Technical Indicator Wisdom 11
Market corrections up or down usually retrace a significant portion of the previous trend.
Where Do You Start?
There is no denying that a company and its corporate dealings affect its share price. These are called fundamental variables that influence the company’s long-term strength or weakness and thus its financial strength. There are far too many such factors to discuss in these volumes, but you do need to understand the most pertinent ones before you launch yourself into the world of trading.
There is a starting point for those that want to be part of global growth and its inherent dangers. You need to make a conscious and absolute decision to seriously want to achieve a portfolio that is well managed, efficient, and competitive against the forces of global traders.
The following is an overview of basic terms and concepts.
Economic Growth
There are two basic forms of economics types that could influence trading. The first is called macro-economics and deals with the overall market, while micro-economics deals with companies and related issues.
As a global trader, the importance of macro-economics is the analytical variables of politics, business, technology, and other factors such as socio-welfare influence and consumer’s ability to buy.
The thread of logic is as follows:
• Companies that sell more products tend to expand.
• This creates demand for additional funds from shareholders or banks.
• In addition, higher profits mean higher tax revenue for government.
• Government in turn spends more money on infrastructure and so on.
• A strong economy benefits everyone.
• Alternatively, weak economies are usually accompanied by little spending and, ultimately, businesses stagnate, profits dwindle, and investors stop buying shares.
• The latter is a recipe for a declining trend in share prices.
Capital Flows
When economists and the media speak about the flow of funds do they mean the amount of shares bought and sold around the world?
Definition: The flow of funds is the movement of foreign exchange from one country to another and can be viewed as including loans, loan repayments, bond issues, foreign direct investment, and portfolio investment such as stocks, bonds, and derivatives.
Effectively, the more money flows into your country’s stock market via foreign acquisition of shares, the higher share prices will move as demand surpasses supply. Traders thus need to have a basic understanding of capital flow balances.
Capital Flows |
Net Balances |
Influence on Securities |
Negative |
A negative net balance means that more money (in the form of investments) is leaving the country, compared to that which is entering the country. |
Excess supply of currency over demand tends to lead to a weakening of the currency. This makes imports more expensive and often devalues shares. |
Positive |
Foreign investments coming into the country are greater than investments leaving the country. |
Excess demand over supply for that country’s currency causes the currency to increase in value. Imports get cheaper and shares often rise in price. |
Traders need to be aware that foreigners move funds around the world in search of:
• High interest rates
• Reasonably strong economic growth
• Stable, strong, and growing financial market
Interest Rates
Simply put, banks borrow funds from the state lending bank, often called The Reserve Bank—or Federal Reserve, to enable them to lend money to consumers, such as businesses. The banks lend this money from Reserve Bank at an interest rate called the prime rate.
They in turn lend money to consumers (public, companies, and individuals) at above the prime rate.
The explanation is simple. If many entrepreneurs need money to expand, they borrow money, which is used to buy additional goods or supply more services. Ultimately, too much cash is chasing too few goods and prices increase. This is inflation.
A higher prime rate is then used as a state inflation management tool; higher interest rates are a disincentive to borrow and thus less cash is chasing goods, and the cycle of falling inflation is resumed.
Examples of global state banks:
• Australia—Reserve Bank of Australia (RBA)
• Canada—Bank of Canada (BOC)
• European Union—European Central Bank (ECB)
• Japan—Bank of Japan (BOJ)
• South Africa—South African Reserve Bank (SARB)
• Switzerland—Swiss National Bank (SNB)
• United Kingdom—Bank of England (BOE)
• United States—Federal Reserve (Fed)
The importance for traders: The higher interest rates are, the worse the effect is on profitability. For instance, if Company A has a net debt level of $100 million and interest rates are at 10 percent, the company will have (simplistically calculated) a debt repayment of $10 million. If interest rates rise to 12 percent, then his debt repayment rises to $12 million.
Without a comparable rise in earnings, the company’s profits fall, which is usually met with a declining share price.
The reverse is also true. When interest rates are falling, businesses tend to borrow more, pushing up retail and capital spending, thus earnings rise.
Trade: Flows and Balances
Definition: A country’s trade balance is thus the monitory value of—or balance of—net imports over exports.
In a globalized world, companies are increasingly selling goods and services across borders to meet their expansion plans and growth targets. The selling of goods without setting up new offices is called exporting goods, while buying goods from another country is called importing goods. This basic concept can have severe results on traders’ perceptions of trends.
Every time goods are imported, they have to be paid for in the currency of that country. This buying and selling is therefore accompanied by the exchange of money (forex), which in turn changes the flow of currency into and out of a country.
The trade balance ratio of exports to imports demonstrates a country’s demand for goods and services, and ultimately signifies the country’s economic strength. If exports are higher than imports, a trade surplus exists and the trade balance is positive. If imports are higher than exports, a trade deficit exists, and the trade balance is negative.
