Articles - Page 19 of 20 - PersonalFinanceLab

Bear Market

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Definition:A long period where the stock market value falls along with a sense of pessimism for the public. If the length of the declining stock prices isg stock prices is short and quickly turns into a period of rising stock prices, it is then called a correction. Bear markets are usually seen when the economy is in a recession and there is high unemployment or when there is rising inflation. The Great Depression of the 1930s is the most famous bear market in US history. Bull markets are the opposite and represent a strong rise in stock prices over a long period.

Example:

The best recent example of a bear market was the one we saw between the end of October 2007 and March 2009. The market declined of 20% by mid-2008 was also seen in other stock markets across the globe. On September 29, 2008, the DJIA had a record breaking drop of 777.68. The DJIA reached a market low of 6,443.27 on March 6, 2009. This was a decline of over 54% since the October 9, 2007 high. A bull market then started on March 9, 2009, as the DJIA regained more than 20% from its low to 7924.56 with three weeks of gains. By the end of the year it had gained over 60%.

A -G, Glossary, Options

At the Money

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Definition: At The Money refers to an option whose strike price equals the price of the underlying equity, index or commodity.

Example: If Pepsi stock is trading at $75, then the Pepsi $75 call option is at the money, and so is the Pepsi $75 put option. An at-the-money option has no intrinsic value (since the strike and the underlying prices are the same), but will have time value (value if the stock goes up during the period of the call option). The options that are at the money tend to be more active than when it is not at the money. These options are also referred to as ATM options (At The Money).

A -G, Glossary

All-or-None Order

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Definition: An order type that only executes when the full amount of the shares in the order can be executed, otherwise the order doesn’t execute at all. In other words, this order type guarantees there are no partial fills.
Example: If you place a Market Buy order for 100 shares of Google (GOOG) and there are only 75 available at the time the order is placed, then the order would not be executed. The order would wait until there were 100 shares available to purchase and then execute at that price.

Advanced, Glossary, N-T, Technical Analysis

Technical Analysis

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SIMPLE DEFINITION: Technical Analysis is the use of technical indicator to predict which direction the stock price will move in the future. Technical indicators use past stock prices to calculate their value.

COMPLETE DEFINITION: Technical analysis evolved from analyzing 100s of years of stock data. The theories for technical analysis began in Joseph de la Vega’s accounts of the Dutch markets in the 17th century. In the 1920s and 1930s Richard W. Schabacker wrote books continuing the work of Charles Dow and William Peter Hamilton from their books Stock Market Theory and Practice and Technical Market Analysis. In 1948 Robert D. Edwards and John Magee published Technical Analysis of Stock Trends. This book is considered to be the break through works of the discipline.

Technical Analysis dates back hundreds of years ago. According to historical records, a great Japanese rice trader by the name of Homma Munehisa (1724-1803) fathered candlestick charting and at today’s value, would have made over $100 billion in profits. He was considered the greatest trader in the history of the financial markets. This type of charting will be covered in subsequent articles (candlestick charting will be used in all articles). Therefore, technical analysis emerged from Japan. In the U.S., technical analysis first started to gain some following due to Charles Dow’s Dow Theory in the late 19th century. Charles Dow formed 6 principles that formed the foundation of technical analysis:

