May 31, 2003
The New EU Constitution - II
Wow.
Matt Scofield over at Irreverent Probity has got an excellent, excellent review of the new EU Constitution.
I don't post many short "go read this" posts, but this justifies an exception.
UPDATE: Looks like the Blogger links aren't working right again. Go here and scroll down.
Investing - Part V
Market Mechanics
OK, time for part five of my four part series of investing tips. This one is going to focus on market mechanics or how trading actually happens on the stock market (and to a lesser degree on the options markets).
First thing to realize is that there are two distinct stock markets: the exchange based markets and the NASDAQ. There are some exchange-listed stocks that can trade on the NASDAQ, but NASDAQ stocks will not trade on an exchange.
How can we tell where a particular stock trades? It's actually pretty easy in most cases. If the symbol has three or fewer letters, like IBM (International Business Machines), KO (Coca-Cola), or F (Ford Motor Company) it will trade on one of the exchanges with its primary exchange, or major market, being either the New York Stock Exchange (NYSE) or the American Stock Exchange (ASE). The concept of the major market will be very important, as we will soon see.
If a stock symbol has 4 or more letters, that indicates that it trades on the NASDAQ or the Over the Counter Bulletin Boards (OTCBB) markets. With NASDAQ or OTCBB issues there is no major market. These are actually networks of interconnected computers. The structure of the NASDAQ and OTCBB will also play an important role in determining how things work out for you.
There are a few oddball exchange listed stocks out there that appear to have four letters, like Agere Class A, which is listed as AGR.A. Most systems drop the "." In doing your pre-purchase analysis, it is always a good idea to confirm the market on which the stock trades.
But why is it important? After all, you place your trade and some computer matches it with someone on the other side of the transaction and off you go, right?
Not exactly.
Let's say you place a limit order to buy 100 shares of XYZ at a limit of $50. With the symbol XYZ, we know it is an exchange-listed stock. For arguments sake, let's say the major market is the NYSE, not the ASE.
So you call your broker or go online and place your trade. Now what?
Chances are, your order will not go to the NYSE, it will probably go to one of the regional exchanges, like the Boston, the Midwest or the Pacific. Brokerage firms do this because the cost of executing the trade on a regional exchange is usually much, much less than running it on the Big Board. It can also have benefits for the client.
When you place your order, let's say the quote line looked like this: 50-50.50 20x40. What does this mean? First we need to identify what those numbers mean. The first number is the bid, or the most someone is willing to pay for the stock at the moment. The second number is the ask, or the lowest price that someone is willing to sell the stock for. The third and fourth numbers are the size, or how many shares are available at each price (expressed in units of 100, so in the example there are 2000 shares available at the bid price and 4000 available at the ask price).
So you place your order. If it went to the NYSE and no trades occurred the quote would become 50-50.50 21x40. Your one hundred-share offer to buy is listed on the bid and you take your place in line on the order book.
Now let's say an order comes in to from someone else to sell 2000 shares at $50. In that case the market specialist would fill the 2000 shares ahead of yours and the quote would become 50-50.50 1x40, with you being the first hundred shares in line when the next sell order comes in.
If the 2000 shares traded and the price then started to move up, you could very well see a trade at your price, after you placed your order and you may not get your order filled. You needed to have 2100 shares trade before you would be assured of a fill.
Now what happens if your order goes out to say the Pacific Stock Exchange? Does it get handled differently?
A little differently. The idea of major market protection says that you can't do any worse than if you had been routed to the major market. So once 2100 shares traded on the Big Board, you would be "due a fill." However, the PSE will also have it's own quote, which may look like this: 50-51 1x10 when you place your order. In that case, if just 200 shares trade on the PSE, you will get your fill. So you can sometimes get a quicker fill on a regional exchange, but you will never do worse than if you had been routed to the NYSE.
The big thing to remember is that the regionals must honor the quotes and fills of the major market. The major market, however, is not bound to (and I never saw it) honor the quotes of the regionals.
So how do the NASDAQ and OTCBB differ from the exchange system? Doesn't the fact that the NASDAQ is computerized make it more efficient?
Actually not. The rules for the being assured of fills on the NASDAQ is vastly different than that on the exchanges.
On the NASDAQ, instead of the specialist in the trading post on the exchange floor brokering the deals, the market maker actually takes the other side of the trade with you. So lets look at how a trade might work on the NASDAQ.
Let's say that you place an order to sell 100 shares of XYZA at $49. You send your order into your broker who is then going to send it out to the market maker. Your broker chooses to send your order over to Prudential's market maker.
The quote on the NASDAQ National Market system was showing 48.25-49 2x200 at the time you place the order. Now let's say an order for 25,000 shares goes off at 49.00. Question is, are you due a fill?
Depends. If the sale of 25,000 happened at Prudential also, then you would probably be able to make an argument. If the 25,000 shares executed over at Merrill Lynch's market maker, then you would not be due. Market makers are not required to make orders available to the entire market. Internal matching between two orders at the market maker is allowed.
In fact, you could see trades executing at other market makers at prices greater than 49, and you still would not be due. Until the bid price hits 49, you really don't have any grounds for complaint on a NASDAQ stock. There is no centralized order book; there is no major market. You are not due a fill until the bid price comes up to your asking price.
Now some of the more advanced traders may be familiar with the Manning rule that states that a market maker cannot trade for their house account before trading a customer's order. But there are quite a few exceptions to the Manning rule that makes enforcement difficult. I saw a few trades filled because of Manning rule oversights, but not too many.
And when we look at the OTCBB and the pink sheets, it gets even more wild. There are no protections in these markets. Quotes are not firm and trades are almost always executed manually, though phone calls between different market makers (yes, they do still use the telephone for them).
Rule #1 of trading the Bulletin Board or pink sheets is never use a market order. This is one of the few times that I will say that anything is absolute in the markets. Never use a market order in these two markets (I once saw a person get a fill at less than 1/3 the quoted price on a pink sheet market order).
The OTCBB and the pink sheets are still the Wild West of the stock market. Anything goes and just about anything can (and will) happen. The oversight in these markets is weak at best and manipulation runs rampant. Most of the "hot tips" and "great opportunities" that are pitched at you will be on one of these two markets. Only trade with limits in the OCTBB and pink sheets. Also make sure that you know exactly what you're getting in to. Opportunity is there for the knowledgeable, disciplined investor; danger abounds for the inexperienced or unknowledgeable.
Most trades go off without a hitch or problem. Even when I was working with the hyperactive traders, I would have maybe two actual trade disputes per month - maybe two. But when a fill was corrected, it was usually very profitable for the client. I have seen corrections in excess of $2500 made due to an exchange or market maker oversight.
Knowing how trading actually occurs can sometimes save you some money. It can also help you to spot potential opportunity once you know how to read the quote lines quickly (you can follow the size and identify support and resistance levels along with potential price trend reversals - all very, very short term technicals - but I have seen people profitable trade them. Beware though, trying to do this is very, very risky. It requires putting up a huge amount of capital for a very short time to hopefully pick up a very small gain).
Most of all, it will make you more knowledgeable, which is really what is needed in order to be successful in the market.
To get to the other sections:
They Don't Get It
4500 protesters have descended on the French town of Annemasse to protest the G8 meeting in Evian. The protesters are so united in their hatred of all things organized that they even attacked a meeting of the French Socialist Party.
The article talks about the protesters attacking stores and pasting signs over gas pumps at closed gas stations.
It never occurs to them that the fact that many commercial establishments in town are closed in spite of a potential bonanza. 4500 normal people stopping in town for a couple of days should be a great deal for business. But these are not normal people.
Even one of their leaders has admitted that there is a small contingent among them "who want to break things just for the sake of breaking things."
So if we look at the protesters agenda, what are they really looking to accomplish? They want to end the move towards globalization. They want to highlight the woes of refugees in Europe. They want to talk about African development and debt relief.
So what about the African agenda? Is debt relief really going to help them? Will forgiving their debt really help them to learn the concept of financial responsibility? I don't think so. It will only make the problem worse. And what about development on the African continent? We have sent billions upon billions of foreign aid, food aid and all kinds of other aid. Yet nothing changes. Corruption still reigns across much of the continent. Until there is a fundamental move among the Africans themselves to stop corruption, no amount of aid will help. For proof we need to look no further than when many of these nations got their independence back in the 1960s, many of them regressed. They were drawn back by the lethal combination of corruption and tribal rivalries. Read the section on Africa in Conquest & Cultures by Thomas Sowell (Buy your copy from Amazon.com!) to get a better feel for what happened post-independence and why it did.
