Stock Market Report Endnotes and Definitions
September 1, 2001
Relationships described in these notes represent the thinking of those analysts who commonly cite these indicators. While many analysts consider these to be commonly used indicators, they are not necessarily endorsed as the prevailing tools used by the analyst community and have not been validated by anyone at the Federal Reserve Bank of Boston.
Technical
Analysis (figures 2 through 5): Research into the
demand and supply for securities and commodities based
on trading volume and price studies. Technical analysts
use charts or computer programs to identify and project
price trends in a market, security, or commodity future.
Some commonly used measures a technical analyst might
study include velocity and momentum indicators like
relative strength, market breadth indicators like the
cumulative advance-decline line, contrary sentiment
indicators like put-call ratios, and surveys of investor
sentiment. Most analysis is done for the short or intermediate
term, but some technicians also predict long-term cycles
based on charts and other data. Unlike fundamental analysis,
technical analysis is not concerned with the financial
position of a company (Source: Barron's Dictionary of Finance and Investment Terms).
Fundamental
Analysis (figures 9-11, 13-16):
Investment: analysis of the balance sheet and income statements
of companies in order to forecast their future stock price
movements. Fundamental analysts consider past records
of assets, earnings, sales, products, management, and
markets in predicting future trends in these indicators
of a company's success or failure. By appraising a firm's
prospects, these analysts assess whether a particular
stock or group of stocks is undervalued or overvalued
at the current market price (Source: Barron's Dictionary
of Finance and Investment Terms). The analyses of individual
company statistics can be combined to create an aggregate
value for an index. This is known as a bottom-up approach,
as seen in the First Call forward and trailing price to
operating earnings ratios in figure 7. Conversely, macro
strategists perform analysis and make predictions based
on the index as a whole. This is known as a top-down approach
and can be seen in the 2-year earnings growth forecasts
found in the bottom panel of figure 7.
Economics: research on such factors as interest
rates, gross national product, inflation, unemployment,
and inventories, as tools to predict the direction of
the economy. The data for computations such as Tobin's
q and the real return on equity in figure 9, or
ratios involving foreign and domestic holdings of U.S.
securities in figure 16 come from national balance sheets
found in the Flow of Funds Accounts of the United States,
provided by the Board
of Governor's of the Federal Reserve System. While
analysis occurs in this case at the national level,
many of the indicators are the same or similar (Wilshire
5000 PE ratio, Return on Equity from National Accounts)
to those generated for individual companies.
1. 50-Day,
200-Day Moving Averages:
Moving averages represent the average price investors
pay for securities over a historical period and present
a smoothed picture of the price trends, eliminating
the volatile daily movements. Because these lines offer
a historical consensus entry point, chartists look to
moving average trend lines of index prices to define
levels of support or resistance in the market. When
a chart trend is predominantly sideways (figure 1, top
chart), moving averages and the underlying series frequently
cross, but during a time of prolonged increase or decrease
(figure 1, bottom chart), the daily prices of a security
typically are above or below the trailing average.
2. 9-Day,
18-Day Moving Averages: The 9-day and 18-day moving
averages are often used together by traders using technical
analysis to provide buy and sell signals. Buy signals
are indicated by the 9-day average crossing above the
18-day when both are in an uptrend. The reverse, the
9-day crossing below the 18-day while both moving averages
are declining, is a sign to sell. However, this simple
tool can often be misleading because of its dependence
on trending markets and its inability to capture quick
market turns.
3. Relative
Strength Index (RSI): This momentum oscillator measures
the velocity of directional price movements. When prices
move rapidly upward it may indicate an overbought condition,
generally assumed to occur above 70 percent. Oversold
conditions arise when prices drop quickly, producing
RSI readings below 30 percent. Traders will often use
values close to 80 percent and 20 percent as sell and
buy signals. The general formula is as follows:
RSI = 100 - [100 / (1 + (AvgUp / AvgDn))], where
AvgDn = Sum of all changes for advancing periods divided
by the total number of RSI periods, and
AvgUp = Sum of all changes for declining periods divided
by the total number of RSI periods.
4. New
Highs, New Lows: A straightforward market breadth
indicator, this is the 10-day moving average of the
number of stocks on a given index or exchange making
new 52-week highs or lows each day. This indicator also
demonstrates divergence. If an index makes a new low,
but the number of stocks in the index making new lows
declines, there is positive divergence. Technical analysts
refer to this as a lack of downside conviction, a situation
where stocks generally fell on a given day but not by
a significant margin that would indicate intense selling
pressure and further declines. Conversely, in rising
markets, if an index makes a new high but the number
of individual stocks in that index making new highs
does not increase, analysts believe the rally may not
be sustained.