Three-moving Parts – The market has a primary movement, a secondary reaction, and a minor swing movement. The primary movement is the long-term trend that lasts for years, the secondary reaction is the retrace from the primary movement (typically lasting for months), and the minor swings are the much shorter swings that occur within a chart (usually neutral and lasting from hours up to a month).
Three-Phase Trends – The market is composed of three phases: an accumulation phase, public/media phase, and a distribution/selling phase. The “smart money” (sophisticated professionals) as the ones who are purchasing shares in Phase 1. In Phase 2, the media starts to focus on the particular stock or sector and the public (retail traders/investors) jump in. These are the momentum traders/investors that see a trend forming and want to get in on the action. In Phase 3, the “smart money” actually sells while the retail traders/investors keep buying.
Discounting Mechanism – The market discounts all news. This means that news that comes out is already factored in, or “priced” in. Obviously, this does not include illegal inside information.
Major Average Confirmation – This means that one industry that is dependent on another cannot rally unless both are rallying. This is especially true if the entire market is rallying but several key sectors are declining. In the chart below, you can see that the homebuilders (orange line) declined long before the market declined. The banking sector (sky blue) declined soon after. The financial sector used to be the #1 sector in terms of capitalization (banks were doing very well at the time!). Real estate and its related industries account for at least 25% of the U.S.’s GDP. With these two major powerhouse sectors declining, the market didn’t stand a chance.
Volume Confirms Action – Volume is extremely important. For a trend to continue, volume must increase. This represents added interest and additional buying which is required for a trend to propel itself to new highs. If a rally continues on lower volume, the trend cannot sustain itself and will fail. Let’s take a look at the rallies we had in 2008 as an example. Notice how the rallies were made on low volume and on the declines, we saw increasing volume. A healthy, strong market would exhibit the complete opposite.
Trends Continue Until They End – This is self-explanatory. An up trend continues until it ends and a downtrend continues until it ends. Typically, a trend ends when a lower high (for an up trend) or a higher low (for a downtrend) is achieved.

Now that we covered the basic history and foundation of technical analysis, let’s move on to its purposes and uses. It’s not designed to be a crystal ball! Patterns can and will fail and you will occasionally take losses. However, if you focus on highly reliable patterns, combine indicators, and perfect your entry and exit points, you’ll be way ahead of the game.

Entry & Exit Points – Technical analysis gives traders and investors advanced warning of when a trend changes against their favor. If you know how to recognize certain chart patterns and use price-volume divergences to your advantage, you’ll join the ranks of the “smart money” that accumulate long before everyone else jumps in. You’ll also be able to identify reversals, sometimes on the very same day and know when to exit a position.
Low-Risk Trading – The chances of putting on a successful trade is greater if you use technical analysis.
Know When to Sell Short – Technical analysis is not only used for “going long” (buying stock). 9 out of 10 investors/traders do not know how to sell stocks short, or are afraid to do so.
Use Candles to “Light the Path” – Candlestick charting, will help you see warnings in advance and give you enough time to react.
Identify and Trade Gaps and News – There are four main types of gaps: area, continuation, breakaway, and exhaustion gaps. Can you tell the difference? Gaps are usually formed on news, such as earnings or FDA approvals, etc.
Identify Potential Support & Resistance Areas – Trend lines are a part of basic chart reading.
Combine Indicators to Support Trading Decisions – There are dozens of indicators that are available to make trading decisions. You may have heard of the MACD, RSI, Stochastics, Money Flow, and many others. Or, perhaps you didn’t.

Glossary, N-T

Trailing Stop

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Definition: Trailing Stop is a Stop Loss order which is placed as a percentage value as opposed to an absolute dollar value. The order will only execute if the price of the security falls by a certain percentage. The trailing stop adjusts automatically as the price of the security rises and bases itself on the new appreciated value. This type of order allows profits to be made while cutting losses simultaneously.

Explanation: This is such a useful tool, yet many fail to use it. Using a trailing stop allows you to let profits run while cutting losses at the same time.

Glossary, H-M

Margin

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Definition: Margin buying is buying securities/stocks with money borrowed from a broker. Since this money is borrowed, margin buying can multiply profits or losses made on the securities. The stocks/securities are used as collateral for the loan.

Explation: The broker will have a set minimum margin requirement which is the maximum percent of the investment that can be paid for with margin/borrowed money. A Margin Call is when the value of your investment drops your equity in the investment below the requirements of the broker at which time you have to add more money to your account or sell the security.

A -G, Advanced, Financial Ratios, Glossary

Current Ratio

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Definition: Current Ratio is the ratio of current assets divided by current liabilities. It provides A liquidity ratio that measures a company’s ability to pay short-term obligations. Also known as “liquidity ratio”, “cash asset ratio” and “cash ratio”. The Current Ratio formula is:

Example: The ratio is mainly used to give an idea of the company’s ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt – as there are many ways to access financing – but it is definitely not a good sign.

