increase re-gardless of whether interest rates go up or down. However, these diver-gences  are  generally  short-term  in  nature.  You  can  usually  count  on  themarket coming back, reacting to the change in interest rates.
If  you  watch  the  day-to-day  price  changes  in  the  stock  market,  youmay ﬁnd that investors and traders are watching bond prices and interestrates  very  closely.  Changes  in  either  may  determine  whether  it  is  a  goodtime to buy or to sell bonds. In addition, if you see interest rates increasing
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quickly,  you  don’t  want  to  be  a  buyer  of  stocks.  An  increase  in  interestrates signals a time of caution due to the negative bias for individual stocksand the stock market in general. However, if you ﬁnd that interest rates arestable  or  decreasing,  being  a  buyer  of  stocks  is  a  good  idea  because  thestock market has an upward bias.
Historically, the general bias of the stock market is to rise. Investorsusually  push  markets  up.  Even  after  stock  market  crashes,  the  marketusually  rebounds  strongly.  The  stock  market’s  cyclical  movement  is  di-rectly related to economic, social, and political factors, with bull marketslasting longer than bear markets—dropping quickly and then rising slowlybut steadily. However, when it comes to the stock market, there are no ab-solutes. Since no one has a crystal ball with which to see the future, I pre-fer  to  create  trades  that  are  nondirectional  in  nature  using  delta  neutralstrategies that reap consistent proﬁts.
KEY INTEREST RATE INDICATORS
Putting together a broad market analysis requires a feeling for where in-terest rates might be headed. In order to do this, the analyst needs a clearunderstanding of three key indicators: the prime rate indicator, the Fed-eral Reserve indicator, and the installment debt indicator. Each indicatorprovides important clues pertaining to future interest rate trends.
The prime rate indicator represents the interest rate that banking in-stitutions require their very best customers to pay which more often thannot are the top corporations in the country. The majority of bank loans ac-tually made are pegged to the prime rate with a premium being chargedrelative to the degree of risk of the loan. So, the worse off the borrower’scredit rating, the more the borrower will pay above the prime rate.
Following  prime  rate  changes  is  relatively  easy  since  it  does  notchange every day, as do other interest rates. In addition, when the primerate indeed does change it is hard to miss it since it is plastered all overthe news. Also, this indicator lags behind other interest rates. For exam-ple, the prime rate typically declines only well after a decrease in the fed-eral  funds  rate  or  certiﬁcates  of  deposit  yields.  But  these  prime  ratechanges should be monitored closely because many times when a distincttrend can be identiﬁed then this can translate into corresponding move-ment in the equity markets.
The Federal Reserve indicator consists of two of its primary monetarypolicy  tools:  the  discount  rate  and  reserve  requirements.  The  discountrate  is  how  much  the  Federal  Reserve  charges  banking  institutions  thatwish to borrow from it. And why would banks ever want to borrow from
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the Federal Reserve? The answer is to satisfy their reserve requirements,which are also controlled by the Fed. These requirement levels basicallydetermine the bank’s loan making ability.
Just  like  the  prime  rate,  the  Fed’s  adjustments  to  the  discount  rateand/or reserve requirements garner a lot of media attention, which makeschanges  quite  easy  to  track.  These  two  data  points  are  rarely  changedwithin the course of a year. The key information that is critical for the an-alyst to capture is the directional change in either of these two key mone-tary tools.
Finally, the other key piece of information in determining interest ratetrends is the installment debt indicator. This indicator gauges the level ofloan demand in the country. This demand has a large impact on the direc-tion of interest rates. If loan demand increases signiﬁcantly interest ratestend to increase. When loan demand decreases at a sharp level the inter-est rates are likely to decline.
Loan  demand  is  measured  from  a  variety  of  sources,  which  includestate, federal, and local governments; corporations using short-term com-mercial  loans  and  longer-term  bond  market  monies;  mortgage  debt;  andconsumer installment debt.
Again, just like the other indicators, this data is simple to track. Keepin mind that when the monthly total of this debt is released by the FederalReserve it is about six weeks late; however, the important thing to note ishow this ﬁgure is trending. This can gives us a keen insight into the futuredirection of interest rates.
