THE OPTIONS COURSE
SECURITIES AND EXCHANGE COMMISSION
In the United States, stock exchanges are regulated by the Securities and Exchange Commission (SEC), which was created by Congress in 1934 during the Depression. It is composed of five commissioners appointed by the President of the United States and approved by the Senate and a team of lawyers, investigators, and accountants. The SEC is charged with making sure that security markets operate fairly and with protecting investors. Among other acts, they enforce the Securities Act of 1933, the Securities Exchange Act of 1934, the Trust Indenture Act of 1939, the Investment Company Act of 1940, and the Investment Advisers Act of 1940.
The SEC is also in charge of monitoring insider trading as well as detecting corporate fraud. Insider trading is a form of trading in which corporate officers buy and sell shares within their own companies. This type of trading is widely influenced by inside information that only corporate officers have access to. Many off-floor traders keep track of insider trading to gauge the movement of a specific stock. In addition, there are a multitude of regulations aimed at preventing corporate officers from profiting from information not released to the general public during mergers or takeovers.
Corporate fraud has been in the news a great deal in the United States since the accounting scandals of 2002 rocked Wall Street and the U.S. economy. The collapse of Enron, the bankruptcy of WorldCom, and a series of lawsuits against high-profile executives, including Martha Stewart, give the impression that global corporate fraud and misconduct are rampant. This, of course, occurred during the second year of a bear market— a period that saw some stocks lose 50, 60, and sometimes 70 percent or more of their values, Since stocks were already reeling, the exact impact on the stock market as a whole is difficult to determine. Therefore, the exact impact of the corporate misconduct remains difficult to quantify.
While the exact impact of accounting scandals and corporate fraud is difficult to measure, without question the fact remains: The Enron debacle and subsequent bankruptcies have eroded investor confidence in U.S. financial markets. They also dealt a financial blow to the shareholders of bankrupt companies like WorldCom, Enron, and Adelphia Communications. On a national level, the scandals and fraud left many investors wondering, who is next? When will the next shoe drop? Those concerns served to keep many investors away from stocks. Unfortunately, there is little hope for a market rebound during an absence of prospective buyers. Eventually, some of the concern faded.
On February 11, 2003, Federal Reserve Chairman Alan Greenspan said that he believed that the corporate scandals that shook Wall Street in the summer of 2002 were reaching an end. “I would be very surprised if it were initiated beyond mid-2003,” the Fed chairman said in a speech to the Senate Banking Committee. “It is not a problem for the immediate future.” One reason for his optimism stemmed from the passage of the Sarbanes-Oxley legislation approved by Congress in 2002. The new law restored some of the lost investor confidence. Yet investor confidence can prove fragile. While it is hard to tell just what impact corporate scandals had on the stock market, it is clear that investors have begun to recognize it as an additional risk.
As time passed, some of the fears and uncertainty began to fade. Stricter regulation and greater enforcement by the Securities and Exchange Commission have played important roles in shoring up investor confidence in financial markets. Still, believing that every issue related to corporate malfeasance and accounting scandal has been solved would be naive. In fact, such problems might resurface at any time and rekindle investor jitters. If and when this scenario will play out again is unpredictable. Nevertheless, corporate misconduct is an important factor to consider before stepping into the financial world. Make sure that all your trades consider the possibility that such problems could resurface anytime in the not too distant future. Manage your risk!
INFLATION CATEGORIES AND GOVERNMENT IMPACT
Economists recognize two principal types of inflation: cost-push inflation, in which increases in the cost of raw materials and/or labor are reflected in higher prices, and demand-pull inflation, which is caused by the demand for goods increasing faster than the supply. Cost-push inflation usually results from a chain of related events. For example, if the labor costs involved in producing a specific raw material rise, the supplier of that material will pass on the increase to the manufacturer who uses the material in a finished product. The manufacturer, in turn, raises prices on the finished product in order to protect their profit margin.
The consumer who buys the product ultimately pays for the higher cost of labor in the price of the product. When this happens in several industries at once, consumers who are also workers demand higher wages to help meet the increased prices. This, in turn, sets off another round of price increases as manufacturers and retailers attempt to recoup their higher labor costs. As the cycle continues, it raises the cost of living for everyone. Demand-pull inflation, in contrast, is caused by increased demand for a product or material, or by scarcity of that commodity. During the 1970s, many of the world’s oil-producing nations held their product back from the market at a time when demand for petroleum was increasing rapidly.
The results were across-the-board increases in the prices of oil, gasoline, and synthetic materials made from petroleum. In turn, refiners, power generating companies, and manufacturers passed along the higher prices of crude oil to consumers. In addition, the fuel costs of freight haulers who delivered goods rose, and these, too, were passed on to consumers. In some instances, demand for goods is stimulated by the availability of extra dollars. The amount of money in circulation increases faster than productivity in the economy, leading to greater demand. In effect, money chases supply.
