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VIEWING THE MARKET, correctly

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HANDBOOK OF FINANCIAL MARKETS, SECURITIES, OPTIONS AND FUTURES, SECOND EDITION,Frank J. Fabozzi & Frank G. Zarb, editors, Dow Jones-Irwin, Homewood, IL, 1986.

 

THE MONEY MARKET  Participants trade hundred of billion of dollars every day.... affects how U.S. government finances its debt [as well as state and municipal governments], how business finances its expansion, how consumers choose to spend or save....  The money market is a wholesale market for low-risk, highly liquid, short-term IOUs....  [The money market] trades includes a large chunk if the U.S. Treasurys debt and billions of dollars worth of federal agency securities, negotiable bank certificates of deposit, bankers acceptances, and commercial paper (183).  Also included within the market are trades in foreign currency and those of secure loan (called the repo market).  The heart of the activity occurs in trading rooms of dealers and brokers.  The money market (MM) shifts funds between banks as needed, to corporations and institutions as needed, funnel surplus funds of cash-rich banks, corporation and institutions, and provides the fed with arena ... to influence interest rates and the growth of the money supply (184-5).  Commissions run about one dollars per million. 

THE INSTRUMENTS:  U.S. Treasury securities, financial futures market, federal agency securities, federal funds, eurodollars, certificates of deposit, variable rate CDs, discount CDs, eurodollar CDs (issued by foreign banks issued in London), Yankee CDs (issued outside of London), commercial paper (unsecured promissory note maturing on a specific day--less than 271 days by regulation of the SEC) issued by a industrial firm and nearly always secured by a banks line of credit to that firm; bankers acceptance issued to secure payment of imports, it is a letter of credit whereby the exporter receives payment from the U.S. bank according to terms; repos and reserves, where the dealer acts as market maker by taking a  position; municipal notes, notes issued which nature in 1 month to 1 year or more. 

MARKET MAKERS:  DEALERS  He buys or sells from his own account (199), and brokering.  Brokering includes advising clients on market conditions, provide lowest possible borrowing, and highest selling rates. 

 

__________________________________________________________________

 

Norman Fosback

Stock Market Logic

 

compiled with commentary by Ilyich

 

 

                                STOCK MARKET INDICATORS

 

It is exceedingly difficult to predict, small, brief price movements.... successive stock price changes are random [but] the market does not follow a random pattern, and that superior profits await investors willing to follow the guidance of these indicators (8). 

THE DOW THEORY:  1).  BOTH THE INDUSTRIAL & TRANSPORTATION AVERAGES MUST CONFIRM ONE ANOTHER.  2).   A BUY SIGNAL:  following a substantial market decline, a rise of each of the 2 averages to a point substantially above their major low, then a decline of substantial length which does not penetrate the major low, finally a rebound from this intermediate low.  The converse for a signal for a bear market.  The Dow Theory at best follows swings in the market, rather than predict them.  Since theory adherents effect the direction of the market, it is worth noting (11). 

 

The Dividends Yield is predictive  (Table 4, p. 13).  The dividends yield is without peer in forecasting the market two to five years in advance (14).  It is based on the dividends of the DJA, expressed as a percentage of its price.

The  Price/Dividends Ratio:  the latest 12 month dividends period (or anticipate dividends) by its current price.                                                                                             

The Price/Earnings Ratio (P/E) is considered by fundamentalist as being more reliable than the dividend yields.  It is calculated by dividing the current price by the earnings per share for the last 12 months (or anticipated earnings).  Since dividends are paid out of earnings, this indicator is highly correlated.

The Book Value is calculated by adding up all the companys assets minus its liabilities and then dividing by the number of common shares outstanding.  A figure in which the stock is worth less than the book value per share is considered a buy sign.  To be considered is the book values of other companies in the same industry.  Since assets vary greatly for different industries as well as the rate of return for assets, it is best to compare apples with apples.

 

                       LEADING ECONOMIC INDICATORS

The Stock Market has predicted 9 out of the ten last economic recessions (17).  It is one of 11indicators the National Bureau of Economic Research (NBER) has found, of the several dozen examined, which tend to lead the economy at cyclical points (17). 