And why are refugees in the situation that they're in? Is it because they were fleeing to Europe to fight the evil forces of globalization? Or would it be because they want to take advantage of the possibilities offered by globalization and the evil corporate machine? If they want to improve the plight of refugees, they need to stop the spread of the cult of victimization in the refugees homelands. Don't tell the Palestinians that they are victims of the evil Zionist Jews. Teach them how to pick themselves up. The protesters always scream about "root causes," but they promptly turn around and misidentify the real root. The cult of the victim, not complex, evil, Zionist capitalist plot are the real root.
And I don't have the patience to go into the folly of trying to stop the globalization freight train by sitting in front of it.
I have yet to hear any of the protesters come up with a viable alternative to the policies that their protesting. Their normal rant is along the lines of "We don't like this so it should stop."
If they want to make a difference, they should become debaters, not protesters. In a debate, they would offer alternatives and would discuss the issues. As protesters, they throw temper tantrums and destroy stuff, but they never offer any ways of improving what their protesting.
But of course, debate requires a certain level of understanding. And the fact that they haven't learned that shopkeepers closing shop when they come to town isn't a good thing tells me they have a ways to go before gaining the understanding needed to engage in real debate.
Investing - Part IV
Welcome to the readers of the Carnival of the Vanities! Glad you stopped by. Please take a look around, enjoy yourself and please leave a comment or two! Also, keep in mind that this series in now a part part series in eight parts. Links to the other seven can be found at the bottom of this post. Thanks! Chris
The Economy and The Market
This is part four of my series on investing knowledge. Today, we're going to look at how some different economic indicators or situations can affect the market.
The two most popular economic indicators are the Consumer Price Index (CPI) and the Producer Price Index (PPI), which are actually related.
The CPI is designed to reflect a change in the prices of a certain basket of goods that are commonly bought by consumers. The idea is to give us an idea of how fast prices are rising, or what the rate of inflation is.
The PPI is designed to reflect a change in the prices that producers are paying to manufacture the goods that are bought by consumers. When the two indexes are used in conjunction, we can tell if profits should be increasing or decreasing. If PPI is rising faster than CPI, profits will fall. Conversely if CPI is rising faster than PPI then corporate profits will rise.
Ideally the market likes to see CPI rising just a tick faster than PPI. That would indicate an expansion of profits. But why would the market want to see the indexes rising when that indicates inflation? After all, everything we've ever been told about inflation is that it's bad and evil.
Actually, in moderation, inflation is good and even necessary for the growth of the economy. A little bit of inflation, encourages spending, which increases profits and powers the economy. Inflation isn't, in and of itself, bad. It's too much inflation that's bad.
But if inflation is a rise in prices, why is deflation - a decline in prices - a bad thing? The less money you spend, the more you can save and invest and the better off you'll be, right?
Wrong.
If prices are dropping, and you know that they will continue to drop for the foreseeable future, you aren't going to spend any more money than absolutely necessary. After all, if your dollar will buy more tomorrow, why spend it today? So spending stops. Soon prices drop again to try to stimulate spending and a vicious cycle ensues where prices drop and spending stays stopped waiting for the next price drop. Once the deflationary cycle starts, it is very, very difficult to pull out of it.
The other great bugaboo that's floating around with the threat of deflation right now is the depreciation of the dollar. Listening to our friends and many of the internationalist crowd we would think that depreciation is the greatest evil to befall our economy since the Depression. But what is depreciation, why does it happen, and what are its effects?
Depreciation is a decline of the value of a dollar in relation to other foreign currencies. In other words as the dollar depreciates, it costs more to buy foreign money. Over the last few months it has gone from costing 89 cents to buy 1 Euro to costing almost $1.20 for 1 Euro. That's depreciation. Our currency is worth less today than it was just a few months ago.
Why does that happen? Currency generally reflects the strength of the underlying economy. A strong currency also serves as a brake on excessive foreign speculation in an economy. How?
Most rational investors aren't going to accept an excessively high degree of risk from any investment, no matter how high the quality. So as the dollar strengthens, the potential risk of an investment goes up for foreigners. As a result, when the dollar is strong they tend to invest less in the US, keeping inflationary pressures in investment prices down. When the dollar weakens, the potential return increases for foreign investors, which helps to encourage additional investments in US markets, which in turn tends to push prices up, which encourages the American economy along.
Along with encouraging foreign investment in the US, the depreciating dollar also has the advantage of making our exports cheaper and it makes imports more expensive. The result is that everyone, here and abroad, ends up buying more American goods which helps to stimulate the economy.
So, if all that is true, why do some people want to protect the dollar? Why is there a great push for tariffs instead?
The main reason is political. A declining dollar is very likely to stimulate the economy, so the opponents of the powers that be nearly always scream about the "loss of prestige" caused by the declining currency. This holds true regardless of who is in power or what nation it happens in. Tariffs on the other hand are less effective for steering the economy and much more effective for punishing enemies or paying off constituents.
The economy is cyclical in nature and is really beyond the control of any small group of men. The economy is almost always based on confidence. In other words, one stupid action can cripple it in a heartbeat, whereas it takes time, sometimes a long time, to rebuild the confidence needed to really get it going. No single decision by the Fed will make the economy better, but a single decision can certainly cripple it.
So besides the CPI, PPI and the dollar, what other economic indicators are out there that people like to use?
My experience showed that there are really only two other indicators that people liked to use: unemployment and home sales.
Unemployment is important in that unemployed people tend not to spend much money. As more and more people become unemployed, spending begins to slowdown. Also, a long-term rise in the rate of unemployment can be forecasting a weakening in the economy. Companies that are doing well almost never are letting people go. An expanding business will need additional people.
Home sales are important because, outside of the fact that the home was sold, there will be other ancillary purchases. People will buy furniture, floors, paint and all kinds of other stuff. The sale of the home is only the beginning of a very deep economic event. And if that home sale is a new construction, the benefits extend even further as you now get construction, equipment and material suppliers involved. Plus home sales are a great indication of consumer confidence, the fuel that powers the economic engine.
So those are the main indicators that people used to look at when I was a broker. Everything economic will eventually translate into a change in stock prices.
Next we'll look at how the market actually works in regards to trading.
To get to the other sections:
May 30, 2003
Wealth Qualifications For Terrorists?
I hope this isn't a case of manipulated statistics.
My personal beliefs about government run more towards the "leave me alone" end of the spectrum. I don't go to the point of full-blown libertarianism, but I don't think that government has as many legitimate purposes as even the Republican Party does. I want to be able to live my life without interference as much as reasonably possible.
Reading this report, it looks like I'm not alone. I just have a better way of expressing my disaffection with the system.
Right now, I qualify as poor (even poorer after dealing with Florida's Department of Motor Vehicles today. What a nightmare! But since the problem was mainly of my own making, I guess I can't complain too much), but I have relatively unfettered liberty to do most anything I please. So when I get pissed, I find an outlet. Sometimes I complain to friends, sometimes I write my feelings here, sometimes I internalize the issue. The choice of how to react is always mine.
In nations most likely to produce terrorists, they don't have that choice. Tell your friend how much you disliked your dealings with the Palestinian DMV, you're likely to find yourself hanging by your toenails from a light pole as everyone in town comes by to take some licks at you with a rubber hose. Write something like this site and they'll throw you in religious jail for the next 40 years or so. Your only choice is to internalize the feelings.
So the pressure builds and builds and builds. Internalizing a problem is not the best way to deal with it (usually). Do it enough and eventually you want to lash out at someone or something with an irrational fury and hatred.
Add in the demagogues running most terrorist factory nations and you've got a recipe for disaster. People who want to lash because of the government, but they can't lash out at the government. Demagogues who convince them that all their problems are the fault of the Jews and the Americans. Demagogues who convince them that their lives will never improve; that their misery can be ended only by a glorious martyrdom operation, which will help to free the rest of the nation from the shackles of the evil Zionist repression.
The rage, the hatred and the need to act build to a furious crescendo. And when they reach their peak, one of the manipulative demagogues straps an explosive vest on them and points them towards Israel or some sends them on some similar suicide mission.
The terrorist dies in a blaze of discontent, not ever realizing the source of his internal torment.
The demagogue moves on to the next victim.
Choice is a wonderful right.
Russian Contradictions
I found this post over on Free Republic. The article quoted is apparently a subscription only article, so I'll have to link just to the FR post, which means I have no idea how long it will be available.
I know that the United States often gets accused of taking contradictory positions. But these two from the Russians are a little tough to swallow.
First, the Russians are expressing concern about Iran's nuclear program. They even want to engage in "an exhaustive discussion of this problem" (italics mine) at the next IAEA meeting. You know, the one at which we want to declare Iran in violation of the Non-Proliferation Treaty? Sounds like the Russians are in pretty good agreement with us about the fact that a problem exists on their southern border, right?