For example, during the 1960s, the government increased the amount of money in the economy rather than raising taxes to pay for the war in Vietnam. The resulting inflation was, in effect, a hidden tax to pay for government operations, because wage earners were pushed into higher tax brackets. The federal government can impact inflation and the overall economy in three major ways. First, the government can spend more money than it collects in taxes, duties, and fees. Such deficit spending tends to stimulate the economy. But the government must borrow the difference between its income and expenditures, usually by selling Treasury bonds or bills.
When the government enters the credit markets, it competes with other big borrowers, such as corporations, for the dollars that are available. The resulting increase in demand for money tends to raise the interest rate. Rising interest rates reduce the overall demand for many goods and services, particularly those that are financed, such as housing, durable goods, and plant and equipment. Thus, initially deficit spending tends to increase overall demand, while borrowing to finance the deficit tends eventually to decrease such demand. The net inflationary impact depends on the state of the economy and the relative effects of these two forces.
If the economy has slack in it, additional stimulation has little or no inflationary impact. If the economy is already booming, further stimulation can push up prices dramatically. The relative effect of the deficit depends on how it is financed. This always prompts an economic debate on how best to impact our economy: balanced budgets versus deficit financing. The second way in which government can affect the economy is through its taxing policies. By raising taxes, government can slow the rate of growth in the economy. By reducing taxes, it can provide more money for economic growth. Over the years, the Congress has tended to use this technique to stimulate specific areas of the economy.
For example, the deduction for mortgage interest payments on personal residences was designed to boost the home-building industry and the many other industries it influences. The investment tax credit, which was repealed in 1986, was instituted to encourage businesses to expand their plants and buy new equipment. Other tax measures have targeted areas in similar ways. Finally, the third major government influence on inflation and the economy is the Federal Reserve. One of its jobs is to regulate the supply of money in the economy. If the money supply grows too quickly, prices will rise faster than productivity, which fuels inflationary pressures. If the Federal Reserve tightens up on the money supply too much, it could throttle a growing economy.
Despite the fact that the Federal Reserve is a government-chartered corporation, it is not required to work with other branches of the government to coordinate action affecting the economy. However, the Federal Reserve is required to report to Congress, and Congress can change the laws affecting it. In addition, the President appoints its membership. In some cases, actions by the Federal Reserve may be opposite those of the Administration and Congress, causing mixed economic results. Regardless of the current political environment a savvy investor must be keenly aware of the current inflation trend and the impact it has on the investor’s savings, income, and portfolio. This understanding can make a major difference in an investor’s financial future.
FED FUNDS FUTURES CONTRACT AND MONETARY POLICY
The federal funds rate is the interest rate banks pay when they borrow Federal Reserve deposits from other banks, usually overnight. It is closely watched in financial markets because the level of the funds rate can be immediately and purposefully affected by Federal Reserve open market operations. The Federal Open Market Committee, the main policy-making arm of the Federal Reserve, communicates an objective for the fed funds rate in a directive to the trading desk at the Federal Reserve Bank of New York. Actions taken to change an intended level of the fed funds rate are motivated by a desire to accomplish ultimate policy objectives, especially price stability.
Permanent changes in the fed funds rate level are thus the consequence of deliberate policy decisions. The fed funds contract, also known as 30-day fed funds futures, calls for delivery of interest paid on a principal amount of $5 million in overnight fed funds. In practice, the total interest is not really paid, but is cash-settled daily. This means that payments are made whenever the futures contract settlement price changes. The futures settlement price is calculated as 100 minus the monthly arithmetic average of the daily effective fed funds rate that the Federal Reserve Bank trading desk reports for each day of the contract month. Payments are made through margin accounts that sellers and holders have with their brokers.
At the end of the trading day, sellers’ and holders’ accounts are debited or credited to facilitate payments. Fed funds futures are a convenient tool for hedging against future interest-rate changes. To illustrate, consider a regional bank that consistently buys $100 million in fed funds. Suppose the bank’s analysts believe that economic data to be released in the upcoming week will induce the FOMC to increase the objective of the fed funds rate by 50 basis points at its next meeting. If the contract settle price (for the meeting month) implies no change from the current rate, the bank may choose to lock in its current cost by selling 20 contracts (or taking a short position) and holding the position to expiration.
