THE OPTIONS COURSE
A Short Course in Economic Analyses
The global financial marketplace strikes a delicate balance between a vast network of business interests. Fascinating events in one area of the global economy, such as energy prices, can trigger a reaction in other markets, like bonds, and the ripple effect can spread to other commodities and stocks. With technology helping to speed up the decision-making process and allowing traders to execute trades at the speed of light, capital can and often does shift from one country’s financial markets to the next. All of this movement in money and investments securities is often based on international events, the global economy, and the outlook for various financial markets around the world.
Understanding the relationship among stocks, bonds, and economic events helps traders to obtain a better understanding of what is happening in the world, the daily movements in the financial markets as well as the long-term trends. This type of broad market analysis allows us to better understand the risk-reward profiles of various directional trades before we actually put money on the line and pull the trigger. This seeks to assess the general behavior of and interrelationships among stocks, bonds, and interest rates and how various economic conditions impact all three.
Historically, two factors have caused the stock market to crash: war and long-term interest rates. If bond prices drop too much, interest rates can climb too high because there is an inverse relationship between bonds and interest rates, or yields. If so, it can devastate the stock market. A 7.5 percent yield on the benchmark long-term Treasury bond has been a catalyst for a decline in the stock market, because it creates competition for investor money. For example, if bonds offer an attractive yield, a large institution might change its asset allocation from 60 percent of the money invested in stocks and 40 percent in bonds to 60 percent in bonds and 40 percent in shares.
In addition, when bond yields go up, companies have to pay more to borrow from banks, which hurts their profits. As a result, the stock market is affected. In addition to bond yield concerns, investors also worry about the earnings of a company. If earnings are better than expected, they can override rising bond yields, which can cause stocks to go up. When stocks aren’t focused on earnings, which are released quarterly, they sometimes focus on bond yields. These interrelationships are both dynamic and constantly evolving.
Here are 11 salient relationships I look for when developing a broad market analysis:
1. Lower bond rates help companies make more profits.
2. Short covering in the bond market can boost the Dow Jones Industrial Average.
3. Falling bond yields can contribute to strength in financial stocks.
4. Bond yields follow the economy. If the economic indicators are coming in strong, bond yields will rise; if they are coming in weak, bond yields will fall.
5. Inflation is not only the enemy of the bond market—it’s also the enemy of the stock market because a rise in prices affects corporate profits.
6. Shares are driven by corporate profits, and profits are driven by a healthy economy with low inflation.
7. The inflation reports such as the Producer Price Index and the Consumer Price Index will affect both stocks and bonds the same way.
8. With steady economic growth, stocks can increase even if earnings aren’t outstanding.
9. When the Fed hikes interest rates, this can cause the yield on the long bond to increase, which will create competition for shares.
10. If the Fed raises rates too high, this can cause a recession and can reduce inflation, during which time, bonds, and interest rate–sensitive stocks will rise.
11. When the dollar is strong, U.S. exports cost more; as the dollar falls, import prices rise, which is inflationary.
If some of these relationships do not hold, then it behooves the trader to analyze the reasons for this divergence and look for opportunities to make money under the circumstances. Dissecting these 11 factors will give the trader a good feel for the current environment as we develop our broad market analysis scenario, which is always an excellent first step before implementing a particular directional strategy at the micro level.
INTEREST RATES, BONDS, AND STOCKS
Forecasting market direction is never a sure thing. Luckily, there are a few economic interrelationships that can help you to make consistent profits. One of the most important of these is the relationship between interest rates and bond prices. The following table illustrates the typical interrelationship of the change in interest rates to the price of a bond and the subsequent effect on the stock market.
Interest Rates Bond Prices Stock Prices
Up Down Down
Down Up Up
Sideways Sideways Up
Although these relationships are relatively stable, occasionally there are deviations from typical economic behavior, referred to as divergences. This table, however, illustrates the normal expected action based on economic theory.
A bond is a debt instrument sold by governments or corporations to raise money for various reasons. The bond most widely considered by investors and traders is the 30-year Treasury bond. It has a corresponding futures contract that is traded at the Chicago Board of Trade and reflects one very important aspect of many Americans’ lives: mortgage interest rates. Bonds are rarely held by the same buyer until maturity. Instead, they are traded at a price that fluctuates according to interest rates and inflation. Since a bond’s interest rate stays the same until maturity, its real value at maturity depends on inflation’s actual value of the dollars at repayment.