The NBER Short List:

 Business Vitality--net business formations                               

 Capital Expenditures--contracts & orders for plant & equipment

 Employment--weekly initial unemployment claims

Housing--new private house building permits

Inventories--net change in inventories

Labor Utilization--length of work week and production workers.

Liquidity--percentage of change in business & consumer borrowing

Money Supply--M2

Production Capacity--Percentage of companies reporting slower deliveries

Stock Prices--S & Ps 500 Stock Price Index

Of these indicators--besides stock prices--in the period from 1923 to1960, which includes 7 peaks, the majority of these indicators peaked before stock prices and the best of these were new housing permits with M2 and New Orders close behind.

 

Peak of                        Peak of                Stock Price Peak    % of Leading Indicat-

S&P 500                Economic Cycle              vs. Economic Peak    tors Peaking Ahead

Mar.  1923    May   1923       2 Month Lead                              60%                     

Sep.  1929    Aug.  1929      1 Month Lag                                83%                  

Feb.  1937    May   1937      3 Month Lead                              67%         

June  1948       Nov.  1948      5 Month Lead                         87%                

Jan.    1953    July    1953        6 Month Lead                                    67%                

July    1956    July    1957        12 Month Lead                  91%                     

July    1959       May   1960        10 Month Lead                  60%

            Average . . . . . . . . . . . . 5 Month Lead                      73%

These economic indicators are not the only variables to influence stock-market trends, as proofed by the current bull market of the 90s and the one of the mid 70s where these indicators peaked in mid-1974 but the S&P 500 Index did not turn down for a full 18 months; moreover The NYSE Total Return Index actually peaked in 1972, more than a full 2 years in advance of the composite of leading indicators.  Another problem with the ll indicators is the lag in reporting, some being only quarterly, and there reporting to the public for all of them occur with substantial lag.  It does little good to know that an indicator has peaked in advance of the market if that fact is not known until some time after the market peak (20).  Another problem is to determine what constitutes a turn in the indicators.  [The value of the collection of 11 indicators when the majority has started to decline, this is a strong signal that the bull market is near ending and ones investment strategy ought to be adjusted.  Even if the indicators fail to predict a turn around, it is quite likely that with such weak economic signals the market will reflect in uncertainty this weakness and be within a trading range.                                                                     

            The economic indicators are subject to corrections, especially the GNP.  Martin Zweig in Barrons of March 26, 2001, points out that corrections are its norm.  The average error between the first and last report was 1.3 percentage points!  So the 1.4% GDP figure for 2000s fourth quarter is as likely to be 2.7% as 0.1%.  In 18 of 52 quarters (35%) the error was at least 1.5 percentage points. 

MONEY SUPPLY INDICATORS

         Many economists believe money supply is the single most important factor in national economic planning, and many investors are influenced by news thereon.  However, the relationship between it and the price of stock is weak; it is not a leading indicator, but rather trailing.  Rising money supply usually accompanies rising stock prices, and vice versa. 

 

MONEY  SUPPLY

M1 =  the total amount held by the public, this includes cash, travelers checks, checking account deposits, and  other checkable deposits.

 

M2 =  M1 + overnight repurchase agreements and Eurodollars, non-institutional money market fund balances, savings deposits and small time deposits.

 

M3  =   M2 +  large time deposits, term repurchase agreements and institutional money market fund balances.

 

L     =    M3 + U.S. savings bonds, short term Treasury securities, bankers acceptances commercial paper and domestic Eurodollar holdings. 

 

     Monetary growth stimulates business activity, but this eventually leads to rising prices which constrict the money supply.  Usually monetary growth stimulates economic growth and later Fed polices which constrict the money supply (direct control of reserve supplies of member banks, discount rate, and open market operations).  An M1 growth rate in the range of 6% annually is held by many economists to be sufficient to alleviate unemployment without stimulating too much inflation.  The chart of change in M2 is misleading unless adjusted for inflation, and such adjusted figures are a moderately good predictor of stock market trends (26).   Moreover, there are 5 different measurements of money supply (also M4 & M5) and they are measured monthly, quarterly, semiannually, and yearly (a total of 20 different results).  This permits news sources to select the numbers to support their viewpoint.  In for example June of 1975 these numbers ranged from 2.2% to 12.3% (25).