Conversely, suppose that a net lender of funds expects a policy action to lower the fed funds rate. It can protect its return by purchasing futures contracts (or taking a long position). Participants in the fed funds futures market need not be banks that borrow in the fed funds market. Anyone who can satisfy margin requirements may participate. Thus, traders who make their living as “Fed watchers” may speculate with fed funds futures. This would suggest that to the extent Fed policy is predictable, speculators would drive futures prices to embody expectations of future policy actions. Since the level of the fed funds rate is essentially determined by deliberative policy decisions, the fed funds futures rate should have predictable value for the size and timing of future policy actions.
Given that the trading desk may face systematic problems that hinder its ability to achieve its objective, the consequences for the funds rate may be predictable. Speculators who anticipate such effects may find it profitable to buy or sell current contracts. In the case of fed funds, the rate is essentially determined by a deliberative decision of the FOMC, the main policy-making arm of the Federal Reserve System. Hence, the fed funds futures markets must anticipate actions taken by the FOMC. In short, through the fed funds futures markets, one can place a bet on what future monetary policy will be. The committee then can get a clear reading of what these market participants expect them to do, which may at times be helpful for FOMC members who place great weight on knowing if a policy choice would surprise the market.
If they are to be instructive for policymakers, the fed funds rate should have some predictive content. The predictive accuracy of futures rates historically improves over the two-month period leading up to the contract’s expiration, providing some evidence that the market is efficient in incorporating new information into its pricing. The largest prediction errors have occurred around policy turning points. Nevertheless, there is considerable evidence to suggest that the fed funds futures markets are efficient processors of information concerning the future path of the fed funds rate.
U.S. DOLLAR’S IMPACT ON GLOBAL COMMERCE
The rate of economic growth—meaning the rate of gross national product (GNP) growth—is determined by three key rates: the interest rate, the tax rate, and exchange rates. The business cycle is influenced by those rates, which in turn are shaped by monetary, fiscal, and trade policy. Given the global economic environment that we live in, it’s important to understand world trade basics and how the dollar actually impacts global commerce. Assume that you buy a Japanese-made car. The dealer who imported the car has to pay an exporter in Japan for the cost of the vehicle that’s been sent over.
The exporter wants to be paid in yen, the Japanese currency. So the importer takes his dollars and buys yen from a currency dealer or bank. The number of dollars he pays for the amount of yen he gets is determined by the exchange rate. He then sends the yen to the exporter in Japan and sells you the car he’s purchased. The same thing happens in reverse when a Japanese consumer buys an American-made product. A U.S. export turns into a Japanese import just the way a Japanese export becomes a U.S. import. All things being equal, if imports and exports occur in the same total amount, the balance of trade will be equal.
Simply put, if the balance of trade between two countries is equal, then the rate of exchange between the currencies of those two countries will also be equal. That may be hard to grasp, because many investors think that currency has intrinsic value. But currency is only worth what it will buy. Ask yourself how much value a U.S. dollar has in a land where goods are bought and sold in yen. If the Japanese have no U.S. imports, they’ll need no dollars, and the dollar will be nothing more than a souvenir. The same is true of the yen’s value in the reverse situation. In Houston, where goods are paid for in dollars, a yen is worthless unless it’s needed to pay for a Japanese import.
And if you need it because you’re taking a trip to Japan, that’s also counted as an import. When Americans spend abroad, they have the same effect on the balance of trade as an importer. In both cases, yen must be bought, and dollars flow out. But if no trade takes place, there is no need for currency exchange. When it does take place, if the Japanese need as many dollars as Americans need yen, the dollar and the yen will be equal in value. That’s how the dollar shapes up when all things are equal. But things are never equal, and that means you’ve got to think about the shape the dollar’s in when you’re trying to stay ahead of economic trends.
The problem is that the United States is now the world’s largest debtor nation. If we exported more than we imported, our trade account would have a surplus. But because we import much more than we export, we now have a hefty yearly trade deficit. The more we import, the more foreign currency we have to buy to pay for it. Since we need more foreign currency and our trading partners need fewer dollars because they have fewer U.S. imports to pay for, demand for dollars is less than demand for yen and German marks, for example. That means a strong yen, or mark, and a weak dollar. Trade imbalance normally works itself out.
As we import more and more Japanese goods, the dollar will weaken against the yen. That will make Japanese goods more expensive, which will reduce our imports of them. On the other side, a weakening dollar makes our exports less expensive. So the Japanese should buy more of them. As they import more and we import less, trade will eventually balance. The difficulty is that countries erect barriers to trade, and these barriers act to strengthen or weaken currency, which in turn affects economic growth. The U.S. can regulate the strength of the dollar in several ways. On the fiscal side it can enact protectionist legislation and impose traffic and import quotas on foreign goods.
