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WEALTH FOREVER - The Analytics of Stock Markets
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1
Chapter 1
THE FASCINATING WORLD OFTHE STOCK MARKET: BASIC
KNOWLEDGE ANDCONSIDERATIONS
1.1 Introduction
Time Line: June 26, 2000
Scientists from the National Institute of Health and from Celera
Genomics Group, a division of PE Corporation, announced that they
have a map for the sequencing of the human genome. The decoding
involved three billion chemical bases (letters) that make up the human
DNA, and allows scientists to find and understand the more than 60,000human genes. The announced draft allows for the identification of 95%
of the genes known to cause disease.
This colossal discovery, some argue the most significant ever in human
history, has incalculable consequences on the quality of life, and on the
longevity of life. The computers are churning to find out what companies
will in fact benefit from this discovery, what will be the impact on their
revenue and their profits, and ultimately on their market price. Do you
know what company to invest in? Do you know what group of companiesyou should invest in so even if only one of them is a big winner, you
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2 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
will reap huge profits? How much of your investable funds would you
put in genome based-companies?
The answers may astound you, as will the fact that there is anaccessible, easy to understand way for systematically going about
answering the above questions to prepare you and your family for a
better working life and a better retirement.
Time Line: April 2000
Financial industry titan, Julian Robertson of the Tiger Fund calls it
quit. Mr. Stanley F. Druckenmiller of the $8.2 billion Quantum Fund,
another hedge fund run by the legendary W. Soros, calls it quit. NicholosRoditi of the London-based Quota Fund, which had lost a third of its
value by the end of April 2000, calls it quit. Many others followed suit.
All claimed that they could no longer make money for their clients in
the ever more unpredictable and gyrating stock market.
And you thought that the stock market is easy to figure out!!!
Down markets may represent the greatest buying opportunity for
the investor.
The twentieth century has been very kind to America, especially the
last twenty years of the century. Ninety percent of US wealth has been
created since 1980, most of it from emerging firms. The trends appeared
to be continuing in the early months of the twenty-first century. Standing
in January 2003 and looking in the rearview mirror over the last two
years, one is hard pressed to write an optimistic book about the stock
market, however. Investors are typically fickle and their circumstancesand attitudes often shift, either because of changing personal experiences
or because of an altered (unpredictably) environment in which they
function.
The US stock market, not unlike practically all stock markets in the
developed countries, has turned in a negative performance in 2000, 2001
and 2002 (Exhibit 1.1). These data are surely the fodder for the stock
market bears, and are likely to keep some investors at bay.
The state of the stock market reflects itself in the venture capitalindustry. In 2002, venture capitalists raised $5 billion compared to
$20 billion in the fourth quarter of 2000. The stock market also impacts
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3The Fascinating World of the Stock Market
consumer confidence, as it is a leading indicator for economic perfor-
mance. It also affects consumer spending, as some argue. The latter is
referred to as the wealth effect.
Pessimism about the stock market ignores the fact that never in its
history has the stock market moved straight up or down. The cyclical
nature of the market is a historical constant, and is hardly an aberration.
The issue is the depth and the length of the downturns and the upturns.The myopic view of the stock market is precisely what this book is
intended to discredit. The evidence we present in the following pages is
Exhibit 1.1: Top panel compares the performances of the three major US stock market
indexes the Dow, the NASDAQ and the S&P 500 from January 1, 2000 to
December 31, 2002 and the bottom panel compares the Dow and the Dow Jones World
Stock Index over this period.
0
1,000
2,000
3,000
4,000
5,000
Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02
0
4,000
8,000
12,000Dow Jones IndustrialAverage (right
scale)
S & P 500
(left scale)
Nasdaq CompositeIndex (left
scale)
0
1,000
2,000
3,000
4,000
5,000
Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02
0
4,000
8,000
12,000
0
1,000
2,000
3,000
4,000
5,000
Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02
0
4,000
8,000
12,000Dow Jones IndustrialAverage (right
scale)
S & P 500
(left scale)
Nasdaq CompositeIndex (left
scale)
100
150
200
250
300
Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02
6,000
7,500
9,000
10,500
12,000Dow Jones Industrial
Average (rightscale)
Dow JonesWorld StockIndex (right scale)
100
150
200
250
300
Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02
6,000
7,500
9,000
10,500
12,000Dow Jones Industrial
Average (rightscale)
Dow JonesWorld StockIndex (right scale)
S&P 500
(left scale)
NASDAQ
5000
4000
3000
2000
1000
0
12,000
8000
4000
0
12,000
10,500
9000
7500
6000
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4 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
compelling when stock market returns are analyzed over sufficiently long
periods, say about 20 years or longer, and are compared with returns
from alternative investments.The data from the last century dwarf those of the one preceding it.
GDP per capita grew at between 1% and 1.5% per year in the US
during the 19th century. This caught the attention of many leading
economists. Even Karl Marx was impressed by these results. However,
the sustainable growth in per capita GDP in the United States rose to
about 2% and some believe that it can easily be at 3% if the pace of
technological innovation in the last decade stay the same or accelerate.