In general, interest rates are also tied to inflation. According to economic theory, if interest rates go up, bond prices go down; and if interest rates go down, bond prices rise. Why does this inverse relationship hold true? Let’s say that you decide you are going to lend me $1,000 for a five-year period. I agree to pay you interest at a rate of 8 percent each year, which happens to be the market rate for interest charges. Therefore, I will pay you $80 per year interest. The very next day, interest rates jump to 10 percent. Now you could lend $1,000 and receive 10 percent interest, which would bring in $100 per year, but you have lost the opportunity of lending that first $1,000 at the higher rate of interest.
Did the value of the first loan go up or down with the rise in interest rates? The first loan’s value went down. If you want to sell that 8 percent loan as an investment to someone else, you will find that its value has decreased. A loan with a 10 percent interest rate has a greater value than one with 8 percent. Therefore, when interest rates go up, bond (loan) prices fall. Let’s examine the converse situation: When interest rates go down, bond prices rise. If interest rates drop from 8 percent to 5 percent, an investor could receive only $50 on the $1,000 investment. A previous loan with an 8 percent interest rate would now increase in value, because it would make the investor $80 a year instead of just $50.
In general, fluctuations in interest rates stimulate the bond market. Trading bond options can also be quite lucrative if you pay close attention to interest rates and inflation. It is also a good practice to monitor certain bond markets’ yield to maturity. This measurement predicts a bond’s return over time by assessing its interest rate, price, par value, and time until maturity. In general terms, the same inverse relationship exists between interest rates and shares as between interest rates and bond prices. Thus, bond prices and the stock market usually move in the same direction. Assume your company has to buy $10,000 worth of equipment.
You don’t want to pay cash for the equipment; therefore, you have to finance the purchase. In this case, you will pay 8 percent interest—$800 per year. Interest is an expense that gets subtracted from what you earn. Therefore, if you earn $20,000 before interest, you will have earned $19,200 after interest is paid. If the interest rate were 10 percent for the same $10,000 loan you would pay $1,000 per year and your earnings would drop to $19,000 after you subtracted interest. Once again, we see an inverse relationship, this time between interest rates and earnings—the higher your interest rate, the less money flows to your earnings.
If your company has reduced its earnings due to a higher interest expense, then your company’s value decreases. This affects your company’s stock price. Therefore, an interest rate increase (bond prices fall) usually decreases stock prices. This inverse relationship does not always hold. There are periods when a divergence will occur and a company’s earnings will increase regardless of whether interest rates go up or down. However, these divergences are generally short-term in nature. You can usually count on the market coming back, reacting to the change in interest rates.
If you watch the day-to-day price changes in the stock market, you may find that investors and traders are watching bond prices and interest rates very closely. Changes in either may determine whether it is a good time to buy or to sell bonds. In addition, if you see interest rates increasing quickly, you don’t want to be a buyer of stocks. An increase in interest rates signals a time of caution due to the negative bias for individual stocks and the stock market in general. However, if you find that interest rates are stable or decreasing, being a buyer of stocks is a good idea because the stock market has an upward bias.
Historically, the general bias of the stock market is to rise. Investors usually push markets up. Even after stock market crashes, the market usually rebounds strongly. The stock market’s cyclical movement is directly related to economic, social, and political factors, with bull markets lasting longer than bear markets—dropping quickly and then rising slowly but steadily. However, when it comes to the stock market, there are no absolutes. Since no one has a crystal ball with which to see the future, I prefer to create trades that are nondirectional in nature using delta neutral strategies that reap consistent profits.
KEY INTEREST RATE INDICATORS
Putting together a broad market analysis requires a feeling for where interest rates might be headed. In order to do this, the analyst needs a clear understanding of three key indicators: the prime rate indicator, the Federal Reserve indicator, and the installment debt indicator. Each indicator provides important clues pertaining to future interest rate trends. The prime rate indicator represents the interest rate that banking institutions require their very best customers to pay which more often than not are the top corporations in the country.
The majority of bank loans actually made are pegged to the prime rate with a premium being charged relative to the degree of risk of the loan. So, the worse off the borrower’s credit rating, the more the borrower will pay above the prime rate. Following prime rate changes is relatively easy since it does not change every day, as do other interest rates. In addition, when the prime rate indeed does change it is hard to miss it since it is plastered all over the news. Also, this indicator lags behind other interest rates. For example, the prime rate typically declines only well after a decrease in the federal funds rate or certificates of deposit yields.
