Now that we have gone through the different business cycles and the roles of the Government and the Fed, it is time to take a detailed look at the different gears that turn the “engine of the market.” In this chapter, we will start with the broad equity markets, work through the fixed income arena (Bonds), and cover sectors and currencies. Real estate will be covered in Chapter 4. The analogy can be seen in Figure 3-1.
FIGURE 3 - 1 Participants should have a solid understanding of the marketplace. Some will be capable of trading in all environments, but all must understand the impact of each gear as indicators and beacons of the business cycle and the capital markets alike.
As Figure 3-1 shows, there are many “gears” within the powerful engine of the market, with some garnishing more “torque” than others. Nonetheless, all of the listed inner workings of the markets cannot be simply discarded as “noise.” Each has an important role that, if spun hard enough, will affect the entire business cycle.
When breaking down one of the main gears, the broad market indices, a good place to start is with the most popular benchmark, the Dow Jones Industrial Average (DJI). Despite being widely recognized by investors as the main index, one inherent problem with the Dow is that it uses only 30 stocks to gauge the sentiment of over 10,000 other stocks. If one stock in the Dow comes out with bad news and its price moves significantly, then this average of only 30 stocks is highly influenced and not necessarily reflecting all 10,000.
Evolving from 11 stocks during its inaugural year under Charles Dow in 1896, the Dow Jones is composed of actively traded high-quality stocks that are price weighted, meaning that the price of each constituent stock is added together and divided by the number of stocks to get a value. The stocks that make up this average have an excellent reputation and demonstrate sustained growth. For the sake of continuity, changes in the stocks used to determine the Dow are rare and happen only if there is a dramatic development in a particular company. For example, the Sears Roebuck Company was removed from the Dow in 1999 because it was seen as reflective of an era past, while Wal-Mart was seen as direct competition and better reflected the current and future era; so Sears was replaced by Wal-Mart. In other words, the market elected Wal-Mart as a better representative of the group than Sears Roebuck.
The majority of the investment community regards the S&P 500 as the true benchmark of broad market performance. This index is calculated using a base weighted aggregate methodology. In other words, the level of the index reflects the total market value of all 500 component stocks relative to a particular base period. The statistical value of the S&P 500 offers a far better benchmark for the technician since it is well regarded by the institutional community. See Figure 3-2 for data on the index.
FIGURE 3 - 2 Notice the correlation the S&P 500 has to the Dow (91 percent) as of this printing. The value of this information is that these two indices are not directly pegged to each other, as many amateurs believe. Additionally, the Nasdaq Index also represents a broad market indicator, but primarily for technology. Therefore, a huge variance can and does occur among broad market indices. Traders and investors must recognize each index for what it measures and its market impact. This will direct trading and investing decisions on many fronts including risk, volatility, relative strength, and even arbitrage techniques. (Image provided by www.sandp.com.)
Although the S&P 500 Index was created in 1957, it is projected from 1941–43 in order to form a basis for comparison. In practice, the daily calculation of the index is made by dividing the total market value of the 500 companies by an index divisor that is adjusted to keep the index comparable over time. The 500 constituent stocks that make up this index are selected by an independent committee. This means that companies cannot nominate themselves, nor can investment banks or other entities nominate them. This committee usually meets every month to discuss how corporate actions will affect the index. They also discuss inclusions and exclusions to the index. The companies selected for the S&P 500 index represent important industry segments and generally have the largest market value within their respective industry. Careful consideration must be made for additions and deletions since many large institutions have S&P 500 index tracking funds. When a stock is added to the index, one is subsequently removed in order to keep the index number at 500. This information is valuable because institutions are indexed to these specific issues and they will sell the stock that leaves the index and buy the stock that is added. This has a large impact on both companies and provides a good trading opportunity due to changes in money flow. Money flow patterns are important measures since mutual funds compete with the S&P 500. Indexing means that they own the same stocks in their portfolios as the components within the index. The funds that beat the index do so by having a heavier weight in the outperforming shares of the index.
Your role is to understand the impact these funds have on the index and trade direction of the trend they set. These funds simply have more money and leverage to set the trend than any single investor, hence the cliché, “the trend is your friend.”