Those adherents to this belief point to the pace of innovation in networkedcomputers and in telecommunications as the foundation for their
optimism. But the investment in information technology has only begun
as Exhibit 1.2 shows. There is ample room for growth in the United
States and in the world despite a massive rise in corporate spending on
technology (Exhibit 1.3). The effects of these technologies do show up
in US macro economic data, but their full impact has yet to be accounted
for, as existing technology makes its way through the operations of the
corporate world, and as new frontiers in technology continue to open.
The genome project is just one of many of these new frontiers.
The pace of technological innovation accelerated enormously in the
last ten years. The shelf life of computer-related products and software
Exhibit 1.2: IT spending as a % of GDP.
Source: IDC
4%
U.S.
5%
3%
2%
1%
0%
Europe Japan Asia (ex. Japan)
19981999
2000 (f)4%
U.S.
5%
3%
2%
1%
0%
Europe Japan Asia (ex. Japan)
20001999
19984%
U.S.
5%
3%
2%
1%
0%
Europe Japan Asia (ex. Japan)
19981999
2000 (f)4%
U.S.
5%
3%
2%
1%
0%
Europe Japan Asia (ex. Japan)
20001999
19984%
U.S.
5%
3%
2%
1%
0%
Europe Japan Asia (ex. Japan)
20001999
1998
US
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5The Fascinating World of the Stock Market
has decreased from years to few months. In the computer area Mooreslaw still holds, albeit tenuously. The capacity of computers: speed,
processing power and storage, according to Gordon Moore, doubles
every 18 months. The Internet has speeded up the innovation process to
a point where a web year is now three months, that is, the time it takes
from concept, to development to innovation has shrunk to three months.
The entire technological foundation, on which Microsoft managed to
increase the wealth of its shareholders at rates unprecedented in human
history, is being revisited and reengineered. Mr. Gates is often ontelevision boosting the transformation of Microsoft. The old paradigm
may forever be replaced with a new one that will most certainly have a
shorter life span. Competition in the twenty first century will be based
on this simple reality, and on the firms capacity to manage innovation
and keep a competitive edge either through internal growth or through
acquisition.
The adoption of technology has almost kept pace with the pace of
innovation. It is driven by the need to support business ventures,
improving performance, improving the flexibility of the firm, improving
Exhibit 1.3: US informational technology spending Investment in equipment, com-
puters and peripheral equipment as percentage of investment in equipment/industrial
equipment.
Source: US Department of Commerce
1960 1970 1980 1990
80%
60%
40%
20%
0%
1970 1980 1990
80%
60%
40%
20%
0%
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6 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
price/performance, end-user demand, the reengineering of business
processes, and the need for a shorter payback period.
All of these developments are ultimately reflected in the economicdata measuring the well being of Americans and their optimism about
the future. The United States, which accounts for only 4.2% of the world
population (Exhibit 1.4), accounts for 21% of the world GDP in real
terms and has led the world in productivity gains throughout the twentieth
century. Our current per capita GDP is the highest in the world except
for that of few small countries like Switzerland and Luxembourg. It stands
currently at about $29,000. Our stock market capitalization (the value
of all outstanding stocks in the United States) stands at over $20 trillion,the highest in the world. The stock market, especially the bull trend of
the last 18 years, has allowed the American people to accumulate more
wealth than ever, in absolute and in relative terms. Exhibit 1.5 shows
the enormous wealth accumulated in the United States, followed by
Japan. Notice how little of the world wealth China (Chine) is controlling.
This will be changing dramatically during the early part of the twenty-
first century. At the heart of this data is an open system that is
transparent, where the role of government is fundamental sustaining of
business expansion, and where the spirit of entrepreneurship is soaring.
Small and medium size businesses created over 1.8 million jobs between
1988 and 1993 alone, while only 100,000 jobs were created by the
FORTUNE 1000 during the same period.
America had solved, or so it appeared, its budget deficit problems
until the September 11, 2001 disaster occurred. Budget deficits are
now projected well into 2005. The US also has massive deficits in its
trade account, and potentially in its Social Security and Medicare
accounts. These problems are being addressed. There is no shortage
of commitment to solutions by either political party, despite their con-
siderable differences in approach. But, there are some trends that are
somewhat disconcerting.
Leading economists have been expressing their concerns over the
falling saving rate in the United States, the excessive consumption of
the American citizen, and the excessive debt incurred in the process.Total consumer debt reached $1589.2 billion in July 2000. During
the year 2000, consumer debt was rising at a rate of 7.5%, about the
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Exhibit 1.4: The dynamics of wor
P a k i s t a n 1 4 1
Af27
Canada: 31
USA:
285
Mexico:
99
Georgia 5Armenia 4
Azerbaijan 8
Russia 1
Ukra ine 49
65Egypt
Yemen 17
Tur key 66
Iran 65
Morrocco 29Mauritania 3
Syria 17Iraq 24
Libya 5Tunisia 10Algeria
31Kuwait 2
U.A.E.3
Lebanon 4
W.Bank 3
Israel 6Jordan 5Saudi Arabia 21
Ger-
many82
France59
Italy58
Bulgaria 8Slovak Rep. 5
Austria 8Hungary 10Czech Rep. 10
Poland
39Romania
22
Netherlands 16Belgium 10
Spain 41Portugal 10
U.K.59
orwaySweden 9
Finland 5
Switzerland 9Former Yugoslavia 10
(Serbia, Croatia, Bosnia-Herzgovina & Montenegro)
Denmark 5
Ireland4
Greece 11
Albania 3
Chile15
Panama 3Jamaica 3
Nicaragua 5Dominican Rep. 8.5
Guatemala 12Venezuela 25
Brazil172
Haiti 8Cuba 11
Argentina37
Paraguay6
Uruguay3
CostaRica4
E
lSalvador6
Honduras6
Bo
livia8.5
Equad
or13
Colombia
43
Peru26
Nige-
ria130
T
anzania35
Madagascar16
Mozambique18
Malawi11
Zambia10
Congo
52
Niger11
Sudan 32Kenya 31
Somalia 9Ethiopia 66
Chad8
South
Africa
43
C.A.