Not exactly. They still plan to keep helping the Iranians in their construction of a reactor in Bushehr.
Now maybe there's just a slight disconnect between the Foreign Ministry and the Atomic Energy Ministry. Maybe some internal discussion will bring clarification as to what the true position of the Russian government is in regards to the nuclear program of the Iranians.
I don't think so, though. I think that the Russians are trying to play us again. They desperately need the $800 million that's coming from the deal. But they also need to try to protect their relations with the US.
So the Foreign Ministry tells us what we want to hear, the Russians are on our side. They're concerned, too. Let's keep talking about how we're going to solve this problem.
In the meantime, the Atomic Energy Ministry keeps working towards fulfillment of the contract. They keep working towards getting that $800 million into the Russian treasury. They don't care so much about the proliferation of nukes to Iran. After all Iran was a friend of the Soviet Union, right?
And when we, the US, notice what's going on and starts to make noise about it, the Russian's can blame all on "miscommunication." The AE Ministry didn't quite understand. And by that point, the reactor should be far enough along that the AE Ministry can ceremoniously cancel the contract - and complete the work using "independent contractors."
Sneaky, sneaky, sneaky and smart. But also incredibly stupid.
Yeah, they'll figure out how to outsmart us. Iran will get the Bomb with Russian help - official help or unofficial, doesn't matter. But what do the Russians get out of the deal?
They get $800 million. They also get an unstably fundamentalist regime with nuclear weapons on their southern border. Give the Iranians the Bomb and I can see them losing some of their fear of destabilizing a number of the -stan nations. I can see them fomenting a religious uprising through much of the southern tier of the former Soviet Union where Islam is strong anyways.
The Russians may very well end up with a hostile, nuclear armed, terrorist nation calling for the Islamification of the Kremlin.
Scary thought.
Now for the second item. The Russians and mainland China are trying to stop proliferation of nukes on the Korean peninsula also. That's all well and fine, although I'm not sure how much their really trying, but that's not the part that throws me.
It's this:
the security of North Korea must be guaranteed and favourable conditions created for its social and economic development
Now maybe I'm not quite catching this. NK is the most Stalinist state still left today. Repression and government control still exist to an unfathomable degree. The only way to create favorable conditions for the social and economic development of NK is to change the government. Nothing, save Kim Jung Il, is standing in the way of NK moving into the 1950s.
Yet the Russians and the ChiComs are opposed to "scenarios of forceful pressure or use of force for solving the existing problems." So are they proposing that we sit back and await the implosion of NK? Do they think that we should condemn millions of people to a life of misery through our inaction?
I think that NK is a different situation than Iraq was. Economically, it is ready to implode. Overt use of military force isn't called for, right now (who knows what next week or next month will bring). But we should be actively encouraging the final collapse of the NK economy. It will mean the end of the reign of Kim Jung Il. It won't immediately improve the lot of the NK people, in fact it will probably make their situation worse at first. But we (meaning the SK and Japanese, with some help from the US) could get started on the rebuilding of NK quicker. The suffering will happen; the implosion will come - that die has already been cast. Why would we not want to get the process over with as soon as possible? Why would we want to let the NK people continue to suffer for even a day longer than absolutely necessary?
For some reason, I don't think the Russians or the Chinese will have the answer for us.
Investing - Part III
Options
Note: Options carry a special level of risk and are not intended or appropriate for every investor. Before considering any option trading, I strongly recommend visiting the Chicago Board of Options website http://www.cboe.com to learn more about the mechanics and then talk it over with your broker. Chances are you firm has additional forms that you will need to fill out along with higher capital and experience requirements. Trading of options should only be undertaken after a discussion with your broker about your account and your situation.
Welcome to Investing - Part III or "So what exactly are my options?"
There are two things that will kill a successful trader quicker than anything else: a lack of discipline and pure unadulterated greed. Between them, those two weaknesses will leave traders holding loser because they wouldn't trade out of them when they were winners.
Wouldn't it be nice to find a tool that could help to avoid those problems? How about one that could be used to magnify a gain (or loss) on a stock? Maybe you'd like to charge rent for your stock. Want to make money being long in a stock that's in a sideways trend? Need to lock in a gain, but don't want to lose the stock dividend?
Options, when used properly, can fill all these needs. But before we can go into much detail as to how options can help, let's look at what they are.
Options are an investment known as a derivative. Simply put, its value is derived from the value of the underlying stock. Generally, but not always, an option contract represents 100 shares of the underlying stock. Prices are quoted on a per share basis, which means you need to multiply the price by 100 to get the true cost of the contract (not including commissions and/or fees).
There are two kinds of options: Puts and Calls. How they affect you depends on the type and whether your position is short or long.
A Put obligates the seller to buy 100 shares of a specified stock at a specific price on or before a certain date in the future. If you buy a put (you're long), you have the right, but not the obligation, to sell 100 shares of the stock at the agreed upon price anytime up until the expiration date of the option. If you sell a put (you're short), you have the obligation to buy 100 shares of the specific stock at a specific price until the expiration date of the option.
Calls obligate the seller to sell 100 shares of a specific stock at a specific stock on or before a specific date in the future. If you buy a call (you're long), you have the right, but not the obligation, to buy 100 shares of the specified stock at the agreed upon price anytime up until expiration date of the option. If you sell a call (you're short), you have the obligation to sell 100 shares of the specific stock at a specific price until the expiration date of the option.
The agreed upon price is called the strike price. The expiration date will always be the Friday preceding the third Saturday of the month.
So how can options help you to avoid problems with discipline and greed? Let's look at an example. Let's say you own 100 shares of XYZ. You bought them intending to trade out of them when the rose 10 points from 15 to 25. Today they hit 25. Now you could sell the stock outright, take your 10 points, and spend the rest of your life boring friends at cocktail parties with the "killing" you made on XYZ. Or you could reevaluate your position.
If you reevaluate the position and decide that XYZ will probably keep going up, you might want to look at buying a put a month out at 25. Let's say it costs a $1 to buy that put. What have you done?
If the stock continues to rise, you spent the $1 on an insurance policy that was never cashed. But say the stock tanks to 13 during the month. At that point you exercise your option, sell at 25 and take a 9-point profit, as opposed to a 2 point loss had you not bought the option. That's an 11-point swing in profit because of your $1 insurance policy. Not a bad deal, huh?
You can also do this at the time of purchase to help minimize your downside risk on a trade. Long puts are a great way to protect long equity positions from significant price drops. I think of them as term life insurance for investments.
Now someone is going to say "But you can do the same thing with a stop order." That's only partially true. A stop order entails the risk that you will trade below the stop price. A stop limit may not trade at all if the stock blows through the limit, as it can when it gaps down after a halt. Put options have the assurance of being able to exercise at the strike price, no matter the price of the stock. I watched one day a few years ago as HIFN lost over half its value in about thirty minutes (a little more than a 35 point drop). People with stops were getting filled at half their stop price; people with stop limits sat there trying to figure out why their order didn't fill. I talked to one guy who had 60 puts for two months out. He was happier than could be. He could wait for two months before selling to see if the stock might come back, and if it didn't (it didn't), he still knew what he would get out of it. Where other people had lost 35 points, this guy lost 15 and couldn't lose any more on that position.
That's what's known as hedging a position. You've bought insurance against it dropping in price. So if options are such great hedging tools, why is everyone so afraid of them? Why are there special disclosures for these types of derivative investments?
Options are leverage. With each contract representing 100 shares of the underlying stock, you can end up with a huge exposure on a stock, without putting up too much money.
Used right, this can sometimes be useful. Let's say you think that GE is about to make a breakout, going from so 35 to around 50. You'd like to buy 100 shares of the stock, but that would require $3500 and you've only got $2000 available. You could buy on margin, but then you risk margin calls and potentially losing more than your $2000 investment. So how can you benefit from the move you see GE making without exposing yourself to too much risk?
This is where options come in. If you were to look at a GE 20 call for two months out, it would probably cost you around $17.50-$18.50. That means that you be putting up say $1800 to "rent" 100 shares of GE stock for 2 months.
Option prices are composed of two components: the intrinsic value and the time value. The intrinsic value is the value per share if the option were to be exercised today. In our GE example, the intrinsic value is $15 ($35 stock price less $20 strike price). The remaining amount is called the time value. In our GE example, the time value is $3 (the $18 option price less the $15 intrinsic value).
Intrinsic value will change dollar for dollar with stock price changes, once the option is profitable (in other words, it has to have positive intrinsic value, or be "in the money"). Time value, on the other hand, is almost constantly declining, particularly in the last month of the option's life. Eventually at expiration, the time value will be 0.