The Nasdaq Composite Index is another wide-based market value weighted index (like the S&P 500). It takes into account all of the common stock listed on the Nasdaq exchange and is one of the broadest indices for technology stocks. The Nasdaq mainly tracks technology stocks, so it is not the best indicator to track the overall market. Created in 1971, this index includes over 3000 securities. To be included in the Nasdaq, the security must be both listed on the Nasdaq and be either an American depository receipt (ADR), common stock, ordinary shares, real estate investment trust (REIT), shares of beneficial interest (SBIs), or a tracking stock. If at any time a component security no longer meets the eligibility criteria, the security is removed from the index.
This index is made up of 100 of the largest market capitalization stocks that are nonfinancial listed on the Nasdaq stock exchange. Still considered the standard for technology stocks, the Nasdaq 100 was launched in 1985 and focuses on several industry groups including computer hardware and software, telecommunication, retail/wholesale trade, and biotechnology. As a pure technology index, the Nasdaq 100 (NDX) is the best broad market representative. To be listed on the Nasdaq 100, securities must be in the top 25 percent market capitalization for the prior six months, having an average trading volume of at least 200,000 shares as well as being a nonfinancial company.
The other main sprocket that complements the broad indices is the fixed income arena, reporting an average daily cash volume of roughly $630 billion versus $70 billion for the three major stock exchanges. Moreover, at the end of 2002, there were over $20 trillion worth of outstanding fixed income securities compared to $11 trillion of total stock market capitalization.
The definition of a fixed income security is simply a certificate of debt issued by a government or corporation guaranteeing payment of the original investment plus interest by a specified future date. For purposes of our discussion, the term bond will be synonymous with the U.S. Treasury bond. This instrument is defined as a negotiable, coupon-bearing debt obligation issued by the U.S. Government and backed by its full faith and credit, as well as having a maturity of more than seven years (if less than seven years, the correct term is Treasury note). Interest on Government bonds is paid semi-annually and exempt from state and local taxes. Bonds are nothing more than the physical evidence of a loan made among the parties. Most bonds are fixed-rate bonds that pay a fixed annual rate of interest to the bondholder. This fixed interest rate is called the coupon rate. Bonds are usually issued to meet long-term obligations, to improve the working capital of the issuer, or to fund growth. Issuing bonds is the alternative to issuing stock (or selling equity).
When it comes to pricing bonds, the value of a bond is equal to its expected cash flow (coupons issued semi-annually) throughout the life of the bond discounted at a certain rate. The result equals the present value (PV) of a bond. An example of calculating the PV of a bond is shown in Figure 3-3:
FIGURE 3 - 3 Present value calculation for a fixed income security.
Example
• Par Value = $1000
• Maturity Date is in five years
• Annual Coupon Payments of $100, which is 10 percent (100/1000)
• Market Interest Rate of 8 percent—The Key Variable
The Present Value of the Coupon Payments (an annuity) = $399.27
The Present Value of the Par Value (time value of money) = $680.58
The Present Value of a Bond = $399.27 + $680.58 = $1079.86
It is important to understand that there is an inverse relationship between interest rates and price. For example, if Company A and another company both issue bonds at 8 percent, these securities will have the same initial cost since they are equally attractive (assuming credit risk is identical). If, on the other hand, the economy deteriorates and interest rates fall to 6 percent, what will happen to the price of these bonds? They will still pay 8 percent; however, since the overall market can now only offer 6 percent, the bonds from Company A will have to demand more than what they did before (called a premium). These investors that pay more to get the 8 percent (or $8 per bond if par is $100) will, however, only get a 6 percent return. Why? Let’s say Company A’s bonds went from a par of $100 to $133. Take the $8 (coupon) and divide by 133. Then multiply by 100. This equals 6 percent. Of course, the holders of these bonds have a 33 percent capital gain they have to contend with.
A common misconception is that bond yields and bond interest rates are the same. They are not. A bond’s yield does not have to fall with interest rates, as seen in past practice when the Fed has raised rates while yields actually fell. Therefore, yields can have a life of their own, representing investor psychology and reflecting a perception of risk used to “grade the Fed” on how its monetary policy is working. Remember, in late 1999–early 2000, it sure didn’t make sense for an investor to pass up stocks that were generating 30 percent annual gains for a small 30-year yield that fell from 6.5 percent, to 6 percent, and then 5.75 percent, most likely due to the Fed raising interest rates. The market will always tell us later “why” the market was buying the higher yields. To calculate yield for bonds and notes, divide the coupon rate by the market price.