R.4
Senegal10
Cote dIvoire 16Ghana 20
Benin 6Guinea
8
Sierra
Leone
5
Li
beria
3
Angola 14Zimbabwe 13
Botswana 2Namibia 2
BurkinaFaso 12
Cameroon 15Uganda 23
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Exhibit 1.5: The uneven distribution of wo
CANADA
TATS-UNIS
MEXIQUE
GUATEMALA HONDURASNICARAGUASALVADOR
COSTA RICAPANAMACOLOMBIEQUATEUR
PROU
BOLIVIEPARAGUAY
CHILIARGENTINE
URUGUAY
VENEZUELATRINIT-ET-TOBAGO
BARBADE
PORTO
BAHAMAS
ESPAGNE
FRANCE
IRLANDE BELGIQUE
ROYAUME-UNI
ISLANDE
PAYS-BAS
DANEMARK
NORVGE FINLAND
LITUANIE
SUSSIE
3
TUR
8
K
AA
G
LIBANSYRIE
ISRAL
CHYPRE
KOWEITARABIE
SAOUDITE
YM
1 BANGLAD2 KIRGHIZS3 MOLDAVI
PNcou
4 OUZBKI
JORDANIE
6
GRCE
ESTONIELETTONIE
SUDE
LUXEMBOURG
ITALIE
SUISSE AUTRICHE
POLOGNE
BILORUSSIE
UKRAINE
RP. TCHEQUE
BULGARIESLOVAQUIE
HONGRIE
ALLEMAGNE
SLOVNIECROATIEALBANIE
MALTE
NIGERIATUNISIEALGRIENIGER
BURKINA FASOMALI
MAROCMAURITANIE
SNGALGUINE
GHANATOGO
BNINCAMEROUN
GABONRP. DM. DU CONGO
CONGOANGOLA
ZAMBIENAMIBIE
BOTSWANAAFRIQUEDU SUD
CTE DIVOIRE
GYPTETCHAD
SQUDANRYTHRE
THIOPIECENTRAFRIQUE
OUGANDAKENYARWANDABURUNDITANZANIE
MALAWI
ZIMBABWEMOZAMBIQUE
SWAZILAND
MAURICEMADAGASCAR
LESOTHO
MACDOINE
PORTUGAL
RP. DOMINICAINEJAMAQUE
HATIRICO
BRSIL
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9The Fascinating World of the Stock Market
same rate of growth between 1980 and 2000. This debt growth exceeded
the growth in personal income, which averaged 5.57% during the same
period. We are more leveraged than ever before, and this is bound toaggravate the fall when the economic downturn comes. A falling saving
rate is deemed disquieting because, over the last twenty years, it has
been associated with a fall in new investment as percentage of GDP.
This will ultimately lower the capital stock available to an American
worker and with it the productivity of the American worker.
Exhibit 1.6 shows the precipitous decline in the saving rate in the
United States. By 2001, the US saving rate was still dismal, while the
Exhibit 1.6: (a) Personal saving rate (percentage). (b) Real personal consumption ex-
penditures (percentage change from preceding period).
0
-1.0
1. 0
2. 0
19 99 20 00 200 1
0
-1.0
1. 0
2. 0
19 99 20 00 200 1
(a)
(b)
Source: Bureau of Economic Analysis
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10 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
average personal saving rate in Europe was 12% and that in Japan
was 13.6%. A technical correction is in order, however. Personal saving
takes into account wages, dividends, interest and rental income andsubtracts taxes and households expenditures on goods and services. The
capital gains on stocks and other assets are excluded, however. This
makes the saving rate lower than it otherwise would be, and it denied the
existence of any wealth effect, which has been shown to have some
influence to one degree or another over the consumption of Americans.
In a recent massive study on the subject by Jonathan A. Parker
prepared for N-BER Working Paper Series, the following surprises were
disclosed:
1. Aggregate wealth to income ratio in the United States has actually
increased as consumption rose.
2. The saving rate including capital gains has not fallen.
3. Only one fifth of the increase of consumption to income can be
explained by the wealth effect. Between 1994 and 1999, the stock
market added over $6 trillion to household wealth. However, even
a 10% spending of this addition could increase consumption by
$600 billion a year.
