Obviously,economic data will have an important bearing on the Fed’s decisions.These goals are accomplished through managing monetary policy, balancing the amount of money in circulation, and keeping the economyprosperous without creating inflation. The Fed holds Federal Open Market Committee (FOMC) meetings every six weeks (eight times a year)to decide if the economy needs a boost and to assess inflation. TheFOMC includes seven Fed governors, as well five presidents of the district banks. Four of the presidents serve on a rotating basis.The FOMC’s most frequently used tool to control monetary policy isopen market operations. Open market operations means the buying orselling of government securities to control liquidity in the economy. That’swhat is happening when you hear that liquidity is going up or down in theeconomy. When liquidity is high, it makes it easier for businesses to borrow money (supply is good), which in turn leads to more spending, whichleads to growth.The Federal Reserve also has other tools to carry out monetary policy.The FOMC meets periodically to discuss the economic outlook and makechanges to the discount rate and the federal funds rate. The discount rateis largely symbolic. It is the rate at which the Federal Reserve lendsmoney to member banks.The Fed’s key rate is the federal funds rate, which is the rate at whichFed member banks make overnight loans to one another. The FOMC canpush this rate up or down based on the outlook for the economy. For instance, from June 2004 to December 2005, the FOMC voted to raise thefederal funds target rate 13 times, bringing it up to 4.25 percent from a 40year low of 1 percent.When the Federal Reserve is aggressively raising rates, the indextrader will want to be careful trading the market to the upside. This hasgiven rise to the adage, “Don’t fight the Fed.” However, not every marketresponse to rising rates will be the same. In 2005, as the FOMC voted tobring the federal funds rate up for the 13th time in 18 months, the S&P500 Index was trading at 4.5-year highs. Therefore, in the most recentcase, the Fed’s actions did not seem to be having a significant negativeimpact on the economy. Some attributed the stock market’s strong performance to the fact that a gradual move higher in interest rates was nota surprise. That is, Federal Reserve officials telegraphed the rate hikesahead of time and made their intentions very clear prior to each of theFOMC meetings. The market was therefore not caught by surprise andthe small incremental rate increases had minimal impact on investorconfidence or business activity. Additionally, the rates were rising froman extremely low level.
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“Three Steps and a Stumble” RuleThe Fed’s discount rate is largely symbolic, but it can serve to decipherthe Federal Reserve’s intentions. If the Fed moves the discount rate, it isa sign that they are trying to slow the economy, which has given rise tothe “three steps and a stumble” rule. According to this principle, ﬁrstobserved by Edson Gould, when the Fed raises its discount rate threetimes in a row, the stock market will stumble. Meanwhile, the “two tumbles and a jump” rule says that when the Federal Reserve cuts the discount rate, it’s time to get in the market because stocks are ready tojump higher.
ENERGYEnergy prices can affect the stock market by impacting the economy. Thelink between energy prices and the economy is fairly evident when oneturns back the pages of history. Three recent recessions in the UnitedStates—1974 to 1975, 1980 to 1982 and 1990 to 1991—all witnessed sharpspikes in oil prices prior to the economic downturn.During the year 2000, energy prices began another ascent. Crude oil,which stood at $10 a barrel in the mid-1990s, surged to $34 at the end of2000. According to economists’ estimates at that time, higher energyprices shaved about one percentage point off of economic growth in 2000and 2001, which goes a long way in explaining why the U.S. economy fellinto recession shortly thereafter.Even Federal Reserve policymakers recognize the importance of energy prices on the economy. In 2001, then Federal Reserve chairman AlanGreenspan made note of the impact of rising energy prices on the U.S.economy in a June 28 speech to the Economic Club in Chicago. The headof the U.S. central bank noted that “We at the Federal Reserve are especially attentive to developments in energy markets and their effects on thebehavior of households and businesses.”*
*Remarks by Chairman Alan Greenspan, “Impact of Energy on the Economy,” before the Economic Club of Chicago, June 28, 2001. (www.federalreserve.gov/boarddocs/speeches/2001/200106282/default.htm).
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What Moves Energy Prices?Predicting the direction of oil prices is no easy task—ask any trader in theoil pits on the futures exchanges. Nevertheless, there are speciﬁc eventsthat trigger volatility in oil markets, and a few are worth noting here.• Weekly inventory: Data from the Energy Information Association(EIA) is released every Wednesday at 10:30 A.M. ET.• OPEC: The Organization of Petroleum Exporting Countries (OPEC)meets periodically to determine production from member countries.Are they going to raise or cut global supplies?• Seasonal factors: Demand for energy increases during the summerdriving season and also during the cold winter months as consumersheat their homes with natural gas and heating oil. Expect greatervolatility during those times.