So what happens if in two months, we were right and GE has gone to $50? We cash out the option, selling it for the intrinsic value of $30. Our net profit is $12 or 67% in two months (that's as compared to 42.8% if we had bought the stock outright). Now in this case we could have made more by borrowing on margin (75% return for that), but then we had the risk of losing our investment and being in the hole another $1500. With buying the call, our max loss was $1800, our original investment.
Many times, you'll find that the potential percentage profit is greater for using call options than for using margin. Also, a $3 time value is somewhat high for a non-volatile stock like GE, had the time value been $1 - which wouldn't be any more out of line than the $3 - then our profit would have been at 87.5%.
Now let's say that we have $3500. Do we buy 100 shares of stock or two of the 20 strike price options for two months out? Assuming the stock runs to $50, with the 100 shares we would make $1500. With 2 options bought at $17.50 each we would make $2500.
The point of this is that options can help to leverage your return. But it's not without risk.
Say in two months GE doesn't run. In fact it closes at $34.75 on expiration Friday. Owning the stock, you've lost $25 and you still have your position. Own the options, you've lost everything invested in them.
Stocks require you to be right once - you only have to pick the direction.
Options require you to be right twice - you have to pick the direction and the time frame. Miss on either one and it's all over.
So now we've seen how options can help you to hedge against a loss and how they can magnify a gain. I mentioned renting stock a few paragraphs back. What's that all about you ask?
When a stock gets stuck in a sideways market, oftentimes people get discouraged, as they see their only possible avenues of return as being either dividends or selling the stock. They don't know the beautiful secret you're about to learn, that of the covered call.
Now most of the hardcore option traders reading this are groaning. Covered calls are boring. There's none of the fast paced excitement of trading. But for someone looking to enhance a return on a stock without taking too much risk, covered calls may be just the way to go.
The idea behind a covered call is that you own 100 shares of the stock, so you sell one call option against your position. True, you have given someone else the right to buy your stock, but they pay you for that right (that's the rent part).
As long as the stock closes at or below the strike price, you keep the stock and their money. If it closes above the strike price, they take your stock, but they pay you the strike price for it. In a sideways market - the best for covered call writing - you can sometimes get away with writing the same calls against the same stock for several months in a row. I knew of one guy who wrote the same strike price option for nine straight months without every getting it called away. He sold each contract for roughly $1, nine months in a row. The stock itself was only trading in the low twenties, so when it was finally called away, he made over $9 a share in "rental profits" or nearly half the price of the stock!
Covered calls do limit your upside potential temporarily. Once the stock goes above the strike price plus the premium you collected when selling the option, you basically sit out the rest of any upside move. Some people can't stand that. They let greed get in the way and they try to buy back the call. They forget that when they sold the call, they said at that point that they would be happy with the profit that that strike price allowed. Never once did I see a client make more money because they bought a call back to uncover a position. Not once. Stupid greed (to be distinguished from the basic greed that is the whole reason behind the market to begin with) and a lack of discipline cost investors more money than anything else in the market.
And now to finish off this conversation, let's talk about Ted Turner and the UN. Seriously. Remember his $1 billion gift? Ever wonder how he was able to make it?
He paid for it with profits from the sale of some of his Time Warner stock. But how could he be sure that the amount of the gift would stay consistent during the negotiation process that preceded the announcement? After all, not even Ted Turner can come up with a billion in cash to give away on a few days notice. So how did he pull it off without committing more capital than necessary or without the value of his contribution losing value?
He used an option combination known as a collar. It's actually a very simple technique. First he would sell calls against the position, bringing in money, but limiting the upside. He then turned out and bought puts, spending money on insurance against a drop on the stock price.
So what did he achieve? If the stock price went up, he got his stock called and the cash was there to give to the UN. If the stock went down, he would exercise his puts and would still end up with the money to give to the UN. And he did it by "renting" the stock to pay for the insurance - no money out of pocket.
But why not just sell the stock? Suppose the deal fell through. With the options, he could unwind the option positions and would be able to maintain his position with very little cost out of pocket (and if the stock had dropped, he may have even been able to profit in that situation). Had he sold the stock, he would have to try to buy it back, and that many shares transacting on one side of the market will certainly create unwanted movement making the sale less valuable and the repurchase more expensive.
Options can be really fun and extremely useful tools in investing. They can also be exceedingly dangerous to someone who doesn't know how to properly understand them.
There are many options seminars available out there to try to make you more knowledgeable. Unless it is offered by the CBOE (and they do travel out sometimes to offer them), don't waste your money. They funniest phone calls we used to get were the little old ladies who wanted to do a credit butterfly spread with a bull moose straddle to hedge it. They would insist that they wanted one of each of the applicable contracts.
At that point we'd start asking for specifics, "What do you want to buy?"; "What do you want to sell?" These questions would invariably be followed by agitation on the part of the little old lady who would then tell us that she was in the bathroom at her option seminar and that the instructor wasn't available, but he had told her how this was the perfect strategy for everyone and we just needed to get it done.
We, of course, could not as she hadn't told us what she really wanted to do. She was throwing around fancy sounding names, not realizing that they only made her sound less knowledgeable.
Read the CBOE site. Learn how options work and what some of the different strategies are. Talk to your broker and make sure that you are in complete understanding. Then and only then should you apply to trade options on your account.
And just in case any one was wondering a credit butterfly spread with a small number of contracts is like throwing your money away. It takes quite a few contracts to make that a profitable strategy. And the bull moose straddle doesn't exist, at least not in the real marketplace. It sounds great in a seminar, but your broker will want to laugh at you if you use it.
Learn before you try to earn with options. I can't say it enough.
Resource:
CBOE.com
If there is enough interest, I might consider doing an advanced options post, looking at the most successful strategies. If you're interested, drop a note in the comments.
To get to the other sections:
An Executive Decision - II
Just to let everyone know where things stand right now, the third part of the originally announced four part series of investing knowledge will be options. I started working on it last night, thinking for some strange reason that I might have been able to get it done. I didn't. It's about halfway done, but I won't be able to finish until I get home this evening so look for it to hit the site around 9 tonight.
I have also made another executive decision to make this a four part series in five sections. A section on market mechanics, or how trading actually occurs, will be forthcoming also. Sometimes knowing how the market works can save you a few bucks, so I'll pass that along.
I'm glad that everyone seems to like this series and I hope that you're finding the information to be of some educational value. If you have any questions, please leave them in the comments and I'll try to answer them as soon as possible.
May 29, 2003
Rapproachement With Iran
"...very, very crude."
That's how the Europeans are describing US pressure on Iran. Apparently it is causing concern around the world that our rhetoric could boost Iran's hard-liners.
I think that there are some valid criticisms that we have used too much stick and not enough carrot in dealing with Iran. We have taken a rather hard-line, belligerent stance towards Iran, one which is not unjustified.
But, if anything I think we haven't used enough of the stick. And the carrot has been completely misused. We need to use the carrot to show the Iranian people that we will reward them, not the Iranian government, for acts of goodness (like helping with Afghanistan or turning away the fleeing Saddamites). At the same time that we're dangling the carrot before the people we need to be whipping the Iranian government with the stick. How to do these? I don't have any specific ideas, but it would seem to me that we should be able to apply pressures and rewards where we want to an extent.
I also believe that the People's Mujahadeen should probably be taken off the list of terrorist organizations. In the aftermath of the Iraq war, they have shown a willingness to work alongside and for common goals with the US. And what of the accusations of "double standards?" Remember, one man's terrorist is another man's freedom fighter. That excuse is a two way street. The clerics can go sit in a corner and sulk about it. The People's Mujahadeen has earned the right of a hearing in the US.
The good thing in this story is the fact that Iran is in a purely reactionary mode. They are only responding to our actions or words. That means that we have them off-balance; we have the initiative.
They're confused. They're scared. They're starting to think that the US might actually be willing to back up some of this rhetoric. They no longer are threatening us daily with annihilation, they now are threatening us with patriotism and nationalism. We have changed the rules of the game, and they no longer know how to play. But they know full well that they've been playing a losing hand up until now.
I would love to see rapprochement with Iran. The people are by and large friendly and intelligent. They could be a real asset in building a peaceful and prosperous Middle East. The only thing standing in the way are the nutcases running the asylum (and no, I don't think that the Son of Shah would be much better. They need a real government there.).
If crude is what it's going to take to get there, crude it is.
Probably just a French official complaining about our lack of Continental sophistication anyways.
The Temple Mount
Back during my visit to Israel, I went to Jerusalem. Twice while in the city I visited the Temple Mount - once on a guided tour, once with my father. Of all the places I went in Israel, the Temple Mount was almost certainly the most historically interesting.