5. Momentum
Oscillator: Also known as the overbought/oversold oscillator, this indicator is calculated by taking the
10-day moving average of the difference between the
numbers of advancing and declining issues for a given
index. The goal of the indicator is to show whether
an index is gaining or losing momentum, so the size
of the moves is more important than the level of the
current reading. The level of the reading is affected
by how the oscillator changes each day, dropping a value
ten days ago and adding today's value. If the advance-decline
line read minus 300 ten days ago, and reads minus 100
today, even though the market is down again, the oscillator
will rise by 200 because of the net difference between
the exchanged days' values. This scenario suggests a
trough. On the other hand, if today's reading was minus
500, it would demonstrate an acceleration of across-the-board
selling.
The magnitude in moves is also useful when it is compared
with the divergence from the index price. If the Dow
peaks at the same time the oscillator peaks in overbought territory, it suggests a top. If the index then
makes a new high but the oscillator fails to make a
higher high, divergence is negative and momentum is
declining. If the index at this point declines and the
oscillator moves into oversold territory, it may again be time to buy. If the index
rises but does not make new highs, but the oscillator
continues to rise above a previous overbought level,
upside momentum exists to continue the rally.
6. Cumulative
Advance - Decline Line: Referred to as market breadth,
the indicator is the cumulative total of advancing minus
declining issues each day. When the line makes new highs,
a rally is considered widespread, but when the line
is lagging, a rally is seen as narrow.
7. Put
/ Call Ratios: These ratios are used by analysts
as contrary sentiment indicators. Unusually high ratio
values, indicating much more put buying than call buying, occur when investors are extremely pessimistic
and believe the market will continue to fall dramatically,
at times from already low levels, and they are often
considered by analysts to indicate overly pessimistic
sentiment. Because so many investors believe prices
will continue to fall, assets can become undervalued
by contemporary valuations, and prices can move quickly
back up quickly. This phenomenon in capital markets
is exacerbated by the volatility and leverage associated
with derivative securities like options.
The CBOE index ratios track put and call option trade
volume for exchange- traded index options like the S&P
500 and Nasdaq 100. These ratios reflect sentiment
of professional and institutional strategies because
they are typically used as hedging tools by professional
money managers. For example, a trader may purchase Nasdaq
100 puts as protection against loss if she also chooses
to simultaneously buy the Nasdaq 100 tracking stock
(AMEX: QQQ).
Her belief is that the Nasdaq 100 will rise, hence the
outright purchase of shares, but she has hedged her
bet by purchasing puts option contracts, which cost
a fraction of the value of the underlying asset. Because
of the institutional presence, there is more put buying
of index options than of individual equity options,
and the index put-call ratios are typically above 1.
Index readings above 1.25 indicate much put buying and
often occur when institutional investors are very pessimistic,
and such readings can lead to a short-term rally in
response to the extreme negativity. Conversely, index
ratios below 0.75 show very optimistic sentiment.
The CBOE equity ratio, however, is composed of trade
volume for individual equity options. While both retail
and institutional investors purchase individual equity
options, this ratio is considered by technical analysts
to be an indicator of retail investor sentiment. Because
there is less of the large-volume put buying associated
with institutional hedging, many analysts believe this
is a more sensitive indicator of sentiment, especially
among individual investors who may be purchasing puts
when they actually believe the price of a particular
stock will fall rather than as a hedge to a long position
in that stock. Readings above 0.6 suggest a rally may
occur because too many investors are pessimistic. Traders
believe readings below 0.3 show complacent investor
psychology and that prices may decline in the future.
8. Volatility:
With regard to stock price and stock index levels, volatility
is a measure of changes in price expressed in percentage
terms without regard to direction. This means that a
rise from 200 to 202 in one index is equal in volatility
terms to a rise from 100 to 101 in another index, because
both changes are 1 percent. Also, a 1 percent price
rise is equal in volatility terms to a 1 percent price
decline. While volatility simply means movement, there
are four ways to describe this movement:
Historical volatility is a measure of actual
price changes during a specific time period in the past.
Mathematically, historical volatility is the annualized
standard deviation of daily returns during a specific
period. CBOE
provides 30-day historical volatility data for obtainable
stocks in the Trader's
Tools section of CBOE's Web site.
Future volatility means the annualized standard
deviation of daily returns during some future period,
typically between now and an option expiration. And it is future volatility that option
pricing formulas need as an input in order to calculate
the theoretical value of an option. Unfortunately, future
volatility is only known when it has become historical
volatility. Consequently, the volatility numbers used
in option pricing formulas are only estimates of future
volatility. Theoretical values are only estimates, and
as with any estimate, they must be interpreted carefully.
Expected volatility is
a trader's forecast of volatility used in an option
pricing formula to estimate the theoretical value of
an option. Many option traders study market conditions
and historical price action to forecast volatility.