 

    

FREE  RESERVES  AND  RESERVE  REQUIREMENT

      Free reserves is the funds a bank has on hand; if high the bank is said to be highly liquid; if low, illiquid.  [Liquidity affects the availability of funds by which a bank makes loans to businesses and consumers].   Interest rates and sentiment affect upon the willingness to assume debt.  However lack of liquidity entails fewer funds available, which will assure slow economic growth.  The rate of borrowing per week, and seasonal trends would be more telling as to the future of the economy & stock market (3/22/01).  The change in reserves requirement correlates to market performance.  The rates followed are that of city banks, which do most of the banking.  [However, such changes are indicative for the fed policy, and thus one of several changes.]  The Federal-Reserve System has announced between 1938 and 1984 for large city banks 15 reductions.  And for all of them there has never been a single instance following which market was not higher at six, nine, twelve, and fifteen months.  For reserve requirement increases, the peak decline of the market on an average is 15 months out; and for decreases in requirement, the peak market performance is 18 months out.  

Prime rate is the interest rate which the Federal Reserve Banks charge their member banks for direct loans.  It is one of three sources for borrowing by banks, the others being t-bills, and over-night deposits from other banks.  It is a follower of market trends and serves at best to announce fed policy.

MARGIN  REQUIREMENT

Margin requirement is the minimum down payment required on purchases of stocks.  Such changes are general made to moderate an over-heated market, or stimulate a bear market.  A rise in rates, on the average, does not reverse an already rising market.

THREE  STEPS  AND  A  STUMBLE (AND CONVERSE)

The rule states that when the feds tighten monetary policy by increasing one of its basic variables (Discount Rate, Margin Requirement or Reserve Requirement) three times in succession, the market should stumble and fall down (38).    The interrelationship between the three key interest rates, they provide important clues of future market stock performance (43).     

BILLS,  FUNDS  AND  DISCOUNTS

There are three basic reserve adjustments for banks for banks:  1).  U.S. Treasury Bills,  2). the money they lend or borrow to other banks in overnight federal funds market,  3). the Federal Reserve system at its discount rate.  The comparative rates of these three determines the source of borrowing.  If 2) is above the discount rate, it means the banks overall are short of funds (illiquid) and thus will to pay a premium for overnight loans.  This indicates tight money and is thus bearish for the market and economy.  Historically, the rates of 1) & 2) are below 3).  Also watched is the relationship between the rates of:   1). t-bills that mature in less than 1 year,  2);  notes with 1-5 years to  maturity;  3). t-bills over 5 years to maturity.  When the long-term is lower than the short-term, this is 80% bearish.  The relationship reflects rapid rise in inflation and the belief that such rise is temporary.  Such periods of rapid rising inflation are bearish.

YIELDS  OF  BONDS

The flow of funds to the stock market is a product of how attractive it is compared to other alternatives, one of which being the bond market.  Several indicators have been developed to capture that relationship.  Obviously high dividends rates would attract investors, especially as economic indicators worsen.  And such shifting of dollars to the bond market would be bearish for the stock market. 

Yield Curve is a relationship between market yields of interest bearing securities of different maturity lengths. The most common ones published are those which track the difference between U.S. government securities; namely between t-bills which mature in less than one year, treasury notes with 1 to 5 years maturity, and long term treasury bonds (more than 5 years).  Normally the longer out the government bond, the greater the yield; this is called upward-sloping yield curve (47).  The upward slope reflects the fears of at some date the interest rates will nudge higher, and secondly that the buyer will need to sell the note and it will be worth less than face value.  Such a normal slope is bullish.  An abnormal slope has been accompanied by sustained downtrends 55% of the time. 

Interest rate spreads:  various others comparisons between long and short-term rates have been tracked.  One is to track the corporate sector spread between high grade, short term corporate debt, such as commercial paper, from the average yield of high grade corporate bonds.  An alternative is commercial paper and the prime rate charged by banks. 

