1. Bank reserve requirements. Banks that are members of the Federal Reserve Board System are required to maintain a percentage of their total deposits as reserve money. This percentage is not lent to the public. When the Fed wants to tighten the monetary policy, it raises the reserve requirements. This action, in turn, lowers banks' liquidity, as the available money for lending to both consumers and business decreases; in other words, the supply of credit contracts. This, in turn, translates to reduced consumption and slowed economic growth. The reverse is also true; the Fed can increase banks' liquidity and money available for credit by lowering reserve requirements.
2. Control of the money supply. The Fed buys and sells government securities to member banks. By selling securities, the Fed receives banks' payment by means of Federal Funds checks. This means that the banks withdraw from their reserves at the Fed to pay for these securities. This process leads to lower banks' reserves, and, hence, their ability to extend credit decreases. However, when buying securities, the Fed pays for them in Federal Funds checks, thus injecting money into the banking system. The decision to buy or sell securities is made by the Fed's Federal Open Market Committee (FOMC). The process of purchasing and selling securities leads to expansion and contraction of the money supply.
3. The discount rate. To meet their reserve requirements and increase the amount of money available for credit, member banks borrow from the Fed at the discount window. The Fed is known as the bankers' bank. The discount rate is the interest that the Fed charges member banks on loans. In other words, the discount rate is the cost of money that banks incur when they borrow from the Fed. This, in turn, establishes a floor under the commercial and personal loan rates that banks charge to their customers. By raising or lowering the discount rate, the Fed tightens or loosens the money supply. This tool has proven to be effective in controlling the amount of money in circulation.
The Fed can also influence liquidity in the stock market. By raising or lowering margin requirements, the Fed can increase or decrease the supply of investment funds that is channeled into equities. Although this option has been available to the Fed, it has seldom been used. The Fed is aware of the domino effect that a stock market plunge can have on the banking system. Since the Great Depression, the Fed has been cautious when dealing with large market declines. For instance, in the wake of the Crash of 1987, the Fed acted immediately to infuse cash into the banking system to reliquify financial markets. In early 1988, after the market had stabilized, the Fed proceeded to tighten its monetary policy, and interest rates rose higher than their pre-crash levels. Having eased the money supply to reestablish confidence and stabilization in world financial markets, the Fed then proceeded to tighten money to fight rising inflation.
Sound financial positions result from a number of fundamental factors. Such a position ensures a company's ability to service its debts and generate the funds needed to sustain growth and finance future plans. A strong cash position, healthy cash flow, and low debt enable a company to capitalize on market opportunities.
Growth stocks have common characteristics that place them apart from well-managed companies. They might be found in any industry, including mature ones. They tend to have a high profit margin, high return on equity, low dividends payout, and above-average sales growth rate. A high profit margin is the sign of good management—one that keeps cost under control and directs the operation toward promising business. To widen the spread between revenues and the costs of operation, a company might restructure its sales mix, expanding those with little or no competition. This maneuver enables the firm to raise prices and pump margins.
Another strategy to help boost margins involves selling unprofitable operations and maximizing labor and plant capacity. Most fast-growing companies earn above-average returns on shareholders' equity. These returns help them finance rapid expansion without incurring a large amount of debt. This modest dividend payout is due to the fact that they invest their profits in research and development, and other long-term planning purposes. Their sales growth is usually dynamic, as the demand for their products is rising. Cash flow generated from operations should also be growing to avoid excessive leverage. A low debt-to-capital ratio is achieved by having the needed liquidity to cover the company's obligation.
The bull market that started in 1982 propelled a strong uptrend in most of those groups. However, while the speculative fever in the real estate sector reached its peak in 1986–1988, the home building group displayed signs of weakness as early as 1985. When the Crash of 1987 materialized, the homebuilding group declined to multiyear lows, signaling the end of the real estate boom. The discounting mechanism of the market correctly anticipated the future fundamentals that were to develop in the housing market.