It is supposedly the site of Solomon's Temple. It is certainly the site of Herod's Second Temple that was destroyed by Titus, leaving only the Western Wall. And it is currently the home of both the Dome of the Rock and of the Al-Asqa Mosque, Islamic holy sites.
During the tour, which was given by an Israeli tour company with a Jewish tour guide, I learned a number of interesting anecdotes (I don't know whether or not to call them facts, as I have never really researched them too much, mainly because many of them I had also heard during one of my religion courses at Florida Southern. If you can prove any of these false, please leave a note in the comments complete with a URL to your source.)
The Jewish Temple contained a room, the Holy of the Holies, in which the Ark of the Covenant, with the Ten Commandments inside, was housed. This was the holiest site in Judaism. No one, save the high priest once per year, was allowed into the Holy of the Holies. After the destruction of the Temple, the exact location of the Holy was lost, so Jews were banned from climbing atop the Temple Mount for fear of desecrating the holy ground.
So after the end of Roman rule in the region, the Temple Mount remained in shambles as devout Jewish workers would not ascend to build a third Temple.
In time came the Muslim conquests and the construction of the Dome of the Rock, supposedly the mountaintop from which Mohammad began his nighttime ride. The Al-Asqa Mosque soon followed as another Muslim holy building.
The Muslims had heard the stories of the Jews and the Christians that the Messiah would enter Jerusalem from the East from across the valley and when he passed through the gates of the city the Temple Mount would be leveled and the third Temple would arise.
So the Muslims bricked up the East Gate of the city and placed an unmarked cemetery outside the walls on the theory that a priest could not defile the dead by walking on their graves. They figured that that would be enough to kill the prophecy. During the Crusades, the Christians unbricked the gate and cleared a path to it; after the Muslims resealed it and cluttered the path again.
So why do I bother to relate all these stories or legends? Well, it looks like the Arabs in Jordan are claiming that reports of Israeli attempts to negotiate renewed access to the Mount are part of a Zionist plot to eventually rebuild the Temple.
Sharon may not be a lover of all things Muslim, but I don't think that even he has any designs on the building of the third Temple. I really think that he is simply trying to reopen the Mount to non-Muslims, whose religion allows them to ascend the Mount. In other words, he would be trying to open it to everyone, except for the ones most likely to destroy it, as their faith won't allow them to set foot on the platform, much less in the buildings themselves.
I can understand the Muslim's desire to protect these two sacred shrines. But they also made pretty good money selling tickets to enter the buildings, money that is needed to ensure their proper upkeep. If they don't want to reopen access to the buildings that's fine. I just wish they would leave the "evil Zionist" rhetoric out.
There are non-Muslims that don't wish to see the destruction of the buildings. Historically, they are significant and architecturally the Dome is impressive (I didn't like the looks of Al-Asqa too much. Too squat and too many dreary colors on the outside).
Their concerns are valid, but their response is out of whack. If Islam wants to distinguish itself from the radicals, this would be a good place to start. No one would begrudge them additional security and searches before entering the grounds of the Mount.
And drop the rhetoric. Not every non-Muslim that wants to come to the Mount is a Zionist.
Not even me.
Investing - Part II
Technical Analysis
All righty then. It's time for post #2 titled Technical Analysis or "I really hate creating a business plan for work from scratch today."
Those of you who are looking for a great detailed thesis on tech analysis will probably be disappointed. My approach to tech analysis, like the one I have for fundamental analysis, is to keep it simple. There won't be any discussion of Fanucci Fans or anything like that, just simple, but effective tech analysis that anyone, with a little study, can apply.
Most traders that I used to talk to did not use technical analysis. They were scared of it. They thought that it would have be complex, involving something like taking the third derivative of the sine wave of the exponentially weighted moving average for the last sixty days. Most brokers fear technical analysis for the same reason - that's why you can ask about it and the canned answer will always be "You can't get anything from reading the charts. They only tell you where a stock has been, not where it is going."
And to a point, they're right. The old standard brokerage line of "Past performance is no guarantee of future results" is true.
The whole concept behind technical analysis (sometimes also called charting) is that history does repeat itself. Not all the time, but in many, many cases, it will. Tech analysis is designed to try to put the odds more in your favor.
So where do we start? The first thing to do (and the one that a lot of clients absolutely refused to do) is to pull up a chart. Go to http://www.bigcharts.com (many brokerage firms also make online charting available through their sites) and pull up just the simple, default chart on a stock.
Just from this simple chart we can already identify the most basic, and one of the most important, pieces of analysis. Draw a line connecting any two points on the chart. Congratulations, you have just drawn a trendline. If it is rising from left to right, you're in an uptrend. If it's falling, you're in a downtrend. That was easy, huh?
Why is the trend important? It's an old axiom, the trend is your friend. Market psychology is such that once a trend is in place, it tends to stay in place until something significant changes. If you're looking at buying a stock that's in a downtrend, you need to make sure that you have a solid reason as to why you think that the downtrend is being broken. Same if you sell a stock in an uptrend. What is making you believe that the trend is about to break? If you can't answer the question without hesitation, then you may want to reconsider the buy or sell until you've had more time to figure out why you want to make that move.
But can you tell that a trend is about to change or reverse? In many cases you can. To do so we need to look at a few other simple to apply indicators.
I would always start by looking at the moving averages. Simply put the moving average is the mean of the prices of a given period of time. Most of the time I would use the 10, 50, and 200 day moving averages in conjunction with one another. When we superimpose the three moving averages on top of the price chart, we immediately notice that the prices and the ten day average track very, very closely. The fifty day average is usually a bit off of the price range, but it still gives a general feel for the gyrations of the stock. The 200 day average you'll notice will be very close to a long term trend line.
So how is the moving average useful? Sometimes it gives a better picture of the actual movements of a volatile stock. But mostly, it gains use through the law of large numbers. The law simply states that large numbers tend to deviate towards the mean. Your moving average is a mean. So the law tells us that eventually the price of the stock and the moving average are going to converge.
This is where most people failed in their moving average analysis. They would understand the law and its implications. So if they saw a stock that was trading above its moving average, they would automatically assume that a sell order was needed, as the price had to drop in order for the MA and the price to converge.
Remember, the moving average moves. If a stock is above the MA its price can either move sideways, or the sharpness of the trend decrease, and the MA will begin to converge with the price. In other words, it is entirely possible for a stock to converge with its moving average, without ever dropping in price. So being above the moving average doesn't necessarily indicate a sell signal (the opposite is also true, a stock below the MA doesn't automatically trigger a buy signal either).
So how can we use the moving averages? They can indicate situations where a particular stock is too far removed from its MA, which would indicate that the angle of the trend will need to decrease or possibly reverse in order to satisfy the law of large numbers.
So now we've identified that a stock is in a particular trend and that the moving averages are showing it getting too far ahead of itself, what can we use to tell if it is ready to make a reversal or if the trend is just simply likely to moderate, but continue? This is where we get into the semi-scary part (for most people) of technical analysis. We now would want to use oscillating indicators.
Oscillators are indicators that factor in prices, volume and time to create derivative indicators. One of the most popular oscillators out there is RSI, or the Relative Strength Indicator. It essentially consists of a horizontal line graph with two parallels, one usually at 20 or 30, the other at 70 or 80. If the graph is over the top parallel, it usually indicates an overbought position, below the bottom parallel is supposed to indicate oversold. This isn't set in stone as a stock making a breakout from a trading range can sometimes show overbought or oversold for days or even weeks on end with no real effect on the performance of the stock.
So we tend to use RSI and another oscillator, the Williams percentage of %R, in conjunction with one another. We would always stack them one above the other, with the RSI on one line, %R on the line below. What we would then look for is when the moving average indicated the something might be up, we would look to the oscillators for confirmation. If the RSI and %R lines were converging, that could be a confirmation of a bullish signal. Conversely, if they were widely separated, that could confirm an impending decline in the stock price. A convergence or divergence without an indication from the moving averages, usually meant nothing, just as an indication without confirmation usually meant that there would be a moderation in the rate of change in the price of the stock.
These indicators all work together to provide a more complete picture, but even now we're not quite there.
A moment ago, I mentioned trading ranges. What is a trading range and how do find out what it is?
Simply put a trading range is the invisible boundary created by the trend. To see the trading range you want to use two parallel lines to connect most of the high points and most of the lows that the stock has traded at recently. You'll notice that the longer term trends tend to be in the same direction as the trading range.
What the trading range is showing you are the points at which the stock encounters resistance on the upside, and where it reaches support on the downside. In other words you have large positions wanting to trade at those prices and that tends to hold the stock in that range.
