To understand
moving direction of the stock market is very crucial to your investment
Since ETFs can track stock market
bull and bear directions, you need to judge which direction the market moves
in. Then make trading decisions to buy
either Bull ETFs or Bear ETFs. If your
judgment is poles apart from being realistic, the harder you try, the more
money you might lose. Thus, to
understand whether the market is in an uptrend, downtrend, or within trending
range, is very crucial to your trading.
There are five key factors to watch
that broadly control the up-and-down movement of stock markets.
Source from Yahoo Financial, edited by blogger.
1
Corporate earnings
Source from
investopeida.com.
Generally speaking, the stock price is determined by market value
per share (often referred to as the P/E ratio) and earnings per share (often
referred to as the EPS), especially in an efficient market. Given the same level of P/E ratio, the higher
the EPS is, the higher the stock price will appreciate. A soaring P/E means that the stock has higher
estimates of earnings expected in the next four quarters.
Different industries have different
levels of P/E ratio. For example, tech
companies tend to have higher P/E ratios, since investors have higher growth
expectations from that industry. In the
past few years, since the recovery of the financial crisis, the rising P/E
ratio has been one of the preeminent factors that have driven the US stock
market rally. However, an extended
rising of the stock market might not be sustainable if the earnings do not
match the same pace. This is because the shares of stock become pricy and won’t
appeal to investors any more.
In bull markets, the P/E ratio tends
to be higher than that in bear markets.
The P/E ratio ranges from 20-25 in bull markets historically.
Federal
Reserve Influence
Source from usatoday.com
The direction that the Federal Reserve moves
affects interest rates.
If interest rates are hiked, the cost for
corporations to function will go higher too.
It will eventually erode corporate profit, and further decrease profit
margins. The EPS will drop
accordingly, which will have an inverse effect on the stock market, assuming
the P/E ratio or valuation stays at a similar level.
In recent years, especially after the
financial crisis of 2007-08, the fiscal and monetary policy from major
countries had a broad and deep effect on the financial marketplace. By
adjusting interest rates, the central banks could adequately slow, or speed up
growth, within that country. This is how monetary policy plays a role in our
economy.
On the other hand, the fiscal policy is
another tool for governments to make an impact on the financial market. By implementing a fiscal policy, our
government either expands or cuts back spending. The current fiscal policy aims
at abating unemployment rates and appreciating asset prices.
Technically,
governments are able to alter investment inflows and outflows among countries
by easing or hiking interest rates. This also influences the amount of money
available on the open market. The money flow in a country has a positive effect
on the strength of a country's economy, wealth, and currency. Generally
speaking, if a large amount of money is leaving a country, this country's economy
and currency is weakened.
On the other hand,
countries that predominantly export either goods or service, reap the profits
from exports flooding into the country’s revenue base. Therefore, this money
can be utilized for reinvestment and stimulating the financial markets and
economic bodies.
Here is an example of
how capital flows can transit between countries. Due to the relative financial
strength of the US economy, the United States attracts capital from other
regions in the world. Please read the article,
“Capital Flows Back to U.S. as Markets Slump Across Asia” for a reference.
On the other hand,
relative strengths or weaknesses of currency
might have a big impact on the stock market too. Traders
can follow this link to find more details about how carry-trade correlates with
the stock market:
The World Situation
Source from
combusem.com
Economic globalization is the growing economic interconnection of economic activities among
countries by the accelerated increase in exchanges of goods, services, capital,
information, etc. In the meanwhile, it
creates an adjoining interdependency, and intensifies competitiveness among
regions and countries. Of course, it ultimately results in much higher
productivity and more optimized resource allocation.
On
the other hand, if something disastrous, such as a large scale earthquake,
terrorism, or tsunami happened in any corner in the world, it might impact the
entire equity markets conversely.
Investor
Sentiment and Confidence
Source from rejournals.com
When the overall investor sentiment and
confidence becomes euphoric, you must be cautious because when everybody chases
the market and stocks, there is not much liquidity left to boost share prices
and the market level.
On July 3, 2009, in a CNBC interview,
Warren Buffet once said, “In investing, pessimism is your friend, euphoria is
the enemy”.
History has shown that when the herd
moves in one direction, it may be time to consider going the other way. Therefore,
the sentiment detection in the stock market becomes increasingly crucial in our
financial life. We are going to discuss some technical indicators which might
be helpful to investors and traders.
It is worthy to mention the
correlation between margin debt and market movement. High margin debts show the consequences of
over-leveraging and willingness to be more risk-taking. Usually rising markets attract more investors
to put debt to work. Most investors think it is easier to make money.