Or it can push for international trade agreements, which require its partners to export less and import more. The United States can also adjust exchange rates by using monetary policy. If the dollar is falling or rising sharply, the Fed, acting with foreign central banks, can buy or sell dollars in the currency markets. This is known as intervention to either support or weaken the dollar, a result that can be achieved in the short run only. In the long run, no amount of intervention can overcome the balance of trade when it comes to determining the dollar’s exchange value. Hopefully, this discussion has given you a greater appreciation of the intimate nature of the U.S. dollar and world trade.
Many traders ignore the macro-type analysis for the stock market that can be put together using various forms of economic and bond data. This big picture provides the trader and investor alike a very important starting point before they hone in on potential trading opportunities. There is an abundance of economic data that has an inextricable linkage to the stock market. For instance, when bond prices drop too much, forcing yields higher, this often has a devastating impact on the stock market. In general, bond yields have more of an effect on the financial sector versus other sectors such as the food service stocks, for example.
To this point you will see that when there is overall strength in the financial stocks, bond yields will drop. Keep in mind that many times declining long-term interest rates fuel a stock market rally and this is why when stocks are not focusing on quarterly earnings they focus on bond yields. If bond yields reach too high a level, companies may have to start paying more to borrow money, which adversely impacts profits. Of course, declining profits in turn lead to declining stock prices. To overcome rising bond yields, earnings have to come in better than expected to see appreciation in the stock price. Another trend to watch closely is when investors leave stocks to go into bonds, making it difficult for companies to raise money.
This also indicates what is known as a “flight to quality” where investors decrease the money flow into stocks to pursue safer investments. Due to its adverse impact on corporate profits, inflation is another key factor that needs to be monitored. For example, the prices-paid element of the Institute of Supply Management report gauges inflation. If prices-paid come in too strong, not only will bonds sell off, but stocks will sell off as well. For these same reasons the Consumer Price Index, which measures prices on consumer goods and services, and the Producer Price Index, which calibrates prices on various goods such as commodities, capital items, automobiles, and textiles, should also be watched closely for inflationary pressures.
Another report that can impact the inflationary outlook is the retail sales report. If this report, for example, experiences an upward revision from the previous month this can cause both the stock and bond market to sell off. Basically, these four inflation-type reports impact both the stock market and the bond market in the same way. The bottom line here is that the primary stock market catalyst is corporate profits. A major factor for profitability is having an economy that shows low inflation. Overall, if the economic reports are coming in strong, the bond market will begin to be concerned about the Fed increasing interest rates to derail possible inflation.
This will in turn cause bond yields to rise and foster an environment where stocks are more than likely going to decline because of the increased competition among the investment community on where to get the best return. Another major reason you should track these reports is that just like corporate earnings, economic reports and Federal Reserve decisions also come with their own expectations. For example, if the stock market is anticipating a raise in rates by the Federal Reserve and it doesn’t happen, then expect the stocks to decline across the board because stocks will reprice themselves to reflect the higher rates. These higher rates dampen both business and consumer spending due to the fact that borrowing costs are now higher.
The higher rates can sometimes actually spur a recession and can reduce inflation with interest rate–sensitive stocks being the beneficiary. Now of course, when the Federal Reserve cuts rates this can have a very positive impact on both the stock and bond market. Also, if rates are unchanged then more often than not this generates a positive signal to the equities market. In this same vein, there is always a concern that the Fed can reduce interest rates too much, pumping too much money into our economic system, which can fuel stock prices, resulting in asset inflation. Another more cryptic thing to monitor is certain chatter that occasionally comes out of the Federal Reserve.
For instance, a news story about a key Federal Reserve official warning about possible inflation or Alan Greenspan talking about overvalued assets could ignite a stock market sell-off. The point I want to leave you with is that this type of macroanalysis of the economic environment is an essential starting point when developing a general bullish or bearish scenario. This analytical backdrop has always given me the extra confidence I needed to pull the trigger based on Elliott wave, MACD, or any other technical tool I choose to employ before making a trading decision based on a directional bias.
Additionally, paying close attention to interest rates can help you to forecast market direction. Although many delta neutral strategies are not dependent on market direction, it never hurts to be able to anticipate movement. Since prices have extremely erratic fluctuation patterns, monitoring interest rates is a relatively consistent method that can help you to find profitable trading opportunities. You don’t have to become an expert in economics to gauge market performance; but you do need to know what you’re looking for and how to use the information that’s out there.
Part of a trader’s learning curve depends on his or her ability to integrate an understanding of the big picture with the multitude of details that trading individual stocks requires. Since money is the lifeblood of the stock market, understanding how it moves and where it moves to is a major key to financial success. Not only events move the markets, but also the international flow of money as investors seek the highest possible rate of return. The thought of international money flow may be overwhelming to many of us, but it is an important part of the big picture. So put on your high waders, the water’s just fine.