A breakout occurs when trading wipes out those large positions and the stock begins to move past the resistance or support point. If the move is sustained, the stock will eventually form a new trading range, either higher or lower than the current one.
Easy to profit from that, right? Just look for the stock to pass through one of the parallel lines and buy if it's going up, sell if it's going down. Can't miss right?
Wrong. Stocks like to test the limits, and even to push a little past them, before withdrawing back into the same comfortable range. So how can we tell if this is a real breakout or just a testing?
We use the moving averages, the trend, the RSI and the %R to tell us whether or not the move could have any strength behind it. We then give it a day or two to confirm that it is a true breakout. A couple of days of trading outside the trading range is usually a pretty good indicator that a new range is being set.
Why do we want to wait for that confirmation? Why not just take advantage of the situation as soon as it presents itself? After all, investing is all about maximizing profits, right? There is a saying in NASCAR, sometimes you have to go slow to go fast. The same holds true in investing. Sometimes giving up a little on each successful trade will save you from making numerous poor trades.
So there you have it, technical analysis made somewhat simple. I used to work with and talk to some of the best technicians you see on CNBC or MSNBC. Even with all their fancy formulas, theories, and ideas nearly every recommendation they came out with was based on one of these simple concepts. They might use candlesticks; they might use some other indicator, but they always had these.
To form the picture you want to look at these in the proper light. Nothing in the technicals is absolute. Fundamental changes in the company will always trump what the charts indicate - that was the main reason that I saw pure technicians fail, they wouldn't even begin to think about the fundamentals of a company.
Look at the trend first - long, short and intermediate term. The trend is the most influential of all the technical indicators. The trend truly is your friend.
Then look at your moving averages and oscillating indicators to see if there might be a technical reason for the trend to break.
Finally, look at your trading range. Try to identify confirmed opportunities with respect to the range (remember the goal is to buy low, sell high - in either order. You can do that even if stuck in a range, provided the range is big enough.)
Properly analyzed, the technicals will help to identify better entry and exit point for stocks that have passed your fundamental analysis.
Remember, nothing is assured in the market, before investing, you simply want to stack the odds as much in your favor as you can. A technical analysis of a stock is every bit a useful and necessary as a fundamental analysis. Don't hurt yourself by ignoring either.
And an aside for those who would comment that they only trade, they don't invest so they have no need to look at the fundamentals. I have seen people trying to trade without fundamental analysis. I saw them buy Enron the day before it went Chapter 11. Every December I'd talk to traders who got stuck with positions in companies that quit trading altogether before they unwound their position. Fundamentals can effect even a 5 minute trade. Believe me, I've seen it happen. Use all your tools, you owe it to yourself. Even if your fundamental analysis consists of only reading the news.
Resources:
Bigcharts.com - free interactive online charting
Equis.com - excellent for technical analysis term definitions
I also found two blogs that do a very good job of looking at the market through the eyes of a technician:
Trader Mike
Eminiblog
I'll try to get some sample charts up later tonight when I get to a computer with a real connection. Can't promise anything, though.
OK the charts are up! It wasn't as easy to find a good example as I had hoped, but we've got something to try to graphically show what I've been rambling on about.
To get straight to the other sections:
May 28, 2003
Saw This One Coming A Mile Away
Don't worry, even with my investing diatribes I haven't forgotten that there is much more fun going on in the world.
Here's one that we should have seen coming, Turkey's military is threatening a coup unless the government makes sure that it respects the Turkish Constitution.
If you go back and read my posts back at the end of February/beginning of March, you'll see that I was taken by surprise when the Turkish government screwed us on the northern front in Iraq.
The Turkish military is the real power in that country. The military wanted us there. They understood the importance of standing beside your allies in a time of need. The military knew who Turkey's real friends were. Which still leaves me surprised that there wasn't a coup back then.
I figured at the time that the military was giving the new government an opportunity to prove that the actions of early March were an aberration. I figured that they wanted to give the fundamentalist government an opportunity to prove that they respected the basic core of the Turkish State - its Constitution.
From this article it sounds like the government didn't get the hint the first time around. They don't understand the military's secularist stance. The stories being leaked by the military sound like a shot across the bow of the Islamofacists.
The Turkish military is not going to shrink from their obligation to uphold and defend their Constitution - they've done it four times in forty years already. The government would be wise to heed the warnings.
Investing - Part I - addendum I
OK, so I've got the first section of my treatise up and I've had a chance to watch both episodes of South Park tonight, so I need to add a couple of additional points.
First, what I write is not the gospel of investing. There are as many different investment theories as there are brokers out there. No one theory is right and very few are completely wrong. What I discuss is but one single theory.
But I discuss it because my personal experience as a broker showed me that these ideas worked. I saw literally hundreds, if not thousands, of trading schemes. Most were abject failures. Why?
Investors have a notion that the more complex the formula, the more likely it is to be accurate. So much attention is paid to the most miniscule details of a company, that the overall picture is never actually viewed (can't see the forest for all the trees?).
I found that people who looked at just the basics, and nothing more, were more likely to be picking winners than the nitpickers. Why? They better understood the company, the industry and the environmental pressures they might face. As a result they had a better data set for making decisions, even without the mini-details.
There were also two other traits of successful investors. They were disciplined and they used as many of the tools available as possible.
When I say they were disciplined, I mean that they could set a plan and stick to it, come good times or bad. I still have trouble believing the number of people who lost money on positions because they would not take a profit. They kept holding out for more and more and more. Eventually when the stock began to fall, they would hold it on the way down waiting for it to rebound so that they could get out with a profit. The disciplined investor would have taken their 10-15% gain in a week or two and they would have gotten out. If the stock keeps running, that's ok. If it reverses, they would look to see if there was opportunity to pull the same trick again. Discipline is easy on the downside; it's nearly impossible on the upside, but it is every bit as important.
And when I say that they were using all the tools available to them, I don't mean that they were using every formula or rule of thumb out there. They would use fundamental analysis to identify good choices, they would use technical analysis to decide when to enter or exit a position, and they would look at using options to hedge or to enhance the profitability of a position. But it was rare that they would use any one technique in isolation. Doing so gave an incomplete picture, a very dangerous situation.
Simplicity and discipline. Those are the two hallmark traits that I saw of successful investors. Fellow brokers that I have advised in the past would attest that those are the messages that I preach.
Also, everything I relate in these posts is completely based on experience. I have no research papers or sites I can send you to for fact checking. This is my experience. This is what I have seen working in the past (past performance is, of course, no guarantee of future returns).
There are a lot of brokers out there who are interested only in their next commission. I want to help to provide you with an ability to protect your own interests. Even with the biggest firms, don't assume your broker has a clue as to what he's doing. Ask questions. Make him prove himself. After all, you're paying him to play with your money.
Investing - Part I
Fundamental Analysis
Before reading any further, please be sure that you have read and understand my disclaimer which essentially states that this information is educational in nature and is not to be construed as investment advice.
OK, I've basically decided to break this into four main sections: fundamental analysis, technical analysis, options, and an overview of how the economy and the market interact.
First a little background as to why I believe that I'm qualified to discuss these matters.
I've worked for two different brokerage firms, one was a small regional firm, and the other was one of the biggest on Wall Street. During my first year and a half I worked almost exclusively with smaller and relatively inactive clients. Later I worked with some of the largest accounts in the major firm. In order to talk to the group I was in required a minimum net worth of $1 million or you had to be a very, very active trader. At the end of my career, I was working exclusively with the hyperactive traders and was also involved in specialized knowledge groups for both fundamental and technical analysis.
So now you know a little about me. Before we really jump into breaking down fundamentals let me let you in on the secret that Wall Street will never tell you.
If you take the time to learn the basics, chances are, you will know more than your broker. I was consistently amazed at the number of call transfers I would get from brokers who didn't know their basic order types or who couldn't tell a PE ratio from a moving average. It was consistently amazing to me.
When I was taking calls for the fundamental analysis group I used to love the calls that I'd get from brokers that had gotten themselves into discussion way over their heads. They'd get me on the phone and start asking how a declining price to sales ratio in light of an increasing inventory that is apparently being financed through increased long-term debt might affect the share price of a competitor in the next three to five years.
At that point, I'd stop the broker and take over the conversation. Fundamental analysis should be just that - fundamental.
The first, most obvious - and most overlooked - step is to identify the company you want to analyze. If you're interested in XYZ Company, it doesn't make much sense to be digging into the financial reports of ABC instead (I'll explain why in a few minutes).
The next step is to determine what the company does. It is amazing how many people would call up and say, "Buy 5000 XYZ." When the trade was done they would then ask, "What do they do?"