But these prime rate changes should be monitored closely because many times when a distinct trend can be identified then this can translate into corresponding movement in the equity markets. The Federal Reserve indicator consists of two of its primary monetary policy tools: the discount rate and reserve requirements. The discount rate is how much the Federal Reserve charges banking institutions that wish to borrow from it. And why would banks ever want to borrow from the Federal Reserve? The answer is to satisfy their reserve requirements, which are also controlled by the Fed.
These requirement levels basically determine the bank’s loan making ability. Just like the prime rate, the Fed’s adjustments to the discount rate and/or reserve requirements garner a lot of media attention, which makes changes quite easy to track. These two data points are rarely changed within the course of a year. The key information that is critical for the analyst to capture is the directional change in either of these two key monetary tools. Finally, the other key piece of information in determining interest rate trends is the installment debt indicator.
This indicator gauges the level of loan demand in the country. This demand has a large impact on the direction of interest rates. If loan demand increases significantly interest rates tend to increase. When loan demand decreases at a sharp level the interest rates are likely to decline. Loan demand is measured from a variety of sources, which include state, federal, and local governments; corporations using short-term commercial loans and longer-term bond market monies; mortgage debt; andm consumer installment debt. Again, just like the other indicators, this data is simple to track.
Keep in mind that when the monthly total of this debt is released by the Federal Reserve it is about six weeks late; however, the important thing to note is how this figure is trending. This can gives us a keen insight into the future direction of interest rates. All three of these interest rate forecasting tools are not only extremely easy to track but easy to interpret as well. And as indicators go, that is exactly how they should be if they are going to be effective. If you are a fundamental analyst who likes to adopt a broad market view before investing, then I suggest adopting these tools as part of your overall approach.
THE ECONOMIC DATA
Since traders are constantly trying to predict the next direction of interest rates, the economic news can have a significant effect on the financial markets. Often, signs of a strong economy can trigger concerns about the prospect of inflation, which has historically led to higher interest rates. In addition, inflation is also a concern due to its adverse impact on corporate profits. There are several pieces of economic data that can give clues regarding the trends in inflation. For instance, the prices-paid element of the Institute of Supply Management (ISM) manufacturing report, which is released monthly, can serve as a guide report that gauges inflation.
If prices paid are too strong, stocks and bonds might react negatively to the news. The Consumer Price Index (CPI) measures prices on consumer goods and services, and the Producer Price Index (PPI) gauges prices on various goods such as commodities, capital items, automobiles, and textiles. Both should be watched for inflationary pressures. Some traders also watch trends in the commodities market for signs of inflation. The Commodity Research Bureau provides an index of commodity prices known as the CRB.
When it is rising, it is a sign of rising commodity prices and, sometimes, mounting inflationary pressures. A host of other economic reports receive the market’s attention on a regular basis. Bond traders sometimes call the monthly unemployment report from the Labor Department the “unenjoyment” report because stocks and bonds sometimes slide following the release of the monthly numbers. It is released on the first Friday of every month. Figures on retail sales, housing, motor vehicle sales, and consumer sentiment numbers can also cause a reaction on the financial markets.
THE IMPORTANT ROLE OF THE FEDERAL RESERVE
Another major reason you should keep track of economic reports is because they can influence the decisions at the Federal Reserve. Just what is the Federal Reserve? Most people believe that it is the branch of the U.S. government charged with making monetary policy decisions. Most people are wrong. While it’s true that the Federal Reserve makes U.S. monetary policy, it is an independent group. The U.S. government was on the verge of bankruptcy back in the early 19-teens. Twelve very wealthy families actually stepped forward to bail out the government, and Congress officially created the Federal Reserve in 1913. Today, the Federal Reserve consists of 12 district banks as well as a board of governors.
Alan Greenspan is currently the Fed chairman. Today, the Federal Reserve works more like a government agency than a corporation. The chairman of the Federal Reserve and his fellow central bankers play a key role in influencing the money supply. As a trader, it is vital to examine how open market operations are one of the primary tools used by the Federal Reserve to implement U.S. monetary policy. You can also track the profound impacts these decisions have on the U.S. economy, as well as the key reports that are monitored to determine if the Fed is indeed meeting its intended goals.
TABLE Important Economic Indicators
The Federal Reserve actually has three tools at its disposal to carry out monetary policy: open market operations, discount rate, and reserve requirements. Open market operations are by far the most widely used mechanism. When the economy is growing too fast and the inflation rate is high, the Federal Reserve will sell government securities from its portfolio to the open market. This decreases bank reserves, which means the money supply decreases. When there are less bank reserves, short-term interest rates increase. This means consumers and businesses have to pay the bank more in order to borrow money. Less borrowing means less spending, which slows the economy and eventually can reduce price pressures.