Current ratio = Current Assets / Current Liabilities.

The current ratio can give a sense of the efficiency of a company’s operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations. Because business operations differ in each industry, it is always more useful to compare companies within the same industry.

This ratio is similar to the acid-test ratio except that the acid-test ratio does not include inventory and prepaids as assets that can be liquidated. The components of current ratio (current assets and current liabilities) can be used to derive working capital (difference between current assets and current liabilities). Working capital is frequently used to derive the working capital ratio, which is working capital as a ratio of sales.

A -G, Glossary

Buy Side Firms

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Buy-side Firms are companies that provide advice on buying stocks and securities for use within their own organizations.

Examples of buy-side firms are mutual funds, pension funds and hedge funds. These firms provide recommendations about upgrades, downgrades, target prices and opinions within the company itself. These firms which are also called non-brokerage firms, work exclusively for the company’s own money and not for outside investors. Buy Side firms are not to be confused with Sell-Side firms.

Analysts in buy side firm are independent with little or no conflicts of interest due mainly to the Chinese wall.

Roles and Responsibilities of Buy Side Firms

Buy side firms, do their own research and buy securities for the company’s own projects
Buy-side analysts work with portfolio managers within their organization which makes it easy to explain their analysis
fixed-income buy-side analysts grade high yield bonds used for their company’s review and benefit

Limitations of Buy Side Firms

Buy side firms can not involve external investors in trading based on their research
They are restricted from brokerage activities for investors and earning transaction costs and brokerage commissions
Buy-side analysts are prohibited from releasing any private recommendations
Investment costs and losses while buying securities are covered by the buy-side firm and cannot be outsourced.

Examples of Buy-Side Firms

Some examples of Buy-Side Firms are:

Fidelity Funds
Putnam Funds
Vanguard Funds
T Rowe Funds

Conclusion

Buy side firms typically engage in trading investments and generating profits/losses using only their own resources.

These firms do not buy and sell investments for public traders.

Advanced, Financial Ratios

Total Asset/Equity Ratio

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DefinitionThe Asset to Equity Ratio is the ratio of total assets divided by stockholders’ equity.

The asset/equity ratio indicates the relationship of the total assets of the firm to the part owned by shareholders (aka, owner’s equity). This ratio is an indicator of the company’s leverage (debt) used to finance the firm.

The importance and value of the company’s asset/equity ratio is dependent upon the industry, the company’s assets and sales, current economic conditions, and other factors. There is no ideal asset/equity ratio value but it is valuable in comparing to similar businesses. A relatively high ratio (indicating lots of assets and very little equity) may indicate the company has taken on substantial debt merely to remain its business. But a high asset/equity ratio can also point to a company that is wisely “trading on the equity.” In other words, there is a high asset/equity ratio because the return on borrowed capital exceeds the cost of that capital.

At some higher levels, however, the ratio can reach unsustainable levels, as the additional debt ratchets up interest costs and the deteriorating financial position puts the firm in jeopardy. By the same token, a low asset/equity ratio can indicate a strong firm that needs no debt, or an overly conservative company, foolishly foregoing business opportunities.

Strategies for Beginners

Trading Strategies

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Today, you can find many articles warning of an imminent market pull back. As a new investor, it is helpful to understand how the various indicators contribute to these forecasts so that you will be forewarned and can make appropriate alterations to your portfolio before a bottom drops out. Those who are unprepared often pay a large penalty.

Current Events

Lets first look at current events. There is a very strong correlation between these events and the near term direction of the market. This week, there were reports that the job market and service sectors are in worse shape than predicted. The Eurozone economy, which has dominated the financial press, is continuing to unravel. Debt, driven by the US government, as a percent of GDP is more than 10 times higher today than it was prior to the great collapse of the 20’s. Market fear from these events can quickly stall the economy. While our economy is so shaky, our government ignores the historical lessons of our prior recessions. Obama has just release new guidelines for federal programs that will 1) remove capital from the market, 2) encourage people with weak credit ratings back into home ownership and 3) increase business uncertainty, risk and fear. The economic stall can be associated with any random event with all these other issues bearing down.