Exports > Imports = Trade Surplus = Positive (+) Trade Balance
Imports > Exports = Trade Deficit = Negative (−) Trade Balance
The importance of these terms is explained in their definitions:
• Monetary policy: management of interest rates and the total supply of money in circulation. Central banks such as the Federal Reserve are charged with this responsibility.
• Fiscal policy: term for the taxing and spending actions of governments.
Knowing that inflation targets exist will help traders to better plan their entry and exit strategies.
Consensus Analysis and Forecasts
A consensus analysis and forecast is also just called a consensus.
• Economic forecasts are usually made by leading economists from banks and financial institutions. The norm is for the financial media to collate these experts’ forecasts and then conclude on the expected outcome.
• Corporate Forecasts: This is the collation of analysts’ forecasts of overall market trends, sector analysis, and listed companies’ financial results.
The benefit of consensus is that it removes rumors about a company’s expected results, but it does form an expected trend, which many novice traders will follow.
For instance, if your analysis shows that Company A’s profits will fall by 2 percent, the consensus forecasted profit is expected to be down by 15 percent. When the consensus hits the media, the share is bound to fall on such negative news.
If you are an astute trader and believe in your own analysis, you would wait for the share to fall by this extent, and then buy the share on its rebound.
There have been times when consensuses have been vastly inaccurate, leading to reversals of share movements. Without doubt, a lot can happen between a company’s year end and the release of its results; a company has three months after its annual year end to release its results.
In that three months the company could have concluded a merger or some other major corporate deals.
So it is always prudent to keep a focus on sentiment, as this can change before the financial results are released. The conclusion is that collated forecast can be wrong, so the answer is not to invest all your funds on someone else’s forecasts. Rather, rely on your own analysis.
Economics and Trading Strategies
For traders, using economic fundamentals to assess a company’s core product or service will improve the rate of successful trades. For instance, the chief executive officer of a major property group told me that their core product was “any increase in the number of people walking through their malls.”
Another chairman said they saw their core product as “anything that could be retailed,” while yet another director told me that their core product meant “a focus on the item that contributed the majority of sales.”
If you know that 80 percent of Company A’s (based in Australia) profits are derived from goods bought in the United States, then forex is important when analysis of profits is conducted. If, however, 80 percent of a company’s profits are directly related to the interest rate (such as large retailers, who sell their products for cash and hold that cash for 90 days), then interest rates are important.
The more directors tell the investing public of their plans and the better such plans are outlined in the financial and general media, the better traders can assess potential share movements.
Example: Take, for instance, the example of an engineering company that is about to undertake a major restructuring of all its divisions. Once the board of directors has made the decision, the next step is to make an announcement to the public via a cautionary announcement, which warns shareholders that the company could be making an announcement that could affect the share price and that shareholders should trade with caution.
They are warning shareholders that they are about to make an announcement? A week later, they release details of the announcement. For traders, there is a process here that needs to be explained. First, the announcement is just that—an announcement, yet the share price often moves upward. Nothing has yet been done or even commenced. No restructuring has taken place, but the share has risen on the back of a positive announcement.
As the company undertakes its restructuring, expenses and possible problems are incurred. In addition, a major restructuring most often takes more than 12 months to complete, which means that investor interest could diminish over that time, as the company often does not meet financial expectations. During this phase investors should buy the share as it declines.
The next step is for the company to consolidate its restructuring and its financials start to benefit from the restructuring, which filters down to earnings per share. The share rises as shareholders and other investors scramble for more shares. It is then time to sell.
The above can be summarized in a number of basic rules pertaining to economics, set out in the next section.
Economists state that the world’s economic resources are limited.
As there are only so many products to go around and everyone wants more than they have, what one person gets, another cannot have.
Subjectivity
Value and price are subjective issues.
This subjectivity means that the public’s likes and dislikes are different and, as value and price are subjective, the trading public is thus willing to pay different prices for what they buy.
From the seller’s side, prices are determined by demand for goods and production costs, which depend on the subjective value of the resources.
Inequality
No one said that life has to be fair.
Differences in natural abilities, acquired skills, individual effort, political influence, and parental wealth mean that some have more income, wealth, and control over resources than others.
Competition
Competition is good and, ultimately, a competitive market is an efficient market.
Competition among buyers and sellers brings out the best in them and in the economy. Less competition among sellers creates higher prices for buyers (and vice versa).
Imperfection
Nothing is perfect and never will be.
While some problems can be fixed, many cannot. Markets have deficiencies that can be corrected only by government action, but government has many flaws, which often prevents corrective actions and even worsen the economic condition.
No one knows everything. Information is a scarce commodity. Acquiring information, like producing any good, entails the opportunity cost of limited resources.
Those with more resources can secure more information. Sellers, who have a good, usually have more relevant information than buyers who want it.
Complexity
Every action has many effects, some intended and obvious, others unintended and more subtle. Any action that is good for one person is likely to be bad for another. One person’s expense can be another’s income.
Chapter 12 discusses analytical methods available to traders.