Figure 3-4 is a good illustration of how yields and rates differ.
FIGURE 3 - 4 This chart illustrates the difference between current interest rates and yields, ranging from 91-day T-Bills to 30-year Treasury bonds.
Another important understanding of the bond market is that there are different maturities issued by the U.S. Treasury. Ranging from four weeks to thirty years, the different slope of the yield curve can definitely tell a different story about the economy. It should be noted that bonds with longer maturities normally fall or rise more than bonds with shorter maturities. If, for example, interest rates fall 1 percent, the price on a 20-year bond will generally rise more than a 5-year bond. See Figure 3-5.
FIGURE 3 - 5 This chart illustrates the difference in yields between short- and long-term Treasury notes and bonds; thus forming a “yield curve” that is either positive (shown) or negative. A positive yield curve is when yields within longer-term bonds are higher than for short-term notes.
A situation in which long-term debt instruments have higher yields than short-term debt instruments is referred to as a positive yield curve. This is common. If, however, long-term interest rates have lower yields than short-term interest rates, it is called a negative yield curve.
Steepening occurs when the yield curve gets more positive. This can be done a variety of ways, but usually happens via the buying of shorter-term maturities (lowering yields) and selling of longer-term maturities (raising yields). The opposite is called flattening. If traders ranging from speculators to foreign central banks are lowering long-term exposure to either a depreciation of the U.S. dollar or falling confidence, there could be a flight-to-quality resulting in more assets on a relative basis being put into short-term notes, thus steepening the curve.
The following rate structure will help explain the impact short-term rates have on the market.
• Prime rate is the base rate on corporate loans at large U.S. money center commercial banks. The prime rate is relatively stable but reacts quickly to policy changes made by the Fed.
• Federal funds rate is the interest rate charged on reserves traded among member banks for overnight use in amounts of $1 million or more. The federal funds rate is the most volatile of all interest rates, changing daily in response to the needs of borrowing banks, and represents a daily average of the rates charged by the lending banks. The rate fluctuates hourly.
• Discount rate is the rate charged on loans to depositary institutions by the FRB of New York.
• Call money rate is the rate charged on loans to brokers on securities used as collateral. This rate forms the basis for the rate charged to customers of the broker for purchasing securities on margin.
• Commercial paper rate is the rate on commercial paper placed directly by GMAC or the rate on high-grade unsecured notes sold through dealers by major corporations.
As you can see, the rates within the market are also top-down and the power of short-term interest rate changes can have a dramatic impact on short-term and even long-term market direction. This does not mean that rising short-term rates mean the stock market will always fall (inflationary posture) or that falling rates will always support market rise. This is not certain; it is only certain to know that the effects of short-term interest rate adjustments can add to market volatility while contributing to a longer lasting trend. It is important to understand that rising rates cost publicly traded companies money based on the bond discussion above, and this makes these companies less valuable in the absence of other factors. Simply stated, rising interest rates means a rising cost of doing business and that means less earnings.
What is the correlation between interest rates and equity prices? Looking at the following two charts in Figures 3-6 and 3-7, the correlation may not be perfect; however, there is reason to believe that, in general, lower interest rates spell out higher equity prices.
FIGURE 3 - 6 The chart depicts the movement of interest rates over the long haul, illustrating the relationship of the prime rate to the federal discount rate to the long T-bond yield.
FIGURE 3 - 7 This chart shows the movement of the key major indices (Dow Utilities to Dow Industrials) since the early 1970s.
Because earnings, as we know, are the true bottom line, and all the speculation we do in the markets is centered on factors that attempt to predict and estimate earnings, earnings are directly under attack when rate hikes occur. This can cause quite a stir in the equity markets. Conversely, other factors that drive investment decisions are not so clearly related to earnings, and this opens the door to subjectivity. Certainly different participants come up with different conclusions, but the complexities of these factors are good reasons to stand aside and let “price” sort it out. The market discounts all factors and reflects the consensus of all opinion in its price. So why broach the subject of interest rates, you make ask—because rate changes are the “fundamental exception.”