Higher energy prices can hurt the economy in a number of differentways. For one, higher oil and natural gas costs put pressure on marginsand cash flows throughout corporate America. As Greenspan noted in thatspeech, “A substantial part of the rise in the total costs of corporations between the second quarter of last year and the first quarter of this year[2001] reflected higher energy costs, only a small part of which companiesapparently were able to pass through into higher prices.”Escalating oil and natural gas prices also hurt the consumer. Forexample, rising gasoline prices impact purchasing power and erodeconfidence. Higher heating oil and natural gas prices can also take abite out of consumer budgets through higher home heating fuel costs.Taken together, rising energy prices have a significant and adverse impact on the economy because they impact both the consumers and corporations. Figure 8.4 shows how a precipitous fall in crude oil duringMarch 2003 helped fuel a rally in the S&P 500 Index over the ensuingthree months.The relationship between energy prices and the stock market is notalways perfect, but crude oil prices are worth following. Indeed, the twowill often move in the same direction. However, the United States consumes roughly 20 million barrels of crude and imports roughly 11 millionper day. This heavy dependence on oil has a significant economic impact. As prices rise and fall, the movement will spill over into the U.S.equity markets.
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FIGURE 8.4 Crude Oil Spot Prices and the S&P 500 Index (Source: www.ProﬁtSource.com)
PROGRAM TRADINGGiven the large number of index funds, hedge funds, and other institutional investors that are active in the market today, it makes sense to understand what they are doing on a day-to-day basis. Like other investors,they will react to economic news, changes in interest rates, energy prices,and FOMC meeting announcements. In addition, institutional investorsare implementing their investment decisions using program trading.When this happens, it can trigger large, sometimes tradable moves in themarket averages.Two Types of InvestorsIn the stock market, there are two very different types of investors:1. Institutional Investors: These are large investors that make investment decisions on the behalf of clients or customers. The Vanguard500 Index fund is a very large institutional investor. Its buying andselling will move stock prices. Other mutual funds, portfolio managers, hedge funds, and ﬁnancial advisers are also considered institutional investors.2. Retail Investors: This includes investors who make investmentdecisions for personal trading accounts. They are not paid to makeinvestment decisions but do so for their own gain.
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According to recent statistics, program trading is at record highs.Large institutions that are trying to simultaneously buy or sell entire baskets of stocks use this type of investing. Through the years, program trading has been criticized for adding to market volatility. For example, whenthe stock market crashed on October 19, 1987, many market watcherspointed the blame at program trading. On that day, the Dow Jones Industrial Average ($INDU) recorded its largest loss in history. The Dow tumbled 508 points, or 22.6 percent. Volume surged, as a new record 600million shares traded hands. The swoon left investors and other marketwatchers scratching their heads and searching for an explanation. Program trading was the scapegoat.So what is program trading and how does it contribute to marketvolatility? The New York Stock Exchange defines program trading as thesimultaneous purchase or sale of 15 or more stocks worth more than $1million. Buy and sell programs are used to achieve a variety of differentobjectives. The process began in the early 1980s when large investmentfirms started using index arbitrage strategies, which is an effort to capitalize on the difference between the price of the stocks (indexes) on the exchanges and the prices of the derivatives (futures and options). In order todo so, program trading allowed arbitrageurs to buy not just one or twostocks but all 500 SPX companies.Portfolio insurance also gained popularity during that time. Portfolioinsurance programs allow large investors to sell off large portions of theirstocks when certain parameters of an insurance model were met. In themid-1980s, it was estimated that nearly $90 billion worth of stock portfolios were under portfolio insurance protection. Although subject to controversy, some argue that portfolio insurance and index arbitrage werethe key factors underlying the market volatility in October 1987.*Today, program trading is used in a variety of ways as well. Someprograms are linked to index arbitrage. Some hedge funds use programtrading. So-called market neutral hedge funds often structure long/shortportfolios, which involves buying a basket of stocks and simultaneouslyselling short a different set of stocks based on a certain variable (e.g.,P/E ratio). The long/short funds often use program trading to buy andsell the portfolios on a monthly or quarterly basis. Brokerage firmssometimes use program trading to move entire portfolios in and out ofcustomer accounts.According to Dow Jones Newswires (www.djnewswires.com), program
*See Jeffrey D. Miller, Program Trading: The New Age of Investing (New York:J. K. Lasser Institute, 1989).