All  three  of  these  interest  rate  forecasting  tools  are  not  only  ex-tremely easy to track but easy to interpret as well. And as indicators go,that  is  exactly  how  they  should  be  if  they  are  going  to  be  effective.  Ifyou are a fundamental analyst who likes to adopt a broad market viewbefore  investing,  then  I  suggest  adopting  these  tools  as  part  of  youroverall approach.
THE ECONOMIC DATA
Since traders are constantly trying to predict the next direction of inter-est rates, the economic news can have a signiﬁcant effect on the ﬁnancialmarkets. Often, signs of a strong economy can trigger concerns about theprospect of inﬂation, which has historically led to higher interest rates. Inaddition, inﬂation is also a concern due to its adverse impact on corpo-rate proﬁts.
There are several pieces of economic data that can give clues regardingthe trends in inﬂation. For instance, the prices-paid element of the Institute
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of  Supply  Management  (ISM)  manufacturing  report,  which  is  releasedmonthly, can serve as a guide report that gauges inﬂation. If prices paid aretoo strong, stocks and bonds might react negatively to the news.
The Consumer Price Index (CPI) measures prices on consumer goodsand services, and the Producer Price Index (PPI) gauges prices on variousgoods such as commodities, capital items, automobiles, and textiles. Bothshould  be  watched  for  inﬂationary  pressures.  Some  traders  also  watchtrends in the commodities market for signs of inﬂation. The CommodityResearch  Bureau  provides  an  index  of  commodity  prices  known  as  theCRB. When it is rising, it is a sign of rising commodity prices and, some-times, mounting inﬂationary pressures.
A host of other economic reports receive the market’s attention on aregular basis. Bond traders sometimes call the monthly unemployment re-port from the Labor Department the “unenjoyment” report because stocksand bonds sometimes slide following the release of the monthly numbers.It  is  released  on  the  ﬁrst  Friday  of  every  month.  Figures  on  retail  sales,housing, motor vehicle sales, and consumer sentiment numbers can alsocause a reaction on the ﬁnancial markets. Table 15.1 shows a list of impor-tant economic indicators.
THE IMPORTANT ROLE OF THE FEDERAL RESERVE
Another major reason you should keep track of economic reports is be-cause they can inﬂuence the decisions at the Federal Reserve. Just what isthe Federal Reserve? Most people believe that it is the branch of the U.S.government charged with making monetary policy decisions. Most peopleare wrong. While it’s true that the Federal Reserve makes U.S. monetarypolicy, it is an independent group. The U.S. government was on the vergeof bankruptcy back in the early 19-teens. Twelve very wealthy families ac-tually stepped forward to bail out the government, and Congress ofﬁciallycreated the Federal Reserve in 1913. Today, the Federal Reserve consistsof  12  district  banks  as  well  as  a  board  of  governors.  Alan  Greenspan  iscurrently the Fed chairman.
Today,  the  Federal  Reserve  works  more  like  a  government  agencythan a corporation. The chairman of the Federal Reserve and his fellowcentral  bankers  play  a  key  role  in  inﬂuencing  the  money  supply.  As  atrader, it is vital to examine how open market operations are one of theprimary  tools  used  by  the  Federal  Reserve  to  implement  U.S.  monetarypolicy. You can also track the profound impacts these decisions have onthe U.S. economy, as well as the key reports that are monitored to deter-mine if the Fed is indeed meeting its intended goals.
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TABLE 15.1 Important Economic Indicators
Component
Release Date
Advancing Numbers
Declining Numbers
Employmentreport
First Friday of the month
Wholesaletrade
Second week of each month
Import andexport prices mid-month
Around 
Employment Once a quarter, Cost Index(ECI)
toward end of month, for preceding quarter
Consumer Price Index (CPI)
Around the 15th of each month, 8:30 A.M., EST
A rise in unemploymentrate is often seen as anegative for stocks but a positive for bonds.