Margins can be a double-edged
sword. When the market goes up, the
brokerage houses are inclined to loan investors money. Thus, investors can
increase their buying power and magnify their investment profit.
Usually the loan from the brokerage
house is collateralized by stock holdings (value in the portfolio). When the
market unwinds, the share value shrinks. In the meantime, the brokerage houses
become more conservative and eager to get the loaned money back.
Often the movement in a market
downtrend compels brokerage firms to disallow or reduce clients’ borrowing
limit, or curtail the trading on certain risky securities. They usually establish stricter criteria. For
example, they increase margin requirements. Then borrowers are either required
to inject more liquidity to keep up with the margin requirement or coerced to
liquidate in order to pay back the debt.
This measurement would force
borrowers to sell shares in a downward market.
If many investors are executing a margin sell in about the same time
frame, it will cause a market crash or collapse. If borrowers are not willing to dump their
shares, the brokerage houses will do it for them relentlessly, which might
intensify the market selloff and drop share prices more violently.
Therefore, the margin debt would stimulate
the market or accelerate the sell-off.
On the other hand, since borrowers
need to pay margin interest on their debts, their psychological perspective could
change! They can’t afford to lose money! Thus, it will have a negative impact
on their trading behavior too, since they’re nervous and uneasy. This factor will disturb the market further.
The year 1999 was a glory year for
the stock market. Everybody was jubilant about his hefty profit, and both
brokerage houses and investors were very bullish. Some brokerage houses even
loosened the margin requirement from normal 1:1 to 4:1. For instance, if
investors had $1 cash, the brokerage houses loaned them $4.
During the tax season April 2000,
many investors needed to pay large amounts of taxes for capital gain. Right
before the tax date, the stock market unexpectedly dived. Investors were eager
to sell because they owed large sums of tax dollars. In the meantime, the
brokerages reversed the loosened margin requirement (1:4) to normal (1:1). It
was an infamous “tax selling down-turn” on Wall Street. The margin sell intensified the selling force
in the stock market and caused more fear! This, in turn, caused more selling.
The malicious cycle was working effectively.
When it rains, it pours.
Supply of liquidity
Supply of liquidity, QE, is another key factor that impacts the
movement of the current stock market.
Quantitative easing (QE) has played increasingly more important roles in the financial
marketplace and economic systems. It was first introduced by Japan. Nowadays,
it has been used by central banks to inject liquidity into the economy and
stimulate the economy. The Federal Reserve Bank first launched QE 1 in November
2008, and ended it in March 2010. Then
QE2 lasted from November 2010, to June 2011.
QE3 was
announced on September 13, 2012 to purchase $40 billion worth of
mortgage-backed securities per month. On September 21, 2011, the Federal Open Market
Committee (FOMC) announced the implementation of Operation Twist. Lastly, on
December 12, 2012 the QE4 was declared to increase the bond purchasing amount
from $40 billion to $85 billion. The Fed pledged to maintain the QE program
until the labor market was improved significantly (6.5% unemployment rate as a
benchmark). Thus, it is called QE Infinity.
The market had the best performance of the last 65 years since the QE
was implemented in late 2008.
The following table outlines a summary for S&P movement during the QE1 through
QE4.
Performance of the S&P for
QE1 through QE4.
S&P data comes from Yahoo
Finance historical prices
Note: The data for QE3, and
QE4 is based on the data from 9/13/2012 to 8/1/2013.
Since the current Fed chairman Mr. Bernanke
is going to step
down in the end of January, 2014, his successor Mrs.
Yellen is gaining attention. We are going to wait and see how the new Fed chairman’s
money policy will impact the financial market and economy.
Supply and demand for
products, coupled with currencies and other investments, create a push-pull
dynamic in prices. Prices and rates change as supply or demand changes. If
supply increases beyond current demand, prices will subsequently fall. If
supply is relatively stable, prices will fluctuate higher and lower as demand
increases or decreases.
This supply and demand
rule is applicable to the stock market too.
When the QE ends, it means the demand for securities decreases too. The
price of equities is expected to drop assuming the P/E ratio remains at similar
levels.
Since May 2013, you can
count how many trading days were dominated by the Fed officers’ voices
regarding the QE tapering. Since the Fed officers expressed their own opinion,
and delivered the mixed information to the market, the market fluctuated along
their either hawkish or dovish tones constantly! Especially on 8/6/2013, when two Fed officers
expressed the possibility the stimulus would start from as early as September
2013, the global market was definitely shaken.
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