However, if the economy is growing too slowly and the inflation rate is low, the Federal Reserve will buy government securities, such as Treasury bills and notes. This increases bank reserves, which increases the money supply and causes short-term interest rates to decrease. Reduced rates induce consumers and businesses to borrow. Consumers will borrow money for items such as automobiles or homes. Businesses borrow to build their inventories or finance new factories. As a result, economic growth will accelerate.The Federal Reserve will also leave rates unchanged if the economy is growing at a moderate pace with low inflation or if they feel the economy will slow down by itself.
They will even take a wait-and-see approach with regard to how fast or how slowly the economy is growing and the rate of inflation, before determining monetary policy. The major goals of the Federal Reserve include moderate growth, low unemployment, and low inflation. To determine how these open market operations have been impacting these areas, the Fed monitors the key related reports for feedback. Economic growth is measured by the gross domestic product, which consists of consumption, investment, government, and exports. The retail sales report would fall under consumption. Business inventories and housing starts would fall under investment. Construction spending would fall under government, and international trade would fall under exports.
Other reports include the employment report, which includes the unemployment rate and is also closely monitored by the Federal Reserve. Finally, the Producer Price Index, Consumer Price Index, capacity utilization rates, and Employment Cost Index are all monitored to determine the current inflation outlook. As these reports are released week-by-week, a consensus is developed among policy makers as to whether the economy and the inflation rate are growing too fast, too slow, or just right. They look for the evidence and then they take a vote on whether to raise or lower rates or leave them unchanged. The bottom line is that the Federal Reserve chairman and fellow central bankers have a great influence on our economy and should be watched closely.
The primary goals of the Federal Reserve are to stabilize prices, promote economic growth, and strive for full employment. These goals are pursued through managing monetary policy, which is implemented by the Federal Open Market Committee (FOMC). The FOMC includes seven Fed governors as well five presidents of the district banks. Four of the presidents serve on a rotating basis. The FOMC’s most frequently used tool to control monetary policy is open market operations. Open market operations means the buying or selling of government securities to control liquidity in the economy. That’s what is happening when you hear that liquidity is going up or down in the economy.
When liquidity is high, it makes it easier for businesses to borrow money, which in turn leads to more research and development (R&D) spending, which leads to growth. Have you ever really looked at a dollar bill? Across the top it says “Federal Reserve Note.” It didn’t always. I actually have a 1917 United States dollar framed on the wall in my office; it was the last year they were printed. How about the back of the current dollar bill? There is a pyramid with an eye on the top and a banner along the bottom with a slogan that stands for “New World Order.” (That’s the original name the 12 families who bailed out the government in 1913 coined for themselves.) Our old money had an “X” across the back with the words “United States of America” embodied in the “X.”
That’s enough history and economics; now let’s examine more recent Fed moves. As the market was racing forward at the end of the 1990s, many may remember the famous “irrational exuberance” speech from Fed Chairman Alan Greenspan. The sad thing is that the Fed helped create that exuberance. In 1999, the Fed began injecting massive doses of liquidity into the economy in anticipation of Y2K. It wanted to make sure businesses had plenty of easily available money. Banks actually had more money than they could lend. So where did all this money end up? That’s right, the stock market. And what was in vogue at the time? The unknown Internet sector.
This just further fueled the raging bull market that already existed. After Y2K arrived with few problems, the Fed began rapidly draining that liquidity back out of the market. At the same time, the Fed was concerned about the rapid growth of our economy. Surely, an economy growing at 6 to 7 percent would spur wild inflation, even though there were no signs of it anywhere. So at the same time the Fed was withdrawing liquidity, it was raising interest rates to “tap the brakes” on the economy. What is so frustrating is that everyone knows that interest rate cuts or hikes take time to affect the economy. The Fed kept pressing that brake with more rate hikes because the economy still looked so healthy.
We now see the results of what withdrawing liquidity combined with rate hikes can do to businesses and a healthy economy. The effect has been more of slamming on the brakes and jamming the gears into reverse. Was there an Internet bubble? Sure there was: It would have eventually become apparent anyway that all those dot-coms were never going to make a profit. The bubble would have suffered a slow leak until it disappeared altogether. Instead, we got a painful “pop.” Could our economy have continued to grow at such a rapid pace without rampant inflation? If you believe in the free enterprise system, supply will always meet demand. Take away the demand and look what happens.