4. Perhaps federal transfers in the form of Social Security and
Medicare are increasing the consumption of the elderly, while
relaxed liquidity constraints are allowing the young to consume
more of their income. The effective discount rate for the representa-
tive agent has actually risen which increases current consumption.
The low saving rate is a problem, but not apparently as serious
a problem as originally thought. The other concern expressed by an
increasing minority of economists deals with the distribution of wealth
in the United States, especially that resulting from the bull stock market.
Exhibit 1.7 shows that the richest 1% of Americans took the lion share
(51.4%) of the huge increases in wealth. This skewness in wealth
distribution could have long term destabilizing effects on the US economy,
but is well beyond the scope of analysis of this book.We now examine the many considerations for investing in equity
securities.
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11The Fascinating World of the Stock Market
1.2 Stock Ownership Has Never Been Easier
Stock ownership in the United States has soared from merely 2.2 million
individuals holding shares in 1900 to almost 80 million people in 1999
holding shares directly or indirectly. The active participation by small
investors and their rather steady nerves in the market, particularly in
downturns, have contributed to further stabilizing the market and tolowering volatility.
Individual investors execute either through their own accounts, through
their advisors and through investment clubs which are proliferating.
Exhibit 1.8 shows the marked increase in the median size of the
portfolio unadjusted for inflation. It had reached $27.5 million by the
end of 1999. Capital gains may explain much of that increase, as would
inflation. The activity level on the NYSE and on the NASDAQ also
increased dramatically. A billion-share-day is now common on bothvenues. The annual volume on the NASDAQ was higher by almost
73 billion shares than that on the NYSE. And the Dow Jones Industrial
Average (DJIA) had risen from a 235.41 level in 1950 to 11,497.1 at
the end of 1999, an increase of 4800%. This impressive increase led an
active participation in the mutual fund industry as well, from $2.5 billion
in 1950 to $92.1 billion in 1999.
This is particularly highlighted in the results of the Federal Reserve
Boards triennial Survey of Consumer Finances. Exhibit 1.9 compares
these data for 1992, 1995, 1998 and 2001. Note the appreciable rise in
an average familys stock holdings. It is not only that over one-half of
Exhibit 1.7: Percentage of stock shares owned in 1997 by different income groups.
Source: The Wall Street Journal, September 13, 1999.
5LFKHVW
1H[WULFKHVW
2WKHUV
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12 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
Exhibit 1.8: Stock market data.
Exhibit 1.9: A comparison of the results of the Federal Reserve Boards triennial Surveyof Consumer Finances.
Ind. shares owners 2.2 mil. 6.3 mil. 25.3 mil. 79.4 mil.
Median portfolio value $1200 $3800 $10,100 $27,500
Annual volume
NYSE 102.4 mil. 524.8 mil. 4693.4 mil. 204 bil.
NASDAQ (started in 1971) 1394 mil. 272.6 bil.
Market capitalization
NYSE $3972 mil. $93.8 bil. $685.1 bil. $12.3 tril.
NASDAQ (started in 1971) $78,190 mil. $5204 bil.
Dow Jones levels
High 236.63 888.85 11,568.8
Low 193.94 619.13 9611.33
Close 70.71 235.41 852.41 11,497.1
Size of the mutual fund assets $2531 mil. $41,720 mil. $92,126 mil.
1900 1950 1975 1999
Source: Ana M. Aizorbe, Arthur B. Kennickell and Kevin B. Moore: Recent Changes in US Family
Finances: Evidence from the 1998 and 2001 Surveys of Consumer Finances, Federal Reserve Bulletin,
vol. 86, pp. 132, January, 2003.
1992 1995 1998 2001
Families having stock holdings 36.7% 40.4% 48.9% 51.9%
(direct or indirect*)
Median value among families $13,000 $16,900 $27,200 $34,300
with holdings
Stock holdings as share of
(a) financial assets 33.7% 39.9% 53.9% 56.0%
(b) total assets 10.7% 14.6% 21.9% 23.5%
Family net-worth $61,300 $66,400 $78,000 $81,100
Median family income $33,000 $35,000 $36,400 $39,900
(before tax)
*Indirect holdings are those in mutual funds, retirement accounts and other managed assets.
The median values are in 2001 dollars.
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13The Fascinating World of the Stock Market
Exhibit 1.10: Discount brokerages.