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trading has been running between 50 and 60 percent of all trading volumeon the New York Stock Exchange.Program Trading is 57.9% of NYSENew York—Program trading in the week ended Dec. 9 accounted for57.9%, or an average of 968 million shares daily, of New York StockExchange volume. Brokerage firms executed an additional 675.5million daily shares of program trading away from the NYSE, with1.4% of the overall total on foreign markets.*Therefore, the trend is clearly toward a greater use of program trading. Today more than half of the total trading on the NYSE is linked to thepractice. That trend, in turn, may help explain why the market sometimesexperiences sharp, sudden intraday swings and why large institutionalinvestors seem to sometimes possess the power to move the market.
TICKThe NYSE Tick Index ($TICK) can help identify when programs are hitting the market. Primarily intraday traders use the tool, but it can be useful for any index trader who is trying to gauge daily buying and sellingpressure. The index tracks upticks and downticks on the New York StockExchange and is updated throughout the day.Tick TalkThe term tick refers to the price change of an investment. It is deﬁned as amovement in the price or quote of a security or contract. If, for example,the most recent trade on a stock occurs at a higher price than the priortrade, the stock is on an uptick. Conversely, downticks occur when astock’s most recent trade occurs at a lower price than the prior trade.
The Tick Index can be either a positive or negative number and generally stays in a range between –900 and +1,100. When TICK increases,upticks are outnumbering downticks. If so, buying pressure is increasingand the bulls are in control. However, when the bears are dominating trading and selling pressure is increasing, the Tick Index will fall. The readings
*Dow Jones Newswires (www.djnewswires.com), December 16, 2005, page C9.
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are updated throughout the day and are available using most live datafeeds with the symbol $TICK.There are different ways to use this index when trading. The mostcommon way is to look at the closing value at the end of each day. For example, “closing TICK” is mentioned on the Nightly Business Report andalso listed daily in the Wall Street Journal. Figure 8.5 shows the closingvalues of the Tick Index in 2005. During that time, it has closed within arange of +1,200 and –350.If TICK’s closing value at the end of the day is +1,000, it means that1,000 more stocks were setting upticks rather than downticks at the endof the day. This is a bullish sign because more stocks were moving higherthan lower. For that reason, a positive closing TICK often sets the stagefor a strong open the next day. This could be a sign that buy programswere hitting the market late in the day and institutions are actively addingmoney to the market.The second way to use TICK is to consider its daily high and lowreadings over a period of weeks or even months. For instance, if thehigh reading from TICK on Monday is +600, on Tuesday +700, Wednesday +800, Thursday +900, and Friday +1,000, the trend is bullish. Duringeach trading day, TICK is rising to new highs. In that case, buying pressure is increasing and probably helping to drive prices higher. Of course,the opposite also holds true. If TICK begins setting new daily lows astime passes, it is a sign of increasing selling pressure and a negative forthe market.
FIGURE 8.5 NYSE TICK Closing Value (Source: www.ProﬁtSource.com)
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Many times, the readings from TICK offer no new information. For instance, readings between +400 and –400 are ignored. However, once TICKbegins rising above +600 (or dropping below –600) it signals that buying(or selling) interest is improving. Readings of +800 or –800 should also getyour attention. Readings of +1,200 or –1,200 are signs of extreme buyingor selling. This is when buy or sell programs are hitting the market and institutions are aggressively buying or selling. Index traders will generallywant to trade on the same side as the institutions or else run the risk offeeling run over by a moving freight train.
CONCLUSIONA number of different factors influence the performance of the stock market. The Federal Reserve, earnings, interest rates, energy prices, and economic news have been discussed in this chapter. All of these events cantrigger big tradable moves in the market indexes. Other events whichhaven’t been discussed, such as presidential elections, terrorist attacks,tax cuts, and other less predictable events, can also influence the market.Ultimately, however, the stock market moves because of buying andselling. The buying and selling is in turn being driven by new informationand fundamentals. Sometimes investors react rationally to the new information. At times they don’t—the market is also driven by fear and greed.This can lead to profit opportunities when the investors overshoot in onedirection or the other.Later chapters include discussions of various other tools for gaugingsentiment. For now, the reader should understand that all investors reactto new information and large institutions will move the markets, especially when implementing their decisions via program trades. The NYSETick Index will help the index trader stay on the right side of the marketwhen these large buy and sell orders hit the stock market.
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System Trading
T
he previous chapter explored how emotion is the main driver of investment decisions. Fear and greed can affect investor behavior andcause the price of an investment or a market to overshoot in one direction or the other. When there is too much bullishness or greed, pricescan climb too high and provide profit opportunities for bearish tradeswhen the market corrects the excess. On the other hand, when fearcauses prices to fall too low, profits can eventually be found in the opposite direction, with bullish trades to the upside.We acknowledge, however, that we are not always imm