Since forecasts vary, there is no specific number that
everyone can agree on for expected volatility.
Implied volatility is the
volatility percentage that explains the current market
price of an option; it is the common denominator
of option prices. Just as p/e ratios allow comparisons
of stock prices over a range of variables such as total
earnings and number of shares outstanding, implied volatility
enables comparison of options on different underlying
instruments and comparison of the same option at different
times. The theoretical value of an option is a statistical
concept, and traders should focus on relative value,
not absolute value. The terms "overvalued" and "undervalued"
describe a relationship between implied volatility and
expected volatility. Two traders could differ in their
opinion of the relative value of the same option if
they have different market forecasts and trading styles
(volatility
explanation courtesy of CBOE).
9. CBOE
Volatility Index (VIX): The VIX,
introduced by CBOE in 1993, measures the volatility of the U.S. equity
market. It provides investors with up-to-the-minute
market estimates of expected volatility by using real-time S&P 100 (OEX)
index option bid/ask quotes. This index is calculated by taking a weighted
average of the implied volatilities of eight OEX calls
and puts. The chosen options have an average time to
maturity of 30 calendar days. Consequently, the VIX
is intended to indicate the implied volatility of 30-day
index options. Some traders use it as a general indication
of index option implied volatility (Source:
CBOE).
10. CBOE
Nasdaq 100 Volatility Index (VXN): Like the VIX,
the VXN measures implied volatility, but in this case
for Nasdaq 100 (NDX, AMEX:
QQQ) index options, thereby representing an intraday
implied volatility of a hypothetical at-the-money NDX
option with 30 calendar days to expiration. Both the
VXN and the VIX are used by market observers as sentiment indicators for the Nasdaq 100 and for the broader market,
respectively. Higher readings and spikes generally occur
during times of investor panic and at times coincide
with market bottoms. Low readings suggest complacency
and often occur around tops in index prices.
11. 2-Year Growth of Earnings:
Growth of earnings over subsequent 8 quarters. Current
observations use forecast of earnings from DRI macro
projections.
[nonfinancial corporate profits with
inventory valuation and capital consumption adjustments
+ (Liabilities of nonfarm nonfinancial corporations
- Assets of nonfarm nonfinancial corporations) * consumer
price index annual percent change] / [current cost of
tangible assets of nofarm nonfinancial business - (Liabilities
of nonfarm nonfinancial corporations - Assets of nonfarm
nonfinancial corporations)]
13. Tobin's q: The ratio of
the market value of equity plus net interest-bearing
debt to the current value of land, inventories, equipment,
and structures.
14. Earnings and Dividend Price
Ratios: These ratios represent an investor's yield from
earnings and dividend payments. Historically, the EP
ratio often has exceeded the real return on bonds, reflecting
the greater risk to shareholders of choosing equity
investments. In recent quarters, the EP ratio has fallen
below the return on bonds. Traditionally, the EP ratio
has fallen below this real bond rate when earnings are
expected to rise dramatically.
15. Real Bond Rate: Moody's
composite yield of A-rated corporate bonds less the
expected rate of inflation over the next 10 years, as
measured by the consumer price index from the Survey
of Professional Forecasters, published by the Federal
Reserve Bank of Philadelphia.
16. Moody's Ratings: For each
time period, Moody's
upgrades and downgrades securities for companies
issuing investment grade (above
ba1) or speculative grade (below
ba1) debt. These series show the total dollar amount
in billions of all the outstanding securities in a rating
class that are upgraded or downgraded. The data are
collected by company and by each group of rated securities
that the company issued, then aggregated to form the
data presented in the charts.
17. Default and Failure Rates:
The default rate shows the frequency of failure of corporate
junk bond issuers to meet their covenant with the respective
bond holders. Breach of covenant can occur from missed
interest payments or if the corporation files Chapter
11 or 13. In this case, junk bonds are defined as those
rated below ba1 by Moody's, and the rate is calculated
by summing the amount of defaulted debt in dollars and
dividing it by the total outstanding junk-rated debt.
The business failure rate refers to companies filing
for one of the four bankruptcy laws, Chapters 7, 11,
12, and 13. The failure rate series is calculated by
dividing all of the balance sheet assets of those corporations
that file for bankruptcy by the outstanding assets of
all corporations. The series is not limited to issuers
of any particular grade of debt securities.
18. Gross Proceeds from Security
Issuance: The Federal Reserve Board collects security
issuance data for bonds and stocks. In this case, 'bonds'
refers to the gross proceeds from the issuance of all
U.S. corporate bonds, issued domestically and in foreign
markets, including private placements. The 'Stocks'
series is all primary corporate offerings in domestic
markets of common and preferred stock.
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