A decrease in unemployment numbers is a positive sign for the economy.
If wholesale trade inventories are falling, consumption is on the rise. If this inventory to sales ratio begins to fall, consumer spending increases (more conﬁdence).
If import prices fall, U.S. companies must lower prices to compete. This isbad for businesses, good for the consumer.
If the wholesale trade inventories number rises, consumption is slowing. Rising inventory-to-sales ratio reﬂects a slowdown in the economy.
Imports constitute 15 percent of U.S. consumption, and also directly affect the proﬁtability of U.S. companies. Higher prices for imports translate to higher prices for domestic goods. This is good news for businesses; bad for the consumer.
slowing economy, and 
Analyzes wages and fringe Lower wages mean a beneﬁts. Rising wages alone have less meaning, will be used in but are used in conjunction with other reports, like housing starts.
conjunction with other economic measurements to gauge the economy’s strength.
Since the CPI describesprice changes of a basket of consumer goods. A rising number means inﬂationary pressures at work. This is bad for the market because inﬂation is held in check with rising interest rates.
A drop in prices is generally considered a good sign for consumers and good for the market. Too much of a drop is a negative, or a sign of possible deﬂation.
(continues)
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TABLE 15.1 (Continued)
Component
Release Date
Advancing Numbers
Declining Numbers
Producer Price Index (PPI)
Previous month’s data released during second full week of current month
Decreases mean the economy is slowing.It is best to look at trends. Prolonged slowing may lead to deﬂation and a recession.
Increases may or may not be good news. If interest rates are declining then a rising PPI number means the economy is reacting to the rate cuts. If rates are increasing, this is bad because further rate hikes may be required.
Institute of Supply Management Index (ISM)
First of month
Above 50 percent indicates economic expansion.
Below 50 percent suggests economic contraction.
Retail sales Midmonth
Gross DomesticProduct (GDP)
One month after end of quarter
Third week of month
Housing starts and sales of new and existing homes
Construction First of monthspending
If people are spending more and conﬁdence is high, it’s a good sign for the market.
If people spend less and conﬁdence shrinks, it’s a bad sign for the market, especially retail stocks.
GDP takes into account consumer demand, trade balance, and so on. Economy expanding is good  news, but not too fast—the Fed raises rates when that happens.
Increasing starts indicate conﬁdence—a good sign for the market.
Lagging indicator. Reports come in only after building is finished. An increase in numbers is a good sign.
Economy slowing. If it continues Fed will (possibly) lower rates, which is good for the market.
Decreasing starts indicate economy slowing. Red ﬂag for Fed to be on lookout for downturn in economy. Market reactionis anybody’s guess.
Since it’s a lagging indicator, it may serve to conﬁrm the economy is slowing and rates need to be lowered. Good for the market.
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TABLE 15.1 (Continued)
Component
Release Date
Advancing Numbers
Declining Numbers
IndustrialProductionIndex
Midmonth, 9:15 A.M., EST
Increasing numbers would indicate the slack is being taken out of the economy; we’re maxing out.
Decreasing numbers indicate factories are slowing down. Might be considered bad for the market, is considered bad for the economy.
Third or fourth 
Personalincome and week after consumption month it expenditures reports on.
Not much effect as it reports after other key data (employment and retail sales).
Prolonged decrease in consumer demand is deﬁnitely bad for consumer stocks.
Factory orders—durable goods and nondurablegoods
Four weeks from end of reporting month (8:30 A.M.EST). However, everyone keys off of the advance release one week prior.
Leading indicator of industrial demand. Numbers going up are generally a positive for the markets.
Slowing demand means a slowing economy, if it stays in a declining mode for several months.Might adversely affect markets, but if it promptsinterest rate reductions it could be good.
The Federal Reserve actually has three tools at its disposal to carryout monetary policy: open market operations, discount rate, and reserverequirements. Open market operations are by far the most widely usedmechanism. When the economy is growing too fast and the inﬂation rateis high, the Federal Reserve will sell government securities from its port-folio to the open market. This decreases bank reserves, which means themoney supply decreases. When there are less bank reserves, short-terminterest  rates  increase.  This  means  consumers  and  businesses  have  topay  the  bank  more  in  order  to  borrow  money.  Less  borrowing  meansless  spending,  which  slows  the  economy  and  eventually  can  reduceprice pressures.