Beside specific current events, we know that seasonality has an impact on specific stock sectors as well as the market in general. Our “Best Months to Buy” article reported that May, June, August, September and October are historically the worst months of the year to hold stock.
Technical Indicators

For many, technical indicators are hard to understand so are overlook. In fact, using these tools are quite easy as they are readily available on the web. We just need to understand what they mean. Lets look at what some of these indicators are saying about our current economy and the market.

As most of us know, the most popular market indexes are hitting record highs but with lower volume. As you may remember from our previous article, volume is the most important early warning indicator for predicting changes in demand and the direction of price.

Avid technical analysts use the MACD as one of the most accurate indicators. Today when you look at the MACD for the DOW, you will see that it is converging and heading toward a bearish crossover. This is a very strong technical indicator predicting a downturn in the market. If the two lines used for MACD continue in their path and cross over, you will find that the smart investors will quickly leave uneducated investors holding the bag.

Finally, there have been five distribution days over the last month. A distribution day is when the market has a big loss with large volume. When you have five distribution days, then these analysts specify that the market moves from a confirmed up trend to a confirmed down trend. Some stock picking companies use this one indicator as the sole tool in choosing market turns. To see a complete list of technical indicators.

In next week’s newsletter, I will write about how to adjust your portfolio when you have identified an upcoming down turn.

Advanced, Glossary, H-M, Technical Analysis

Moving Averages

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Moving Averages

Moving Averages are one of the most popular and important technical analysis tools. The ease of use and simple calculation make it a great tool to get information quickly. They also provide the basics for more advanced technical analysis tools like MACD and Bollinger Bands and can be useful for removing some of the “noise” from daily fluctuations in the market. In simple terms, the moving average is an average that compares the previous period over time. There are two types of moving averages: the Simple Moving Average (SMA) and the Exponential Moving Average (EMA) which puts more weight on the latest date. We will explore the differences more in depth later on.

Moving Average Technical Analysis

Moving Averages are lagging indicators and give an indication of the strength of a trend rather than predict movement in the asset or market. They are also useful for identifying support and resistance lines and can be used to look at a market reversal. As we will see below, the longer the period used for the SMA, the stronger the trend, hence a 200 day SMA provides a stronger indication of trend than a 10 day SMA.

Moving Averages give a lot of information at crossings between shorter and longer Moving Averages, the distance between the price and the moving average and provide support and resistance lines as well.

Below is a graph with a 50 day and 200 day SMA.

The first thing to point out is that the 50 day SMA follows the price much more closely than the 200 day SMA. Hence the longer the period of the SMA, the smoother and more static the line is. As an analogy the 10-day SMA is like a sports car that can turn quick and easily whereas the 200-day SMA is like a large truck that cannot change or turn quickly.

Take note of the points where price and SMA’s or EMA’s cross each other. If we start with the leftmost arrow (1), we can see that the price crosses the 50 day and 200 day multiple times. This is not a strong indication of trend, as the price can frequently give “false” warnings in day to day trading.

A much stronger indication is when a shorter period SMA crosses a longer period SMA. As we can see at the second arrow (2). The 50 day SMA crosses the 200 day SMA from the top (downward) which is a strong indication of a bear market.

On the other hand, the third arrow (3) has the 50 day SMA crossing the 200 day SMA from the bottom (upward) giving a strong indication of a bull market.

Another aspect we can see from moving averages is the support and resistance lines. Support lines are when the moving average is below the price and resistance lines are when the moving average is above the price. As we can see from the multiple small circles, the price rarely goes above or below the moving averages for long and even less frequently when it is a longer period. The other thing to notice is the large oval. The greater the distance between a moving average and the underlying price, the more we can expect a reversal of the current trend as we can see above.

