Wiser Trader Stocks and Options Newsletter

Issue No. 1 – November 29, 2004

http://www.WiserTrader.com

Systems@WiserTrader.com

James A. Andrews

1.0 Introduction – Relationships between Markets

      Periodically the small investor needs to assess his basic understanding of interrelationships between major forces that move the stock market.  Among the largest and most well known of these forces are inflation, interest rates, bond prices, commodity prices and currencies. 

      There are times when the stock market reverses itself for little apparent reason.  Typically this is followed by analytical statements explaining it after the fact, pointing to some obscure detail or another.   Such explanations are often phrased in a manner to suggest that because the writer knew about the detail, he was able to predict the market turn.  Such circumstances leave the beginning investor somewhat overwhelmed and amazed at the infinite amount of continuing factual input and infallible interpretation needed to avoid going against the market. 

      While there are continuing sources of input that one needs in order to invest successfully in the stock market, they are limited.  What is more important is to have a good model for interpreting new information.  As always, any understanding of markets begins with human nature with its perceptions of supply, demand and value.  The emphasis is on perceptions.  Investors can be depended upon to seek the largest return for the least amount of risk.  When new information first becomes available, markets can be depended upon to over react.  The subsequent rebound makes it appear that the initial response was much to do about nothing.  But no, perceptions simply oscillated between extremes and prices followed.  Perceptions are real forces.

      With all this in mind, it is perceived that stock prices should rise with lowering interest rates because it becomes cheaper for companies to finance projects and operations that are funded through borrowing.  Lower borrowing costs allow higher earnings which increase the perceived value of a stock.  In a low interest rate environment, companies can borrow by issuing corporate bonds offering rates slightly above the average Treasury bond rate without incurring excessive borrowing costs.  Borrowing rates, especially for mortgages, are closely tied to the 10 year Treasury interest rate.  All of this increased borrowing effectively puts more money into circulation in the economy with more dollars chasing after a relatively fixed quantity of commodities.

      Bond traders continually compare the yields (interest rates) for bonds versus for stocks.  Stock yield is computed from the reciprocal P/E ratio of a stock.  Earnings divided by price gives earning yield, whether it is an average for the S&P 500, as a whole, or for a single stock.  The assumption here is that the price of a stock will move to reflect its earnings.  If stock yields are the same as bond yields, investors prefer the safety of bonds.  As bond prices trade higher, due to their popularity, the effective yield for a given bond will decrease because the face value of a bond at maturity is fixed.  As bond yields decline further, stocks begin to look more attractive, although with a higher risk.   Longer term interest rates for bonds or for any kind of borrowing are naturally higher than short term rates.  Equilibrium is eventually reached where stock yields appear higher than corporate bond yields which are higher than Treasury bond yields which are higher than savings account rates. 

      That is, until the introduction of higher prices and inflation.  Having an increased supply of money in circulation in the economy causes prices to rise.  Long term bond holders keep an eye on inflation because their real rate of return is equal to the bond yield minus the expected rate of inflation.  Therefore, rising inflation makes bonds less attractive, causing the coupon or interest rate on newly issued bonds to increase to make it worth while for investors.  With higher rates on newly issued bonds, the price of existing lower interest bonds fall causing their effective interest rates to increase, as well.  The Federal Reserve, seeing higher inflation, also raises interest rates to remove money from circulation to hopefully reduce prices once again.  Borrowing costs rise, making raising capital more difficult for companies, causing their earnings to decrease.  Stock investors, perceiving the effects of higher interest rates on company profits, begin to lower their expectations of earnings and stock prices fall.  So both stock and bond prices fall in an inflationary environment.    

      In addition to having too many dollars in a low interest rate environment chasing after too few commodities, inflation is also increased by a drop in the value of the dollar in foreign exchange markets.  Foreign goods become more expensive.  When foreign investors are perceived as finding US dollar investments less attractive, putting less money into the US stock market, a liquidity problem may result in falling stock prices.  Political turmoil and uncertainty cause the value of currencies to decrease and the value of hard commodities to increase.  Hard commodity stocks do well in this environment. 