However, if the economy is growing too slowly and the inﬂation rateis low, the Federal Reserve will buy government securities, such as Trea-sury  bills  and  notes.  This  increases  bank  reserves,  which  increases  themoney supply and causes short-term interest rates to decrease. Reducedrates  induce  consumers  and  businesses  to  borrow.  Consumers  will  bor-row money for items such as automobiles or homes. Businesses borrowto build their inventories or ﬁnance new factories. As a result, economicgrowth will accelerate.
The Federal Reserve will also leave rates unchanged if the economy isgrowing at a moderate pace with low inﬂation or if they feel the economy
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will slow down by itself. They will even take a wait-and-see approach withregard to how fast or how slowly the economy is growing and the rate ofinﬂation, before determining monetary policy.
The major goals of the Federal Reserve include moderate growth, lowunemployment,  and  low  inﬂation.  To  determine  how  these  open  marketoperations have been impacting these areas, the Fed monitors the key re-lated reports for feedback.
Economic growth is measured by the gross domestic product, whichconsists of consumption, investment, government, and exports. The retailsales  report  would  fall  under  consumption.  Business  inventories  andhousing starts would fall under investment. Construction spending wouldfall under government, and international trade would fall under exports.Other reports include the employment report, which includes the unem-ployment  rate  and  is  also  closely  monitored  by  the  Federal  Reserve.  Fi-nally, the Producer Price Index, Consumer Price Index, capacity utilizationrates, and Employment Cost Index are all monitored to determine the cur-rent inﬂation outlook.
As  these  reports  are  released  week-by-week,  a  consensus  is  devel-oped among policy makers as to whether the economy and the inﬂationrate  are  growing  too  fast,  too  slow,  or  just  right.  They  look  for  the  evi-dence  and  then  they  take  a  vote  on  whether  to  raise  or  lower  rates  orleave them unchanged. The bottom line is that the Federal Reserve chair-man  and  fellow  central  bankers  have  a  great  inﬂuence  on  our  economyand should be watched closely.
The primary goals of the Federal Reserve are to stabilize prices, pro-mote  economic  growth,  and  strive  for  full  employment.  These  goals  arepursued through managing monetary policy, which is implemented by theFederal Open Market Committee (FOMC). The FOMC includes seven Fedgovernors as well ﬁve presidents of the district banks. Four of the presi-dents serve on a rotating basis. The FOMC’s most frequently used tool tocontrol monetary policy is open market operations. Open market opera-tions means the buying or selling of government securities to control liq-uidity  in  the  economy.  That’s  what  is  happening  when  you  hear  thatliquidity  is  going  up  or  down  in  the  economy.  When  liquidity  is  high,  itmakes  it  easier  for  businesses  to  borrow  money,  which  in  turn  leads  tomore research and development (R&D) spending, which leads to growth.Have  you  ever  really  looked  at  a  dollar  bill?  Across  the  top  it  says“Federal  Reserve  Note.”  It  didn’t  always.  I  actually  have  a  1917  UnitedStates dollar framed on the wall in my ofﬁce; it was the last year they wereprinted. How about the back of the current dollar bill? There is a pyramidwith an eye on the top and a banner along the bottom with a slogan thatstands  for  “New  World  Order.”  (That’s  the  original  name  the  12  familieswho  bailed  out  the  government  in  1913  coined  for  themselves.)  Our  old
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money had an “X” across the back with the words “United States of Amer-ica” embodied in the “X.”