It is amazing what you can determine about the future prospects of a company simply from figuring out what they do. Why are they in business? Do they produce buggy whips or rotary dial telephones? Are they a biotech company? It will also give you a general idea as to how much of their business might be international. Identifying the business of the company will also usually give you a basic understanding of who the major competitors might be.
Next we get into the actual fundamental analysis. I would always start with a simple question: why is this company in business? The answer with every single company is the same: to make money. So the question becomes whether the company is really making money or not.
Most people would immediately reach for the balance sheet to look for an increase in the shareholder equity. Others would immediately grab for the income statement. Almost no one would actually go and look at the statement of cash flows. So why would I?
Neither the balance sheet nor the income statement provides a true picture of a company's financial situation. Too often they are easy to manipulate. How is the balance sheet computed? Has the company changed their inventory accounting method (not unusual in companies that are struggling)? Are they moving debt off the balance sheet through various dodges to avoid being labeled as debt-laden? What really comprises the income statement? Are there extraordinary items? Has the company recently changed the accounting for depreciation?
Companies manipulate these numbers because they know that most people won't look any deeper. After all, these are audited statements. So the numbers, and any derivates thereof (like PE, cash-to-debt ratios, etc), must be absolutely true and factual. But after Enron and Arthur Andersen, we know that that is not the case.
The statement of cash flows is comprised of three sections: cash flow from operations, cash flow from investing activities and cash flow from financing. The section that I focus on is the first: cash from operations.
Businesses exist to sell products or services to customers at a profit. That is the absolute basic reason for business. Cash flow from operations attempts to remove all the outside factors and looks basically just at revenue from sales and the cost of producing the good or service that is being sold. The resultant answer tells you if a company can satisfy it's basic reason for being.
We can then look at past quarters' or past years' cash flows to determine if the company is growing, shrinking or staying even. The cash flow from operations should be a positive number, except in extraordinary circumstances.
After finishing the cash flows, we would next pull a 10-K report from the EDGAR Database at SEC.gov. Why the 10-K?
The 10-K is essentially the annual report, but it contains some additional sections. The most significant for my purposes was the section on risks. This is where the company would disclose the relevant risks that needed to be disclosed, while avoiding having them in the annual report. You can also find some unusual information about the operations of the business in the 10-K.
Let me provide an example of how this worked.
I had a client one day in late 2001 that wanted to look into Lucent as a long-term investment. The stock was trading at about $4/share at the time. The company appeared to be a potential turnaround, if you analyzed just the balance sheet and income statements.
When we started looking at the cash flows, we realized that the company was losing a significant amount of money from operations, every quarter. We also noticed a very high positive cash flow from investing activities. This is not the ideal pattern that you're searching for when looking for a new opportunity.
So we started to look through the 10-K. In there we found a small spreadsheet showing the companies the Lucent had acquired during the previous year and how the acquisitions were all financed. Every one of them was financed through the issuance of additional shares of Lucent stock.
All few pages further along, we found a list of divestitures that Lucent had made during the year and what was received in kind. We quickly realized that many of the same names were on both lists.
Lucent was issuing stock to acquire companies, which it in turn sold for cash.
If you had looked at the balance sheet, it was showing a growing cash position. If you looked at the cash on hand at the end of each quarter, it was improving. If you looked at the income statement with the extraordinary items included (which is how they published it) everything looked good. The PE ratio was even reasonable.
But the statement of cash flows told the true story. Lucent couldn't make a dime selling telephone equipment. They were surviving essentially by selling their goodwill.
If you know what the industry average is for price to operating cash flow you can usually make comparisons with other, similar companies. We found at one point that AOL/Time Warner was trading at 125 times operating cash flows. The average for the media industry at the time was around 30 times OCF. During the next 9 months or so, AOL slid from $40/share to $13/share - which brought the cash flow number in line.
Fundamental analysis is easy as long as you remember that it is fundamental. The idea is to learn about the company you are researching and to determine its business condition. Complex formulas like price to sales over inventory less work in progress don't really tell you anything worthwhile. They might be good management tools, but remember, you're an investor, not a manager. Keep it simple: what does the company do and can they really make money doing it?
If you like what you see there, then maybe its time to move on to looking at the technicals. If not, it's time to move on to another stock.
To get straight to the other sections:
An Executive Decision
OK, I've made an executive decision that relates to this blog. Starting this evening and maybe only going through tonight, maybe going for a few days, I'm going to run a series of informational and education lessons on the stock market and the economy in general. My goal is to spread some of the knowledge that I acquired in my years of being a stockbroker, I also want to put somewhat in context my interest in the ups and downs of the dollar.
Coming soon! Watch for it!
May 27, 2003
American Imperialism?
Where to start, where to start?
Here is a nice long and fairly well written article by Bernard Weiner talking about the evils of the Republican Party in general, and the Bush administration in particular.
There are so many things in the article that I disagree with, it's truly incredible. I could go down a list of points, point by point by point, but this would probably be a little too long of a post (I don't have that much space on my site). So instead I'll pick on just one piece.
Everyone loves a winner, and American citizens are no different. It makes a lot of people feel good that we "won" the battle for Iraq, but in doing so we paid too high a price at that, and may well have risked losing the larger war in the Arab/Muslim region: the U.S. now lacks moral stature and standing in much of the world, it is revealed as a liar for all to see (no WMDs in Iraq, no connection to 9/11, no quick handing-over the interim reins of government to the Iraqis as initially promised), it destroyed a good share of the United Nation's effectiveness and prestige that may come in handy later, it needlessly alienated our traditional allies, it infuriated key elements of the Muslim world, it provided political and emotional ammunition for anti-U.S. terrorists, etc.Already, we're talking about $80 to $100 billion from the U.S. treasury for reconstruction in Iraq. And the PNACers are gearing up for their next war: let's see, should we move first on Iran or on Syria, or maybe do Syria-lite first in Lebanon?
One can believe that maybe PNAC sincerely believes its rhetoric - that instituting U.S.-style free-markets and democratically-elected governments in Iraq and the other authoritarian-run countries of the Islamic Middle East will be American interests as well - but even if that is true, it's clear that these incompetents are not operating in the world of Middle Eastern realities.
These are armchair theoreticians - most of whom made sure not to serve in the military in Vietnam - who truly believed, for example, that the Iraqis would welcome the invading U.S. forces with bouquets of flowers and kisses when they "liberated" their country from the horribleness of Saddam Hussein's reign. The Iraqis, by and large, were happy to be freed of Saddam's terror, but, as it stands now, the U.S. military forces are more likely to be engulfed in a political/religious quagmire for years there, as so many of the majority Shia population just want the occupying soldiers to leave.
And yet PNAC theorists continue to believe that remaking the political structure of the Middle East - by force if necessary, although they hope the example of what the U.S. did to Iraq will make war unnecessary - will be fairly easy.
These are men of big ideas, but who don't really think. They certainly don't think through what takes place in the real world, when the genies of war and religious righteousness are let out of the bottle.
Statements like this really, really annoy me. They ignore or twist the basic facts of the situation that we find ourselves in.
We are at war with the radical Islamists. We have been since long before 9/11. The only change since 9/11 is that we have finally recognized the fact and have consequently begun to act on it. 9/11 was not the beginning of a war, but it may very well be the beginning of the end of it. We have now shown that we have the courage and conviction to stand up to the terrorists and as a result they're now fighting for relevance, rather than for a broader purpose.
Bush and the Republican Party are not the ones guilty of not thinking in this case. Terrorists like bin Laden and Saddam didn't think through what the consequences of waking the American giant would be. They let out the genies of war and religious righteousness, not us. We fear not the genies because we don't rely on them. Our nation, our military, our people are grounded in a reality which doesn't count on the whims of a deity or a fantasy. We believe in the actions of man.
If you don't agree with the war in Iraq, that's fine. If you think that we're combating terrorism the wrong way, that's ok too. Everyone is entitled to their opinion and reasonable people can disagree without either party necessarily being wrong.
It's just that both parties have to analyze the same facts and realities.
Worried Muslims?
Interesting column here by Muhammad Irshad of Pakistan expressing concern that the US might actually be serious about ending terrorism - in all its forms. He is expressing concern that we might actually be serious about rooting out the terrorists - no matter where they might be.
This is good.
Underlying the normal Middle Eastern anti-Semitism and anti-Americanism is the realization that they are on the wrong side of history.
But they still haven't completely understood the goals of the US. They understand the demands as evidenced by this line:
Now along comes the Bush administration, under the influence of Wolfowitz, Perle & Co., and issues an ultimatum to the Syrians: give up your chemical weapons, eliminate Hizbullah, get rid of the “terrorists”.