      Too few dollars in circulation causes deflation.  Companies are unable to sell products at any price and prices fall dramatically.  The resulting effect on stocks is negative in a deflationary environment due to a simple lack of liquidity. 

      In summary, in order for stock prices to move smoothly, perceptions of inflation and deflation must be in balance.  A disturbance in that balance is usually reflected as a change in interest rates and the foreign currency exchange rate.  Today’s interest rates are rising and the value of the dollar is falling.  Where they find equilibrium is difficult to say.  It would be prudent to keep an eye on the rate at which bond rates and the value of the US dollar change.  They are big movers.   World wide it was estimated at the end of 2001 that there were $33 trillion of bonds outstanding. The US market represented just over half of that at around $17.1 trillion.  By comparison the estimated global market capitalization of stock markets was around $20.5 trillion.   The NYSE was the largest at roughly $8.5 trillion (all figures US$).  The Global Derivatives market had an estimated size of $100 trillion.   It was estimated that the average daily trading volume of US Treasury Securities alone was around $360 billion per day. By comparison the US Equity markets traded only around $50 billion per day. Both of these pale in comparison to the Foreign Exchange market that averaged $1.5 trillion transactions in a day.

2.0 Analysis

  Week ending 11/28/04:

  Gold for past 30 days:

  USD   +5.52%

  CAD   +1.22%

  CHF   +0.33%

  GBP   +2.97%

  EUR   +1.77%

  JPY   +1.54%

  Indices for the week:

  Dow Jones    +0.3%

  NASDAQ 100   +1.4%

  S&P500 Index  +0.8%

  Russel 2000   +2.4%

  Leaders for the week:

  Sector:   Energy

  Industry: Mining

3.0 Procedure

      We are looking for optionable stocks whose percentage relative strength over the past 6 months is greater than 95%, EPS Growth over the past 12 months is greater than 80% and are within 5% of their 52 week high. If we can find such stocks that fall within a leading sector and industry based on the above information, we consider that a plus.  See Table 1.

Table 1

Watch List as of 11/28/04

      USG, TXU, URBN, MDR, SWN AND BTU were moved from the watch list to the portfolio last week because of the apparent bottoming out of their stochastic indicators.  We’ll see. 

      Trades can apply to either options or the underlying stock, depending on available resources, investment time frame and money management rules as discussed below.  Options are chosen to be mildly or deeply in the money so as to have a reasonably high delta. Delta, which ranges from zero to one, is equal to the probability that an option will be in the money on its expiration date.  More near term it equals the dollar amount that the option premium changes for every dollar amount that the underlying stock price changes.  Expiration dates are picked as far as possible into the future not exceeding one year.  It’s perfectly OK to exceed one year but it’s just easier to remain under one year for the trading platform that I personally use.  The value of the time premium decays less rapidly the farther out one goes and one does not need to panic to get out of a trade as the expiration date approaches.  With this in mind, one seeks to exit any trade a month or two before expiration.

4.0 Results - Model Portfolio

      For the week ending 11/28/04, the stock portfolio is shown in Table 2.  Options performance are shown in Table 3. 

Table 2

Sock Portfolio as of 11/28/04

Table 3

Options Portfolio as of 11/28/04

Option

 Buy Date

  Buy Price

  Last

 Action

 P/L(%)

 USG MAY 25.00 CALL

  11/23/04

  $ 8.40

  $ 8.40

   long

      0.0

 TXU APR 55.00 CALL

  11/23/04

  $11.30

 $10.80

   long

     -4.4

 URBN JUN 35.00 CALL

  11/23/04

  $11.50

 $11.50

   long

      0.0

5.0 Conclusion – P/L

      The average  P/L is 1.7%, with 3.6% for stocks and -1.5% for options.