1st Discount Brokerage, Inc. None $14.75
1st Global, Inc. None $35.00
Access Brokerage Limited $5000 $29.50
American Express Financial Dir $15,000 $14.95
Ameritrade Holding Company $2000 $8.00
Andrew Peck Associates, Inc. $3000 $13.50
Bank of San Francisco None $29 + 1.7% (gross)
BrokerageBidwell & Company $2000 $12 (1500 shares
or less)
Bright Trading, Inc None $0.01/share
Brown & Company $15,000 (cash account) $5 + $0.01/share
Bull & Bear Securities, Inc. $3000 $19.95
Burke, Christensen and None $13 (5000 shares
Lewin S or less)
Charles Schwab & Co. $5000 $20.00 (2c/shares
over 1000)CompuTEL Securities HIGH SECURITY HIGH SECURITY
RATE SITE
CT Market Partner $15,000 $29 (1000 shares
or less) + depends on
shares prices
Cutter & Co. Brokerage, Inc. None $40
Dashin Securities Co., Ltd. FOREIGN SITE FOREIGN SITE
Datek None $9.99 (15000 shares)
Day-Traders Network $100,000 N/ADiscount Direct AG FOREIGN SITE FOREIGN SITE
DJF Discount Brokerage None $35 (100 shares)
DLJdirect None $19.95 ($14.95 NYSE/
AMEX only)
Downstate Discounts Direct None $30.00 + $0.03/share
(up to 1000)
Dreylus Brokerage Services None $15.00 (Flat Rate)
E*Trade $1000 $14.95 (2000 shares
or less)Empire Financial Discounts $1000 $6.95 (5000 shares
Direct or less)
Brokerage Minimum to Average cost per trade
open account
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14 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
Exhibit 1.10 (Continued)
FCNIS Brokerage None $14.95
Fidelity $5000 $14.95
Financial Discounts Direct 3000 pounds No handling fee
First Midwest Securities, Inc. None $24 (10,000 shares
or less)
Firstrade.com None $6.95
Freeman Welwood None $14.95 (2000 shares)
Frontier Futuras, Inc. None $29 (2999 sharesor less)
Green Line Investor Services See TD Waterhouse See TD Waterhouse
HongKong Bank Discount FOREIGN SITE FOREIGN SITE
Tradi
Investex Securities Group $5000 to cover first $13.95
purchase
InvestNet FOREIGN SITE FOREIGN SITE
InvesTrade Discount Securities $2000 $7.95
Jack White & Company $2000 + $10,000 See TD Waterhousenet worth
JB Oxford & Company $2000 $14.50 (1000 shares) +
$0.04/share
Killik & Co None 40 pounds
Livebroker.com None $39 (1000 shares) +
$0.04/share
Marquette de Bary Co., Inc. FOREIGN SITE $50
Midwest Discount Brokers, Inc. None $40 (depends on price)
Morgan Stanley Dean None $29.95 (1000 sharesWitter or less)
Mr. Stock 100% coverage of $14.95 (5000 shares
first purchase or less)
Muriel Sibert & Co.
National Discount Brokers, Inc. None $14.75 (1002500
shares)
Nestlerode & Co., Inc None $52 (1000 shares
or less)
Net Investor $5000 $19.95 + (100 shares)Netstock Direct Corporation None $19.95
Newport Discount Brokerage None $19 (100 shares)
Brokerage Minimum to Average cost per trade
open account
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15The Fascinating World of the Stock Market
Exhibit 1.10 (Continued)
NexTrend $25,000 $12 (5000 shares
(daytraders account) or less)
OLDE Discount $500,000 $20 ($15; 1100
(cash/securities) shares)
Online Trading, Inc. $100,000 $24.95 (1000 or less)
Pennaiuna & Company None $45 (1000 shares
or less)
Pont Securities See TD Waterhouse See TD WaterhousePrime Time Trading, Inc. 5000 Free Trial; $19.95
Quick & Relly None $14.95
RML Trading and $250,000 $14.95 + $2220/month
Stock Cam Ins.
Royal Bank Action Direct None $40
Sanford Securities, Inc. None $19.95
Scotia Discount Brokerage None $28
Scottrade $500 equity $7.00
Self Trading Securities $25,000 $9.50 + $0.02/shareShamrock Financial Services $5000 $5 (300 shares or less)
Shochet Securities None $14.95 (2000 shares
or less)
Sovereign Securities None $12 (5000 shares
or less)
STA Research None $14 (5000 shares
or less)
Stock Power None Direct trade
w/ companySunlogic Securities $2000 $15.99 + $0.02/share
SuperTradeUSA None $14.95 (5000 shares
or less)
Suretrade.com None $7.95
T. Rowe Price $500 $24.95
TD Waterhouse Group $1000 $19.95
Trade Securities $50,000 N/A
TradeStar Investments, Inc. $2000 equity N/A
Tradewell $500 (cash account) $22.00US RICA Financial Inc. None $4.95 + $29.95/month
Brokerage Minimum to Average cost per trade
open account
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16 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
*Market Orders Limit orders are on average $25 additional costs.
Note: IRA accounts on average requires an initial minimum deposit of $2000.
Exhibit 1.10 (Continued)
Wall Street Access $10,000 $25 (5000 shares
or less)
Wall Street Discount None $19.95
Corporation
Wall Street Equities, Inc. $2000 $12.00
WallStreet Electronica Online $5000 $24.95 (1000 shares
or less)
Web Street Securities $0 (cash account) $14.95 (1000 shares$2000 (margin) or less)
Westminister Securities None $39 (1000 shares
Coroporation or less)
White Discount $2000 (IRA) N/A
Securities/Thom
Wilshire Capital Management $10,000 (cash/securities) $20 (050 trades) +
$300/month
Yamner & Co., Inc. $50,000 equity $35 + $0.02/share
York Securities 25% of first purchase $25.00
Brokerage Minimum to Average cost per trade
open account
American families held stocks in 2001, compared to a little over a third
in 1992, but also that the proportion of familys assets held in stocks
has more than doubled in this period.