The banks and S&Ls continued their advance into late 1986, but while the broad market exploded to new highs, these groups displayed relative price deterioration. The Crash of 1987 affected them even more severely than the rest of the market. With the benefit of hindsight, the S&Ls crisis could have been anticipated because the group displayed weakness amid the great bull stampede that preceded the crash. While the broad market resumed its advance in 1988–1989, the S&Ls continued to deteriorate until the government had to deal with the agonizing bailout process. As early as 1986, the message was that interest rates were bound to rise and that the credit risk in those groups was about to soar. The extent of the decline among members of those groups varied from the bankruptcy candidates to institutions that the market deemed healthy enough to survive and even prosper. Initially, the big money-center banks fared much better than other interest-rate sensitive groups, as the market expected that their well-diversified loan portfolios could pull them through. However, as business conditions continued to deteriorate, bond stocks weakened further. By early 1990, they went into a full-fledged bear market of their own, as the housing market seemed to be in a free fall.
In 1987, the interest-rate sensitive groups showed signs of deteriorating much sooner than they usually do. At that time, the investment environment was optimistic, and while many analysts, portfolio managers, and sophisticated investors expected the market to move to new record highs as late as September 1987, those industry groups flashed a warning signal that could not be ignored. Notice, in particular, the apparent weakness in the utilities group during most of 1987. The downtrend in both the utilities and the bond market warned market timers of the impending collapse.
The book value technique, however, was revived in the wake of the takeover mania of the 1980s. When a stock is selling below its worth, the theory goes, shareholders can benefit if there is a takeover attempt, or in the case of total liquidation. Seldom has a company been liquidated and the value of its assets distributed to its shareholders. However, stocks selling at discounts from book value might offer above-average appreciation potential, provided that they have healthy fundamentals. This is exactly what happened during the so-called roaring eighties. After a decade of lingering stock performance and mediocre appreciation, the price of the real corporate assets far outpaced the disclosed value, which was carried at historic acquisition cost. Corporate real estate holdings, in particular, soared in the marketplace, although they were still reported at low book-value prices. This, in turn, led to the takeover mania that swept the securities markets in that decade and invited corporate raiders. They bid for a company, took it private, stripped its valuable assets, and recouped all that had been paid for it. The net result was a new company that still operated in the same field, generating cash flow and maintaining its market share position, but without much in the way of real assets.
From a broad investment standpoint, however, the book value theory offers some help in valuing common stocks. As mentioned, when a stock is selling below its book value it might invite takeover. Moreover, this might encourage its management to invest excess cash to buy back some of its shares from the open market at less than their net asset value. When the number of shares floating decreases, the stock price might increase, as a reduced number of shares might enhance the reported earnings per share and other financial ratios. While investment decisions should not be made based on any single criterion, stocks selling at a discount from their book value should be carefully analyzed to assess their fundamental position. Should there be other favorable factors, investors should be alert to the potential capital appreciation that the stock might have.
The real book value of a company is often understated on the balance sheet, as assets are reported at their historical cost instead of their replacement value. The relatively low multiples—during the inflationary 1970s and the swelling values of corporate real estate in the 1980's—left behind a large number of companies selling far below their true worth in the marketplace. Investors were suddenly awakened to the fact that buying the whole company was more beneficial than buying a share of its stock.
Market timers rely heavily on rate-of-change oscillators to assess market momentum. These indicators are often charted against the major averages to analyze short, intermediate, or long-term trend potential. The rate-of-change indicators tend to fluctuate between two extreme readings, which coincide with the peaks or troughs of the market. These boundaries are commonly known as overbought and oversold levels. The market is considered overbought when a rally drives the rate-of-change oscillators to the upper range. Over-bought levels are cautionary signals that the advance is extended and that a correction might ensue. The market is considered oversold when a decline pushes the oscillator to the lower range. Oversold levels are bullish since they indicate that the market has reached an area of significant support from which it can rally.
Rate-of-change oscillators are calculated by subtracting the price of the market average a certain number of days ago from its current value. The outcome is then divided by the number of days used as a basis for comparison. Market timers often use a large number of rate-of-change oscillators when studying the position of the averages. For short-term purposes, 10-day rate-of-change oscillators are common. For intermediate-term purposes, the 30-day rate-of-change oscillators are used. For long-term trend studies, 150-to 250-day rate-of-change oscillators are preferred.