As we have made clear, interest rates matter, affecting markets dramatically as they are the universal language of all companies within the S&P 500, the market, and the world. The factors noted earlier may only apply to certain sectors or stocks, but interest rates are broad market indicators because they affect all stocks and therefore the broad market.
Here is a universal example using the objectivity of the math. Suppose a company has a present value of $5 billion and a present cost of money of 9 percent (adjustable rate) on debt funding for 10 more years. If the cost of money increases to 10 percent, the company’s present value is reduced by $450 million (PV = FV/(1 + R)^t) due to the drag on earnings. This 9 percent reduction in value can have a dramatic and lasting impact on stock prices.
If a company carries little or no debt, many would surmise the impact would be minimal. We must also remember the consumer of the goods and services of the publicly traded company will also be affected through reduced buying power. Higher cost of money equals lower buying power. The Fed therefore becomes somewhat of a drug dealer. The drug is debt, and the cheaper it is, the more the money supply is eased, and the more buying power created. If debt is expensive, the cost of money is higher, which in turn means lower buying power, and less spending (tightening money supply). The drug is given, the drug is taken away—and America likes this drug.
Bond futures are a standardized, leveraged instrument with specific coupon and specific maturities that trades at the Chicago Board of Trade (CBOT) as either a hedging instrument for cash traders, a market for speculators, or simply a benchmark for observers who use the moment in bonds to possibly reflect sentiment in equities. A futures account allows you to buy/sell a contract for much less than the face value of a bond (100 equals 100,000), since margin is only a few thousand dollars. Every tick (1/32) debits or credits $31.25 into your account. There are no dividends paid and very few traders hold the bond until delivery. Futures, by definition, give traders an idea where yields might be down the road.
Futures accounts must be opened separately from equities under a commodity futures trading account regulated by the Commodity Futures Trading Commission (CFTC). Equity accounts are regulated by the SEC. Consequently, funds cannot be commingled with an equities account.
Commodities are the physical product. They represent the earliest descendents of speculation tools such as coal, oil, iron, copper, agricultural products, etc. Yet the markets today operate around the risk management of the commodity for which the producers of the actual commodity play little part. The farmers of grains, butchers of frozen pork bellies, or producers of orange juice generally have little impact on the derivative markets that trade their physical goods. Instead, the futures market leads this domain as a means of managing risk. This at least was the original purpose of said market, but today, the evolution of markets has given way more to speculation than to risk mitigation.
In theory, futures contracts act like insurance policies, whereby the risk and protections provided by the insurance company is somewhat predetermined in exchange for the insurance premiums collected. One party pays a premium for protection while the other promises to protect against a certain unknown outcome. They are called premiums because the cost of such protection generally exceeds the risk of the exposure. Both parties are obligated to the contract for as long as the agreement is in place. This is how insurance companies make money. In the case of commodities, similar contracts exist.
The producer of a good essentially buys a contract that allows them to sell the good at a predetermined future date at a predetermined fixed price. This ensures and removes risk to the producers who may develop volatile goods in terms of price based on the supply/demand environment in the future (unknown). This way, through a commodities futures contract, the producer may sell a product at a determined price that they have not even produced yet. This principal reduces the risk to the producer and can give the producer incentive to go forward with the production. They essentially give up the opportunity for selling at higher prices in the future in exchange for certainty today. Just like an insurance policy; we pay a premium today to eliminate risk tomorrow. The premium paid for the commodity is the potential upside profit available in the future. Like insurance companies, the risk from the insurance company’s point of view, like that of the commodity futures issuer, is less than the premium received, hence the profitability.
On one hand this market is created to hedge risk for the producers of the commodity, while on the other hand it has become a game of chance for speculators to try and guess future pricing. This makes it a game of chance and a zero sum game as well. For every winner there is an offsetting loser with one exception. The bookie in the middle bringing the parties together called the exchanges and clearing firms. These intermediaries make the “vig” on transactional revenue with little risk. This is clearly the best business to be in!