The massive interest in the stock market has led to the proliferationof discount brokers, documented in Exhibit 1.10, who offered for the most
part discounted trading (execution systems) with little or no investment
advice, and often no contact with a broker. Most of the systems allowed
for direct orders to be placed by the client using the Internet. Small
investors responded with great enthusiasm as the average per unit trading
costs fell sharply, as computer and Internet availability and usage soared,
as the information about stocks and stock markets proliferated through
a multitude of venues (the Internet, television (CNBC, CNN-fn, etc),
newspapers) and as the performance of the stock market left the
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17The Fascinating World of the Stock Market
non-participant feeling left out, if not outright stupid. The psychology
of you cannot be helping yourself and your family if you are out of the
market became dominant. Meanwhile, technology and its costs weregetting more accessible and ever cheaper to the point that there currently
exist Internet connections that are literally free. By the end of 1999,
40% of stock trades completed by individuals were done online. Some
companies have experienced much higher rates of Internet usage for
stock purposes. Schwab International gets 70 to 80% of its trading activity
from outside the United States through the Internet. Some firms have
added even more interesting features in order to facilitate further the
use of technology. Ameritrade, a discount broker, now uses InterVoice,a speech-enabled system that allows its customers to act on their
investment decisions via telephone using natural speech recognition.
Note that many of the discount brokers documented in Exhibit 1.10
do not require a minimum amount to open an account, and those that do
are cutting their minimum on a regular basis. The costs do vary depending
on the size of the order, how it is placed, and how much information
Exhibit 1.11: Mean implied roundtrip transaction costs.
Note: Estimates based on Lesmond, Ogden, Trzcinka, RFS, 1999.
1980 1981 1983 1984 1986 1987 1989 1990 1992 1993 1995 1996 1998
16%
14%
12%
10%
8%
4%
2%
0%
Transactioncostestim
ate
Small Stocks
Large Stocks
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18 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
and service components are included in the transaction. Many of these
companies have yet to show profitability, and many are said to be on
the extinction block. No matter, they never anticipated. The winner inall of this has been the investor, the small one, especially. The mean,
implied roundtrip transaction costs (all costs) for small and large stocks
have fallen steadily as Exhibit 1.11 shows.
The traditional broker/investment advisor had also to see his preemi-
nent position as the sole, or primary, provider of investment information
eroded because of the avalanche of new sources of information, especially
on the Internet, available at no cost to practically everyone. Exhibit 1.12
lists some of the most often used sources and the quality of theircoverage.
The ability of investors to invest internationally has also been enhanced
by technology and with the development of sophisticated exchanges and
trading systems all over the world. Exchanges, London and New York
especially, have been adding a lot of foreign stocks to their listings. Daily
trading in foreign stocks (non-British stocks) account for a third, at least,
of all daily trading volume. The New York Stock Exchange (NYSE) has
twelve foreign stocks listed directly and 326 stocks listed through ADRs
(American Depository Receipts, an alternative stock certificate issued
in the US against a foreign stock). The latter allows foreign stock values
to be denominated in US dollars, but does not eliminate, contrary to
public perception, foreign exchange risk, as the returns on the underlying
stock are still influenced by exchange rate changes.
The cross listing of securities across exchanges is becoming the
order of the day in Europe as the move toward economic and financial
integration, one Europe, accelerates. Similar conversions are taking place
in the rest of the world as cross listing improves the image of a stock
and in the process the interest of the investor in it. Mercedes Corporation
saw a major appreciation (about 30%) in the value of its stock the
moment it listed on the New York Stock Exchange. The cross-listed
securities across financial markets are shown in Exhibit 1.13. The list is
very dynamic. It even changes from one day to the next.
All of these developments in the financial markets are a reflection ofan incredible movement toward globalization (Exhibit 1.14). Although
potent and almost all-inclusive, globalization is not as deep, yet, as many
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Exhibit 1.12: Data sources Fast and
1 Bloomberg www.bloomberg.com Market information
Macroeconomic data
Stock quotes and research
Investment tools
2 CNN Financial www.cnnfn.com Market information
Macroeconomic data
CNN Money Money.cnn.com Stock quotes and research
Investment tools3 Quicken www.quicken.com Stock quotes and research
Investment tools
4 Big Charts www.bigcharts.com Technical analysis tools
Rank Name Location Content
1 CompuStat, a.k.a. Computer Labs Company specific dataResearch Insight Industry specific data
2 Data Stream Computer Labs Company specific data
Industry specific data
Country specific data
Macroeconomic data
Rank Name Web site Content
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Exhibit 1.12 (Continued)
5 CNBC www.cnbc.com Market information
Macroeconomic data
Stock quotes and research
Investment tools
6 Yahoo Finance finance.yahoo.com Market news
Marcoeconomic data
Stock quotes and researchInvestment tools
7 Hoovers www.hoovers.com Stock quotes and research
8 Red Herring www.redherring.com IPO data
9 Motley Fool www.fool.com Personal investing educatio
10 Quote.com www.quote.com Real time quote and news
11 SEC www.sec.gov Company filings
12 Prophet Finance www.prohpetcharts.com Technical analysis tools
Rank Name Web site Content
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21The Fascinating World of the Stock Market
Exhibit 1.13: (a) The country-to-country distribution of foreign listings.