That’s enough history and economics; now let’s examine more recentFed  moves.  As  the  market  was  racing  forward  at  the  end  of  the  1990s,many may remember the famous “irrational exuberance” speech from FedChairman  Alan  Greenspan.  The  sad  thing  is  that  the  Fed  helped  createthat exuberance. In 1999, the Fed began injecting massive doses of liquid-ity into the economy in anticipation of Y2K. It wanted to make sure busi-nesses  had  plenty  of  easily  available  money.  Banks  actually  had  moremoney than they could lend. So where did all this money end up? That’sright, the stock market. And what was in vogue at the time? The unknownInternet sector. This just further fueled the raging bull market that alreadyexisted. After Y2K arrived with few problems, the Fed began rapidly drain-ing that liquidity back out of the market. At the same time, the Fed wasconcerned  about  the  rapid  growth  of  our  economy.  Surely,  an  economygrowing  at  6  to  7  percent  would  spur  wild  inﬂation,  even  though  therewere no signs of it anywhere. So at the same time the Fed was withdraw-ing liquidity, it was raising interest rates to “tap the brakes” on the econ-omy. What is so frustrating is that everyone knows that interest rate cutsor hikes take time to affect the economy. The Fed kept pressing that brakewith more rate hikes because the economy still looked so healthy.
We now see the results of what withdrawing liquidity combined withrate  hikes  can  do  to  businesses  and  a  healthy  economy.  The  effect  hasbeen more of slamming on the brakes and jamming the gears into reverse.Was  there  an  Internet  bubble?  Sure  there  was:  It  would  have  eventuallybecome  apparent  anyway  that  all  those  dot-coms  were  never  going  tomake a proﬁt. The bubble would have suffered a slow leak until it disap-peared  altogether.  Instead,  we  got  a  painful  “pop.”  Could  our  economyhave continued to grow at such a rapid pace without rampant inﬂation? Ifyou  believe  in  the  free  enterprise  system,  supply  will  always  meet  de-mand. Take away the demand and look what happens.
SECURITIES AND EXCHANGE COMMISSION
In the United States, stock exchanges are regulated by the Securities andExchange  Commission  (SEC),  which  was  created  by  Congress  in  1934during the Depression. It is composed of ﬁve commissioners appointed bythe President of the United States and approved by the Senate and a teamof lawyers, investigators, and accountants. The SEC is charged with mak-ing sure that security markets operate fairly and with protecting investors.Among other acts, they enforce the Securities Act of 1933, the Securities
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Exchange  Act  of  1934,  the  Trust  Indenture  Act  of  1939,  the  InvestmentCompany Act of 1940, and the Investment Advisers Act of 1940.
The SEC is also in charge of monitoring insider trading as well as de-tecting corporate fraud. Insider trading is a form of trading in which cor-porate  ofﬁcers  buy  and  sell  shares  within  their  own  companies.  Thistype of trading is widely inﬂuenced by inside information that only cor-porate  ofﬁcers  have  access  to.  Many  off-ﬂoor  traders  keep  track  of  in-sider  trading  to  gauge  the  movement  of  a  speciﬁc  stock.  In  addition,there are a multitude of regulations aimed at preventing corporate ofﬁ-cers from proﬁting from information not released to the general publicduring mergers or takeovers.
Corporate Fraud
Corporate  fraud  has  been  in  the  news  a  great  deal  in  the  United  Statessince  the  accounting  scandals  of  2002  rocked  Wall  Street  and  the  U.S.economy. The collapse of Enron, the bankruptcy of WorldCom, and a se-ries of lawsuits against high-proﬁle executives, including Martha Stewart,give the impression that global corporate fraud and misconduct are ram-pant. This, of course, occurred during the second year of a bear market—a period that saw some stocks lose 50, 60, and sometimes 70 percent ormore of their values, Since stocks were already reeling, the exact impacton the stock market as a whole is difﬁcult to determine. Therefore, the ex-act impact of the corporate misconduct remains difﬁcult to quantify.