Rate-of-change oscillators can be used in analyzing market averages, industry groups, or individual stock momentum. They are of universal value, as they also help measure the momentum of the dollar index, commodity prices, foreign securities, market averages, economic statistics, and fundamental data.
It is worth mentioning at this stage that overbought markets do not necessarily indicate that a plunge is imminent. Extremes in overbought levels have often suggested a very strong upward momentum that is likely to resume after short-term hesitation. Similarly, an excessively oversold position might mean that the market or the stock is very weak and that downward pressure is likely to resume after some sideways consolidation. Oscillators are most useful in a market in which the averages are fluctuating within a trading range. At the onset of a primary bull market, the oscillators are expected to remain in an overbought position for an extensive period of time. Also, in a bear market their oversold position might persist, which should not be interpreted as a reason for bargain hunting. Oscillators in general should be used with the major trend in mind, and they should be interpreted in light of the cyclical position of the broad market.
Among the most useful and widely known oscillators are the annual S&P 500 rate of change, the nine-month diffusion index, and the 25-day and 13-day NYSE index rate of change.
The term Achilles' heel comes from the Greek myth of the great warrior Achilles. According to the myth, when Achilles' mother dipped him in the river Styx to make him invincible, the water washed every part of his body except the heel by which she held him. That one weak spot, his heel, was both the proof of his being human and his potential downfall. Rather than accepting his vulnerability and learning from it, Achilles defiantly sought to prove his invincibility. He repeatedly exposed himself to attacks and he won several battles before his bitter rival Paris shot a fatal arrow into his heel.
This legend can be applied to the way an investor operates in the market. If mistakes are accepted and learned from, then an investor's Achilles' heel can be the source of success in the investment process. It is more common, however, for bright individuals who know a great deal about market mechanics to demonstrate his or her lack of ability to beat the game by being too set in his or her ways. Then there are other investors who go to Wall Street unprepared. Most of these people are successful in their careers as physicians, accountants, lawyers, or engineers, but they do not spend the time necessary to learn the basic rules of investment analysis. However, another type of investor sticks to his or her conviction, even when the weight of the evidence suggests that he or she should use a different strategy. By then it is too late to repair the financial damage that is eventually incurred.
Everyone has his or her Achilles' heel. The brightest analysts, the most astute strategists, or the wisest decision makers, can have dismal investment results when they fail to consider risk seriously. Successful investors recognize their limitations at an early stage, thereby curing themselves from their Achilles' heels.
The determination of momentum during the cycle is crucial, as it indicates the point from which weakness and a major trend reversal should be suspected. Stock prices from here on are likely to be driven by earnings. The market might enter a prolonged phase of group rotation until the final peak is reached. Rotation might dominate the market action as some groups strengthen while others weaken. The market grows increasingly selective as the difference between the number of advancing and declining stocks decreases. The loss of momentum becomes apparent as the cumulative breadth fails to confirm the new highs reached on subsequent market rallies. By the time the cyclical peak is finally reached, momentum oscillators have already signaled the trend's subtle deterioration. The market’s breadth lags. The list of stocks reaching new highs shrinks. The number of stocks trading at new lows expands, and the annual rate of change trends lower. More stocks and industry groups falter on market pullbacks, and very few advance on market rallies: the bear market is about to start.
Typically, the downtrend starts with a sudden decline that is characterized by abnormal weakness in almost all stocks, and this takes the averages below their most recent lows. The number of stocks making new lows expands, and many issues dip below their 200-day moving average. Group after group declines as the downtrend proceeds. During this initial break, many investors, still driven by hope and greed, are still unwary of the creeping weaknesses. The known fundamentals at this juncture are still robust, showing hardly any deterioration. Typically in such times, inflation rises and economic statistics reach cyclical highs. Capacity utilization is near the upper limits, signaling the full utilization of production resources. The Fed then tightens and interest rates rise. Housing permits might already have begun to show some softness in demand while retail sales numbers come on strong. The bear market is now in progress, however, as it foresees the declining earnings and the beginning of a contraction phase in the economy.