This table provides the country-to-country frequency distribution of cross listings as of
1998 obtained from the individual exchanges. The total sample is comprised of 2367overseas listings. The listings in the US include foreign companies traded only on the
NYSE and NASDAQ. Only those countries with non-zero sample cross listings are listed
as host markets.
Australia
Austria
Belgium
Brazil
Canada
Denmark
Finland
France
Germany
H.
Kong
Ireland
Italy
Japan
Luxem.
Malaysia
Nether.
N.
Zealand
Norway
Peru
Singapore
S.
Africe
Spain
Sweden
Switz.
UK
USA
Host country
Argentina 1 3 1 1 12
Australia 5 3 4 1 25 2 2 9 30Austria 1 1 8
Belgium 7 3 6 7 1 2 1 5 2 1
Brazil 5 1 21
Canada 3 7 6 2 1 3 1 1 6 21 213
Chile 21
Colombia 3 2
Czech R. 4
Denmark 1 1 2 1 1 3 6
Finland 1 1 3 2 4
France 11 8 1 2 3 10 1 3 5 6 23
Germany 15 8 13 2 9 6 13 1 2 1 31 10 11
Greece 1 1 1 8 5
H. Kong 3 1 1 1 4 24
Hungary 2 5 5 1
India 48 17
Indonesia 1 1 2 4
Ireland 56 17
Israel 4 84
Italy 2 4 5 3 1 22
Japan 5 1 31 54 21 19 6 15 29 28
Korea 1 12 12 3
Luxem. 2 4 1 2 1 2 2 4
Malaysia 1 1 4
Mexico 31
Nether. 6 14 13 23 1 8 1 1 1 19 17 36
N. Zealand 19 1 4
Norway 2 1 2 1 2 1 5 5
Peru 3
Philippines 6 1
Poland 1 9
Portugal 1 1 4
Singapore 2 3 1 3
S. Africa 1 15 6 4 5 37 13
Spain 4 4 4 3 2 4 5
Sweden 5 3 4 2 2 4 12 16
Switz. 1 1 5 12 4 2 1 2 5
Taiwan 15 1 13 3
Thailand 2 1Turkey 1 6
UK 4 4 1 15 11 1 16 8 2 12 4 2 3 5 89
USA 5 2 34 29 33 43 23 3 75 4 2 1 5 74 92
Venezuela 1 1 3
Home
country
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22 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
Exhibit 1.13: (b) Aggregate market data and accounting standards.
This table provides aggregate economic, equity market, and exchange listing standards
data for the sample countries. GDP is from the 1999 CIA World Factbook. Market
capitalization is from the International Federation of Stock Exchanges (FIBV). Volatility
is the markets estimate of the standard deviation of monthly US dollar denominated returns
over the period 19901998. Turnover is the ratio of average trading volume of domestic
shares in 1998 over the home market capitalization reported by either the FIBV or respective
stock exchange. Aggregate imports and exports for each country are also from the 1999
CIA World Factbook. IAS GAAP is a dummy variable which is set to one if the country
allows foreign firms to list with IAS GAAP-based financial statements and zero otherwise.US GAAP is a dummy variable which is set to one if the country allows foreign firms to
list with US GAAP-based financial statements and zero otherwise.
US
GAAP
Argentina 374 45 15.71 51 32 0 0
Australia 393 329 5.34 53 61 1 0
Austria 185 36 6.27 42 66 1 1
Belgium 236 246 4.27 28 137 1 0
Brazil 1035 161 16.27 66 58 0 0
Canada 688 543 4.69 59 202 0 0
Chile 185 52 8.11 7 17 0 0
Columbia 255 11 10.16 11 14 1 1
Czech Rep. 117 10 9.66 206 27 0 0
Denmark 124 99 4.65 65 46 1 1
Finland 103 155 7.90 55 31 1 0
France 1320 992 5.10 66 255 1 0
Germany 1813 1094 4.58 138 426 1 0
Greece 143 80 11.64 83 28 1 0
Hong Kong 168 344 8.66 62 208 0 0
Hungary 75 14 12.55 436 23 1 0
India 1689 93 9.93 52 41 1 0
Indonesia 602 22 13.93 57 24 1 0
Listing
standardsMarket size Liquidity Trade
GDP
($B)
Market cap
($B)
Volatility
(%)
Turnover
(%)
Imports
($B)
IAS
GAAP
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23The Fascinating World of the Stock Market
Exhibit 1.13 (Continued)
US
GAAP
Ireland 339 67 6.05 60 43 0 0
Israel 101 39 8.07 34 26 0 1Italy 1181 570 6.70 102 202 1 0
Japan 2903 2440 7.93 34 319 1 0
Korea 584 115 13.13 207 94 0 0
Luxembourg 14 38 4.89 4 10 1 1
Malaysia 215 96 11.40 30 59 1 0
Mexico 815 92 10.26 27 111 1 0
Netherlands 348 603 4.11 71 142 1 1
New Zealand 61 25 6.33 48 13 1 1
Norway 109 46 7.45 66 37 1 1Peru 112 10 9.87 23 10 1 0
Philippines 270 35 11.15 32 29 0 0
Poland 263 21 14.79 58 38 0 0
Portugal 145 63 6.45 82 34 1 0
Singapore 91 97 6.53 64 133 1 0
South Africa 290 151 7.45 27 27 1 0
Spain 645 402 6.27 170 132 0 0
Sweden 175 279 6.95 70 67 0 0
Switzerland 191 689 4.97 100 95 1 1Taiwan 363 261 12.36 314 114 0 0
Thailand 369 34 13.01 69 73 1 1
Turkey 425 34 17.14 143 47 1 1
UK 1252 2373 4.48 47 304 1 0
USA 8511 12,926 3.68 152* 912 0 1
Venezuela 194 8 15.28 19 12 0 0
Listing
standardsMarket size Liquidity Trade
GDP
($B)
Market cap
($B)
Volatility
(%)
Turnover
(%)
Imports
($B)
IAS
GAAP
*The turnover rate in the US is the market capitalization weighted turnover rates on the NYSE and
NASDAQ.