!!! Note: These indicators can be useful to determine resistance, support, some reversals and trend strength. However, as you can see from the top left in the graph, this is not always the case. The 50 day SMA came very close to crossing the 200 day average but would not have indicated a very strong trend!

SMA vs EMA

As we saw earlier the EMA gives more weight to the current price which we will see in more detail in the calculation section.

You can see slight discrepancies above between the EMA and SMA. With a price that has more volatility however, you will see greater differences. We can also see that there the EMA tracks some big changes more closely, especially for the EMA that is 10 days as opposed to 50 days.

Moving Average Calculations

The Simple Moving Average calculation is far more straight forward than the Exponential Moving Average Calculation.

SMA calculation:

N Day SMA: Is the sum of N previous closing prices over N where N is the number of Days considered.

For example: 20 Day SMA is the sum of the closing prices of the 19 previous days(includes today’s closing) over 20.

If we have a 5 day SMA with prices as follows:

Jan 1st	12.5
Jan 2nd	13.7
Jan 3rd	14.5
Jan 4th	13.9
Jan 5th	16.8

Then the 5-Day SMA on the 5th of January is: (12.5+13.7+14.5+13.9+16.8)/5 = 14.28

!!! You always need the number of days data before you can calculate that day’s Average! So if you want the 200 day SMA for a particular day you need 200 days of data before that!

Mathematical Formula:

(Σ closing price from i-N to i) / N where i is the current day and N is the time period.

EMA calculation:

The EMA is a more complex calculation, though, as we have seen, just as easy to interpret.

EMA = (current Price * 2/(1+N)) + (Previous Day’s EMA * (1-2/(1+N))

The expression 2/(1+N) is called the weighting multiplier and will be higher for smaller periods of EMA. This means that more weight will be given to the last day’s price.

SMA VS EMA

Price	SMA-5	EMA-5
19	17	17
20	18	18
50	24.8	28.67
22	25.8	26.44
23	26.8	25.3

Recession is generally described as a slowdown of economic growth over a sustained period of time.

Advanced, Financial Ratios, Glossary, N-T

Quick Ratio

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Derivative is a type of security whose value is “derived” from an underlying asset. (Eg; Futures and Options).

Futures and options are both derivatives – meaning a security whose value solely depends on the value of the underlying asset.

A future derives its value from the commodities or currencies which it represents
An option derives its value from the underlying stock

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What are they doing with your money? Have you ever wondered how well your money is really being managed by the corporations you hand it over to?

After all, the media is full of stories about CEO compensation reaching new heights, buy-outs of non-profitable holdings, million dollar birthday parties and other horror stories.

Formula for ROE

What is ROE used for?

Return on Equity (ROE) is used to measure how much profit a company is able to generate from the money invested by shareholders.

Think of this way; if your friend asked to borrow $1,000 to start-up a small side business then chances are you would comply. When they came back to ask for $10,000 you would examine how well they performed with the initial $1,000 before making the next loan.

It makes such good sense that you might wonder why more people don’t use this handy little measure before pouring massive sums into a money pit masking as a company.

What kind of ROE to look for

Join the ranks of those in the know. ROE is easy to compute and provides valuable insight into the workings of the company.

Think twice before investing in a company with a negative ROE. Instead, search out self-sustaining companies with a healthy ROE that indicates the willingness and ability to use invested dollars for future growth rather than operating expenses.

A good ROE is 15% or better so keep your eyes – and ears – open for opportunity.

DuPont Analysis and the need to break down ROE

ROE measures what kind of income can be generated for a given level of equity injected into the company. It is essential to understand that different sections of the company that return is generated from.

This in turn will help investors identify where their equity is being used wisely, and where it is being wasted in trying to generate income.

You need to perform a DuPont Analysis to identify where equity is going and returns are coming from.

Moving Averages

Moving Average Technical Analysis

SMA vs EMA

Moving Average Calculations

Formula for ROE

What is ROE used for?

What kind of ROE to look for

DuPont Analysis and the need to break down ROE

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