The problem is that the author still spews the garbage that essentially says that it is all a plot to avoid a Muslim reawakening. He believes that we are out to subjugate and humiliate the entire Arab race.
It never enters his mind that we are in pursuit of peace. He never entertains the thought that we are coming to the realization that a true and lasting peace will not come from the destruction of Israel or from terrorism.
He professes a multitude of concerns about disarmament. He complains of US military might. He all but calls for terrorist attacks to attempt to thwart the US, which is being controlled by its "Zionist lobby."
Never once does he even pretend to understand the US position or motivation. Never once does he call for dialogue with or understanding of Israel.
This wacky Paki is so far out in the lefty fields that he believes Senator Bob Graham to be a hawk. Sen. Graham is anything but a hawk, even on the terrorism issue.
With his complaints about the treatment of Syria, Iran and Pakistan the author shows a complete misunderstanding of the United States. Our goal is not war. Our goal is not imperialism. Our goal isn't even control of the oil fields or appeasement of any particular lobby.
Our overriding goal is peace.
Thus underlining a well-known lesson for us, that in military and economic strength lies the safety of our nation.
Not quite. The lesson to be learned here is that the slumbering giant has been awakened. The safety of your nation lies in your ability to understand the objective of the United States of America.
We want peace.
Trade Sanctions To Fix The Economy?
I talked the other day about the potential benefits of depreciation in the value of the dollar. But it is wise to bear in mind that there is more than one way to work on staving off the threat of deflation.
William Hawkins of tradealert.org is proposing to raise punitive tariffs instead.
Raising tariffs does achieve the goal of reducing imports. In order to get the US economy kick started, we really need to start getting American consumers to buy American goods instead of imported ones. Depreciation and raising tariffs both work towards that goal.
Tariffs also have the additional benefit of being targeted. Depreciation affects all imports, no matter what they are or where they're from. Tariffs allow the targeting of certain industry segments or the products of certain nations.
So if both paths achieve the same goal and the tariff route affects fewer industries, products or people, why not use punitive tariffs to bring about the economic recovery that we need?
There are really two big reasons why the raising of tariffs is not the proper path: one is political the other is economic.
Politically, the raising of tariffs is a very dangerous thing. Other nations expect a certain level of stability in their dealings with the US. If we raise tariffs, we change the rules of trade midstream with introduces additional risks to trading with us. When a foreign company is unable to ascertain within reason their profits, they will be much more likely to avoid trading with us at all. And we have to remember that the idea is change American spending habits, not to discourage international trade.
Economically, the tariffs smack of a controlled economy. The dollar represents, like shares of a corporation, a degree of ownership in the US economy. And like a corporation, the US economy is subject to various cycles and pressures, some make the economy more valuable; some make it less valuable.
During the last five to ten years we have experienced foreign investors putting money into the US market because the opportunities offered elsewhere weren't all that great. The reward that was being offered overseas wasn't commensurate with the risk. As a result foreign investors were making investments in the US, not because of our strength, but because of weakness elsewhere.
Recently the Euro had depreciated to the point where investment in Europe started to look attractive again. The economies there are stumbling along, but the Euro had become so depreciated that the potential for outsized returns (in relation to dollar denominated investments) began to overcome the inertia of having to unwind positions in the US. As a result, investors having been buying Euro denominated investments, financed by the sale of dollar denominated investments. Hence we see the decline of the dollar and the rise of the Euro.
As the dollar depreciates and more consumers begin buying American goods, the US economy will begin to strengthen at the fundamental level. The combination of a cheap dollar and improving fundamentals will bring foreign investors in search of better returns back into the US capital markets.
Allowing the depreciation mechanism to run its course tends to lead to the economy correcting itself. Using tariffs imposes a correction that may not be supported or justified by the current economic state.
It was tariffs and protectionism, as exemplified by the Hawley-Smoot Tariff Act, which helped to propel us into the Great Depression. At the time the economic situation was not all that dissimilar: the US was coming down off a boom, Japan and the European economies were weak to the point of collapse. Hawley-Smoot really helped to tip the balance in a way that ultimately hurt the American workingman.
Tariffs are not the answer. Beating our trade partners into new, more favorable to us, trade agreements is not the answer. Only a fundamental rebuilding of the US economy is going to get us out of this mess.
Mr. Hawkins likens the imposition of tariffs to stopping the bleeding of the economy.
A Band-Aid doesn't really help on an infected wound. It may stop the bleeding temporarily, but the infection will eventually spread - and could be fatal.
We need to treat the problem, a weak US economy, not the symptom of a weak dollar.
May 26, 2003
The New EU Constitution
The EU has unveiled its new Constitution. Most of the larger European nations are generally happy with the new document; the smaller nations are not quite as enthusiastic, mainly because Britain and France still have veto rights over EU foreign policy. All in all it seems like they have at least come up with a decent starting point for further negotiations.
But the whole process is fundamentally flawed and is therefore likely to fail.
Constitutions work best when they are limited in scope. The US Constitution is timeless not because of what it says, but because of what it doesn't say.
The US Constitution allows certain rights to the government and reserves all the others for the people (or the states). It doesn't dictate how we are to achieve the ideals of our nation. It doesn't even dictate the form of our government, beyond the three branches and the concept of checks and balances. What was left unsaid has given the US the flexibility to adapt to a changing world.
The EU Constitution does the opposite. It proposes a philosophy and then details how to implement it. Instead of laying out the basic framework of a government, it goes into detail about the form and the workings that it should have.
Instead of allowing for flexibility in an ever-changing world, the EU Constitution restricts the ability of the government to react. Some actions will require unanimous consent; others will require majority votes. Some "states" have veto rights over the superior government. In other words, the government is already being made more complicated than the average person will want to deal with. A disconnect between the government and the governed is already being formed.
And that's just in foreign affairs. In domestic issues, it's even worse. The EU wants to establish Union wide labor laws and social policies. Instead of making the EU more competitive in the global economy, this vast exercise in social engineering will serve to raise the costs of EU products. In a time when deflation is a real concern, raising of costs is not a good thing.
Many nations have attempted to replicate the flexibility and timelessness of the US Constitution. Most have failed because they, like the EU, have failed to recognize that the US Constitution is great because it limits the rights of government, not the rights of the people.
The EU Constitution will eventually fail through its own inflexibility, unless significant changes are made.
Since that would require giving up the precious socialist experiments, I don't see that happening.
Memorial Day Posts
OK, I made most of my Memorial Day posts yesterday - a day early - so I thought I would provide links to them since there are a couple of lengthy posts to go through to get to them.
First I had a personal-type essay on Memorial Day.
Followed by a poem I found that seemed rather appropriate.
And finally ended up with a post about an amazing young Cub Scout.
That's it so far. Have a great Memorial Day everyone!
Gotta Love Baby Bashar
The President of Syria, Baby Bashar, has lodged a number of complaints about the West in one of his latest interviews. Nothing terribly surprising about that, or about the complaints themselves. They just go to show the depth of the fantasy world in which some of these Arab "leaders" are operating.
He begins by questioning the very existence of al-Qaida. He goes on the claim that since bin Laden "cannot talk on the phone or use the internet" that it would be impossible for the big cheese to even be leading such a phantom organization.
Short of the incredibly delusional, no one is denying the existence of al-Qaida. Even the mildly delusional, as represented by such luminaries as Sen. Graham and Gov. Dean, acknowledge that al-Qaida exists. To take it a step further, even much of the Arab leadership admits (and fears) the existence of al-Qaida.
Besides, bin Laden doesn't need to talk directly to the members of al-Qaida via telephone or internet. He has messenger lackeys to do it for him. Some of the messengers will be individuals; some are the news media (think he hasn't tried to use Al-Jazeera a few times to get messages out?). Just as Baby Bashar doesn't call Hezbollah every time he needs a distraction along the Israeli border, bin Laden doesn't make the calls himself. He has someone else, who can communicate more freely, do it for him.
The distractions along the Israeli border bring us to the second complaint of Bashar: that he has to deal with Israel.
Baby Bashar doesn't like having to deal with Israel. He believes that the US is the true power in the region and that as such he should be able to deal directly with us instead of having to work with the Israelis, which would mean taking Israeli concerns into account.
He believes that he shouldn’t have to deal with Israel because they are occupying "our land." And he's right; Israel has taken over the Golan Heights. Israel won the fight; his country lost. If he wants to discuss the territorial issue, then he will have to take Israeli concerns into account. Israel has the right of demand in these negotiations, not Syria - that is part of being the victor in a war.
Baby Bashar knows this. He knows that Israel will put conditions on the return of the Golan to Syria - conditions that are unacceptable to Hezbollah. But he also knows that there is a