Confidence index, developed by Barrons over 50 years ago, is calculated by dividing the yield of high grade corporate bonds by that of the yield for intermediate grade corporate bonds.  When investors are confident in economic trends, they are more willing to buy the lower grade bond, thus bidding up its price.  Thus by dividing the price of one by the other yields another figure which reflects investors sentiments. 

                                 OTHER POPULAR INDICATORS

Other indicators of market trends include:  1).  TOTAL SHORTS/TOTAL VOLUME RATION;   2) SHORT INTEREST RATIO;  3)  SPECIALIST SHORT SALES RATIO;  4) NON-MEMBER SHORT SALES RATIO;  5) MEMBER OFF-FLOOR BALANCE INDEX;  6) ODD LOTTERS;  7) RATIO OF NEW HIGHS TO NEW LOWS;  8) MUTUAL FUND CASH RESERVES;  9)  PUT CALL RATIO;  10)  STOCK MARGIN DEBT;  11) CREDIT BALANCE;  12) STOCK MARKET DEBT/CREDIT BALANCE;  14)  RATIO OF VOLUME OF ASE TO NYSE;  15) SECONDARY OFFERINGS;  16) NEW STOCK OFFERINGS; 17) STOCK SPLITS;  18) BELLWETHER STOCKS {GM, Utilities};  19)  NEGATIVE/POSITIVE VOLUME INDEX {daily volume};*  20) UNCHANGED {stock price} INDEX;  21) ABSOLUTE BREATH {# OF ADVANCES TO DECLINES} INDEX;  23) MOST ACTIVE STOCKS {their avg. price};  24) ADVANCES/DECLINES;  25) SHORT TRADING INDEX;  26) MOVING AVERAGE SYSTEMS;  27) PRICE VS. VOLUME;  28)  BUYING & SELLING CLIMAXES {with rising volumes on successive days};  29) WEEKLY # OF LARGE BLOCKS TRADED;  30) LOW PRICED STOCKS VOLUME;   31) JANUARY BAROMETER;  32) WAVE THEORIES {Kondraftieff, Elliot,  Prichard};  33) RISING/LOWERING INFLATION RATES;  34) SEASONAL INDICATORS;  35) INFLATION AND STOCK PRICES;  36) NEWS & THE MARKET.

*  Of all these indicators, the Negative Volume Index (NVI) and (PVI) have been particular good at predicting breaking out of bear and bull markets.  It is constructed from advance-decline data, but only for days in which volume is below that of the previous day and conjunctively the price of stock rose.  Fosback has modified the procedure and used the stock market average volume of a year ago as the standard, and moreover, it is not the daily change, but rather the weekly used.  If the volume of the past week is below that of a year before and the price of the market average rises (he uses NYSE), then the NVI is graded bullish; smart money has been buying (122).  Conversely if the volume is down and the market price for the week is down, then smart money is selling.  Calculated Fosbacks way, between 1941 and 1975 an up NVI has predicted a bull market 96% of the times; however, for the bear market when the NVI has been down, its forecast has been confirmed only 53%.  NVI is an excellent indicator of the primary market trend.  The converse, PVI, is of little worth.

            

ECONOMETRICS AND THE STOCK MARKET

In recent years many of their [academic] published works have insisted that technical analysis is pure bunk... that superior market forecasting using publicly available information is impossible (177).  For a run a superior results, the random-walk theorists hold this to be pure chance; viz., a few out of 10,000  (one out of 1,024) will have such results 10 years running.  All predicting methods used by the professional seem to work equally well as applied by the professional, for they like the fortune tell use information outside of their particular ball.  However, such studies dont include those using econometric modeling which is used in 3 principle areas:  the economy, investors sentiments, corporate fundamentals in conjunction with the companys sector and the stocks price.  Other factors, such as insider trading, corporate buy back of shares, and whether or not a quarterly earnings report meets expectations on the street.                                                                                         

              The predictiveness of econometric modeling is dependent upon:  A) the accuracy of data; B) how representative the data is of the behavior of the phenomena (positively correlated with length of period; C) accuracy of weighing the different indicators used in the model; D) time frame of each indicator (how long between sign and effect and how long the effect runs): E) the interrelationship of indicators (converging bearish changes in interest rates and other finance signs is far more probative then the weight of each taken alone, sum is greater than the parts because of they are much more likely to be noted by investors.  Moreover each of 2 indicators might gain most of its forecasting force from the same effect, small investors sentiment for example.); and most importantly, how well the S & P 500 correlates with changes in the indicator given a particular lag time. 