While the exact impact of accounting scandals and corporate fraud isdifﬁcult to measure, without question the fact remains: The Enron debacleand subsequent bankruptcies have eroded investor conﬁdence in U.S. ﬁ-nancial  markets.  They  also  dealt  a  ﬁnancial  blow  to  the  shareholders  ofbankrupt  companies  like  WorldCom,  Enron,  and  Adelphia  Communica-tions. On a national level, the scandals and fraud left many investors won-dering,  who  is  next?  When  will  the  next  shoe  drop?  Those  concernsserved to keep many investors away from stocks. Unfortunately, there islittle hope for a market rebound during an absence of prospective buyers.Eventually, some of the concern faded. On February 11, 2003, FederalReserve Chairman Alan Greenspan said that he believed that the corporatescandals  that  shook  Wall  Street  in  the  summer  of  2002  were  reaching  anend.  “I  would  be  very  surprised  if  it  were  initiated  beyond  mid-2003,”  theFed chairman said in a speech to the Senate Banking Committee. “It is not aproblem for the immediate future.” One reason for his optimism stemmedfrom the passage of the Sarbanes-Oxley legislation approved by Congress in2002. The new law restored some of the lost investor conﬁdence.
Yet investor conﬁdence can prove fragile. While it is hard to tell justwhat impact corporate scandals had on the stock market, it is clear that
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investors have begun to recognize it as an additional risk. As time passed,some of the fears and uncertainty began to fade. Stricter regulation andgreater  enforcement  by  the  Securities  and  Exchange  Commission  haveplayed important roles in shoring up investor conﬁdence in ﬁnancial mar-kets. Still, believing that every issue related to corporate malfeasance andaccounting  scandal  has  been  solved  would  be  naive.  In  fact,  such  prob-lems might resurface at any time and rekindle investor jitters. If and whenthis scenario will play out again is unpredictable.
Nevertheless,  corporate  misconduct  is  an  important  factor  to  con-sider  before  stepping  into  the  ﬁnancial  world.  Make  sure  that  all  yourtrades  consider  the  possibility  that  such  problems  could  resurface  any-time in the not too distant future. Manage your risk!
INFLATION CATEGORIES AND GOVERNMENT IMPACT
Economists recognize two principal types of inﬂation: cost-push inﬂation,in which increases in the cost of raw materials and/or labor are reﬂectedin  higher  prices,  and  demand-pull  inﬂation,  which  is  caused  by  the  de-mand for goods increasing faster than the supply.
Cost-push inﬂation usually results from a chain of related events. Forexample, if the labor costs involved in producing a speciﬁc raw materialrise, the supplier of that material will pass on the increase to the manu-facturer who uses the material in a ﬁnished product. The manufacturer,in  turn,  raises  prices  on  the  ﬁnished  product  in  order  to  protect  theirproﬁt margin.
The consumer who buys the product ultimately pays for the highercost of labor in the price of the product. When this happens in severalindustries  at  once,  consumers  who  are  also  workers  demand  higherwages to help meet the increased prices. This, in turn, sets off anotherround of price increases as manufacturers and retailers attempt to re-coup their higher labor costs. As the cycle continues, it raises the costof living for everyone.
Demand-pull inﬂation, in contrast, is caused by increased demand fora product or material, or by scarcity of that commodity. During the 1970s,many  of  the  world’s  oil-producing  nations  held  their  product  back  fromthe market at a time when demand for petroleum was increasing rapidly.The results were across-the-board increases in the prices of oil, gasoline,and  synthetic  materials  made  from  petroleum.  In  turn,  reﬁners,  powergenerating companies, and manufacturers passed along the higher pricesof  crude  oil  to  consumers.  In  addition,  the  fuel  costs  of  freight  haulerswho delivered goods rose, and these, too, were passed on to consumers.
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In some instances, demand for goods is stimulated by the availabilityof extra dollars. The amount of money in circulation increases faster thanproductivity in the economy, leading to greater demand. In effect, moneychases supply. For example, during the 1960s, the government increasedthe amount of money in the economy rather than raising taxes to pay forthe war in Vietnam. The resulting inﬂation was, in effect, a hidden tax topay for government operations, because wage earners were pushed intohigher tax brackets.
The federal government can impact inﬂation and the overall economyin three major ways. First, the government can spend more money than itcollects in taxes, duties, and fees. Such deﬁcit spending tends to stimulatethe economy. But the government must borrow the difference between itsincome and expendit