Market timers use momentum analysis to measure the strength or weakness of the prevailing trend during the different stages of the business cycle. Momentum is a barometer of the upside or downside velocity of the broad market. It is the true reflection of the supply-and-demand balance that is constantly governing the price action of financial markets. The message of the momentum analysis reflects both the known and the potential fundamentals that can affect the position of the market, industry groups, and individual stocks.
To summarize, in a rising market, the price momentum of the broad market is powerful. After a bull market has been in progress for some time, momentum starts to weaken. When the loss of momentum prevails while the market averages are still proceeding to new highs, market timers are alerted to the developing deterioration. A closer analysis is then warranted, as a loss in momentum often signals the early stage of a trend reversal.
Probably the most important characteristics of investor psychology at the onset of an economic contraction are the latent bullishness resulting from the previous boom, the hefty paper profits on stocks, the favorable unemployment numbers, and the hesitation of investors to acknowledge the possibility of a recession. Overwhelming disbelief sets in and the mood is likely to be governed by bullish emotions. Enthusiasm will wear out with time, but complacency surfaces as the major cause for big portfolio losses. The news background is likely to be mixed at that stage. Opinions are often split, and confusion clouds future possibilities.
such times, the stock market is declining precipitously with bear
market rallies—usually very sharp—interrupting the downward
trend. Industry groups are falling in unison. Any negative
development is penalized harshly as stocks plummet. Good earnings
don't matter as much as bad ones, which for a while would seem to
take hold. The price decline is slow but persistent. Shattered hopes
soon awaken to reality as the relentless melting of values proceeds.
Worries begin to replace optimism, and capitulation is about to take
place. The slow decline is now accelerating as several sharp plunges
scare even the boldest investors. The cautiousness of investors is
only a step away from fear. Often, the market goes into a deep
tailspin, which shakes out the remaining hesitation. Volume is likely
to soar as margin liquidation and panicked selling intensifies. The
bear market is by now about to end amid a gloomy economic and
fundamental outlook. The
momentum indicators spend most of the time in oversold territories.
The annual rate of change is now trending lower. The percentage of
stocks trading above their 200-day moving average continues to fall.
Advisory services are gradually turning bearish and getting very
selective on the market. Their commentaries are likely to be
dominated by unclear, hedged statements. The put-to-call ratio
usually rises during market declines. During
bear trends, the market, as well as the security risk, rises and real
losses might occur. Stocks might take years to double or triple, but
they might take weeks, if not days, to roll back all of their gains.
Bear markets are vicious and merciless. Even the best fundamentals
might not be sufficient to keep a stock from losing ground. Cash is
king—at least during the first few months of the bear market—as
it might be difficult for many stocks to rebound to their previous
During such times, the stock market is declining precipitously with bear market rallies—usually very sharp—interrupting the downward trend. Industry groups are falling in unison. Any negative development is penalized harshly as stocks plummet. Good earnings don't matter as much as bad ones, which for a while would seem to take hold. The price decline is slow but persistent. Shattered hopes soon awaken to reality as the relentless melting of values proceeds. Worries begin to replace optimism, and capitulation is about to take place. The slow decline is now accelerating as several sharp plunges scare even the boldest investors. The cautiousness of investors is only a step away from fear. Often, the market goes into a deep tailspin, which shakes out the remaining hesitation. Volume is likely to soar as margin liquidation and panicked selling intensifies. The bear market is by now about to end amid a gloomy economic and fundamental outlook.
The momentum indicators spend most of the time in oversold territories. The annual rate of change is now trending lower. The percentage of stocks trading above their 200-day moving average continues to fall. Advisory services are gradually turning bearish and getting very selective on the market. Their commentaries are likely to be dominated by unclear, hedged statements. The put-to-call ratio usually rises during market declines.
During bear trends, the market, as well as the security risk, rises and real losses might occur. Stocks might take years to double or triple, but they might take weeks, if not days, to roll back all of their gains. Bear markets are vicious and merciless. Even the best fundamentals might not be sufficient to keep a stock from losing ground. Cash is king—at least during the first few months of the bear market—as it might be difficult for many stocks to rebound to their previous cyclical highs.