 

STOCK SELECTION THEORIES

A).  RELATIVE STRENGTH:  (STRONG STOCKS) Stocks that outperform the market on an average continue to do so.  Those in the top 40% (based on preceding 26 weeks), slightly outperformed the lower groups.  The return can be improved if one doesnt fight the trend, and if one.  Strength performs best in a rising market.  Relative strength is a valid stock selection tool less than half the time (229).  (WEAK STOCKS)* When a stock is at an extremely low price/value ratio, for there is more room for a recovery (231).  They often rebound fastest.

Very few ... of these fundamentals have been able to consistently derive better than average investment results, and in recent years most have under-performed the market (197).  The usual explanation holds that the information, such as P/E, is rapidly incorporated into the price of the stock.  However, investors in the main use these fundamental such as P/E to justify select much more so than to actually guide selection, and certainly few investors look to more than a few readily available fundamentals in making stock selections and they lack the skill to weigh the many categories which make up the fundamentals.  In a flat market change in price may be thought of to be the recognized change in value and secondly the investors perceptions of value (investors heed P/E much more than short term corporate debt).  In addition, investors are creatures of emotions: the sentiments of other on the future of stock prices, as well as their own sentiments toward their portfolio affect an investor so that he may hold (or sell) a stock contrary to the dictates of fundamentals.  When the majority of investors in a stock fail to accurately weigh the fundamental soundness or unsoundness of a company, their expectations as to future earnings of that company will be significantly inaccurate over the period of quarters and years; thus an opportunity for superior returns.  Similarly, they will fail to predict economic and market trends accurately.  All these weaknesses in the typical investor permit for the astute investor superior returns.  Superior return not because in the future investors will wake up and see all the pertinent variables, but because a company which has sound finances is more likely to be well managed and thus more likely to improve its position (numbers) than a company whose pertinent variable are currently poor, and such improvement, and lack will be noticed for it is reflected in earnings and other pertinent variables followed by the common herd.  However, Fosback says such pattern of GROWTH RATE in earnings shows little persistence from year to year (205). 

            

         STOCK MARKET LOGIC--Norman G. Fosback--1986

The Institute for Econometric Research, 3471 North Federal Highway, Fort Lauderdale, FL 33306

    

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     Holds that there is a strong correlation between the price of a stock and both its sales and profits; viz. stress value approach.  [He fails to adjust for stock-market trends.]  Earnings forecasts have become the most common form of stock valuation (30).  Stock evaluation based upon P/E Accounting uses various arbitrary assumptions to determining how assets are calculate.  There is new cluster of points at which P/E reflect future action, viz. that each bear and bull market has its own logic and trends for each industry.  Finally, predicted earnings often have a greater effect upon future price than current P/E, and such predictions are subjected to quarterly verification.  

PRICE SALES RATIO (PSR)

Price Sales Ratio is the market value of its shares (number of share times closing price) divided by the companys gross sales.  The greater the sales, if the price is constant, then the lower its PSR.  He found that those small companies have low PSR values [that is to be expected in those days (early 80s) when a smaller proportion of investors capital went to purchase thinly traded stocks, such as on NASQD.]  [Again he totally misses the quite relevant factors of market trend and industry.]  He next turns to the cost of R&D.  [The kind of work--like wave theory--a smaller mind attempting to grasp complex phenomena beyond his grasp, a pseudo analysis.]  NO NEED TO READ MORE!

SUPER STOCKS--Kenneth L. Fisher

Dow Jones-Irwin, Homewook, IL, 1984

 

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