The commodities markets were once not easily assessable to ordinary investors. They were something that your average everyday investor did not speculate in. Over the past several years, however, there has been an increased interest and increased money flow into the commodities markets. With the introduction of mini-sized commodities futures contracts that trade electronically, most investors and traders now have the ability to participate in the commodities market directly. The influx of money into commodities is mainly due to the fact that they can be a good hedge and are great trading vehicles. Throughout history, gold has been a hedge to risk. When there is mistrust about the future of the financial markets as a whole, there has typically been an influx from equities into treasuries and gold. As participants in financial markets buy a set of equities, they will typically hedge their investment in some way. More and more there has been a transition from going to treasuries and gold as a place of safety to going to energy. Two of the fastest growing commodities contracts are the light, sweet crude oil futures contract and the natural gas futures contract.
Crude oil is known as black gold for good reason. First of all oil is valuable and many fortunes have been made or lost because of it. Secondly, it trades much like gold. Crude oil is currently one of the world’s most actively traded commodities, and the most liquid futures contract on crude oil is traded on the New York Mercantile Exchange (NYMEX). The movements of crude oil are direct descendants of supply and demand as well as the perception of supply and demand. Since much of the oil supply for the U.S. comes from other countries, the price is highly affected by world events. This could be terrorist acts, worker strikes, or war—any disruption of supply. These causes will typically also cause equities to decline, making it an ideal hedge. All of these types of events have an effect on the price of crude oil. Anything that adversely affects the supply of oil into the country will drive prices higher. During the 1990s the par value of oil was $18–21. Anything lower than $18 for oil was considered cheap and anything over $21 was considered rich. In the early 2000s par value was raised. The par value for crude oil moved to the $30-a-barrel area. With the U.S. oil supply so dependant on foreign nations, the market for trading crude oil is very volatile and liquid, as shown in Figure 3-8.
FIGURE 3 - 8 The bar has been raised to the $30 area for crude oil. When there is uncertainty about the disruption of the supply of oil the price spikes.
As a final note, Saudi Arabia is the biggest supplier of crude oil to the U.S., and the ruling family is getting older and one day a change will occur in the rule of the country. This will have a direct effect on the price of oil.
Natural gas is another commodity that is increasing in popularity. The natural gas market is purely driven by supply and demand. The factors that affect the supply and demand make this a uniquely traded instrument. There are many countries around the world that have large supplies of natural gas. The trouble with natural gas is that it is not easily transportable nor stored since it must be compressed or liquefied and is highly explosive. This makes it a natural terrorist target. Imagine a ship filled with liquid natural gas. Since natural gas is explosive, it makes it a floating bomb. There is no insurance company that would insure this type of shipment.
The U.S. is becoming increasingly dependant on natural gas each year. Being that natural gas is not easily transported, the main supply comes from within the U.S. and Canada, and this makes supply limited. The internal infrastructure within the U.S. for getting natural gas out of the ground is getting old. When the large energy trading firms went bankrupt, the scheduled repairs to the infrastructure didn’t happen. As a consequence the equipment breaks down often, which disrupts supply and affects the price of natural gas. Weather may also impact the price of natural gas. In cold weather, people may use more natural gas. Energy is taking the place of gold and treasuries in the portfolios of many people as a hedge to long side exposure in the equities markets. See Figure 3-9.
FIGURE 3 - 9 Notice the volatile nature of natural gas.
When fitting commodities into the sprocket relationship outlined earlier, there is normally an inverse relationship between Bond and Commodity prices (CRB Index). This is because a higher CRB Index usually means more inflation, which in turn generally pressures bond prices.
There are also many other commodities that are actively traded. These include coal, cocoa, coffee, sugar, and pork bellies. As with any other traded item, it is a simple matter of supply and demand. Prices are affected by rain in other parts of the world and forecasts of El Niño and La Niña seasons. These commodities may trade in unique ways but you should know that these markets exist and they are necessary to help supply meet demand. If all of a sudden the supply of sugar were cut off, the price of sugar would rise until there wasn’t any more and there is a real problem. Many products couldn’t be produced, people would lose jobs, and it would come to a point where it would turn into sheer madness. Though you will probably not trade any of these products, you need to know that in the overall picture they are important and necessary.
There are many ways of measuring the market. There are different ways of looking at the market depending on what you are trading. It is necessary to formulate an overall view of the market whether you are trading it actively or investing. Now that you have a taste of what is out there you can decide which indices and indicators you like personally. Though most of the focus of the book is on technical analysis, if you plan on participating in the market for any length time it is necessary to touch on a fundamental understanding of these products and indices and their market impact.