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24 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
assume it to be. There are still numerous regional monopolies, and
considerable differences in rates and transactions costs across national
borders. The disappearance of the power of the state is premature despite
the fact that many transactions across national borders are seamless.
The talk now is shifting, interestingly, from globalization into
regionalism. The Europeans, the Asians and the Americans are all
becoming more regional in their focus. We may well be moving toward
a tri-polar world where borders are still relevant, but are less relevant
only within a specific region. The North American Free Trade Agreement
(NAFTA) has allowed for this kind of development between the member
states (US, Mexico, and Canada), as has the Maastricht treaty between
the member states of the European Union.
BordersFalling
Demand forConsumer Goods
Capital Flows toEmerging Markets
Industrialization ofEmerging Markets
BordersFalling
BordersFalling
Demand forConsumer Goods
Demand forConsumer Goods
Capital Flows toEmerging MarketsCapital Flows to
Emerging Markets
Industrialization ofEmerging MarketsIndustrialization ofEmerging Markets
Exhibit 1.14: Globalization Virtuous cycle.
Ive arrange dto sen d yourportfolio o nthe ne xt spaceshuttle. If yoursto cks wontrise in ze ro
gravity, then Igive up!
Copyright 2002 by Randy . www.glasbergen.com
Ive arrange dto sen d yourportfolio o nthe ne xt spaceshuttle. If yoursto cks wontrise in ze ro
gravity, then Igive up!
Copyright 2002 by Randy Glasbergen. www.glasbergen.com
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25The Fascinating World of the Stock Market
1.3 Markets and Their Indices
Each market is like the human body. Complex as it is, you need not
examine every part in order to determine whether it is healthy or not.
You are generally satisfied with taking its temperature, or the heartbeat
or the blood pressure, or a combination of these three indicators to
determine its health. Similarly, the health of the stock market and its
direction may be inferred from a small sample of stocks included in
an average or an index. The average is simply the adjusted arithmetic
average of a carefully selected group of stocks, and the index is the
value of a carefully selected group of stocks in relation to a base periodchosen with history and efficiency in mind. Typically, the standard value
picked for the base period is 100.
The most famous and the oldest of the averages is the Dow Jones
Industrial Average (DJIA) made up of thirty stocks, most of which are
listed on the New York Stock Exchange and representing a wide set of
industries without, unfortunately, being very representative. The average
is price weighted which means that you add the price of the component
stocks and you divide by the divisor, which is the number of sharesadjusted for stock splits, stock dividends, etc. The higher price stocks
will have, by the very nature of the mathematics, a greater impact on
the movement of the average.
Despite the obvious drawbacks, the DJIA remains the most followed
average (index) in the world. It is well inculcated in the minds of
investors as it dates back to 1896, as it is constantly updated during
trading hours, as it is published in every financial publication and through
every financial information transmission medium, and as it is an average
constantly pushed by The Wall Street Journal, the dominant business
publication owned by the Dow Jones News Services. Also, the Dow
theory which has many adherents in the wild world of technical analysts
relies on the DJIA and on the Dow Jones Transportation Average (DJTA).
The transportation average covers 20 stocks in the airline and railroad
sectors and is used as a tool for the confirmation of developments (trends)
in the DJIA. The Dow Jones Company has developed averages similarto the DJIA for the world and for many of the leading financial markets
of the world. They are reported on regularly in The Wall Street Journal.
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26 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
The second most popular market indicator is the Standard and Poors
500 index (S&P 500). This index is value weighted. The index is calcu-
lated by summing across the total market value of each of the 500 sharesthat make up the index, and dividing by the value of the index in the base
period (1950). The reservation about this index is its representativeness of
the US economy and its mathematical construct that allows for a larger
impact for price movements in the high capitalization stocks in the index.
The third most commonly followed index is the NASDAQ index
which contains the value of all shares of each company traded on the
NASDAQ divided by the base period. Like the S&P 500, it is a value-
weighted index (value being the market value of all the shares), wherecompanies with the highest capitalization have a disproportionate impact
on the movement of the index.
The NASDAQ is the where the hottest companies in America are
traded. It is where the tech companies are traded and represents to many
the future of Americas industry. These companies include Microsoft,
eBay, Dell, Yahoo, etc The NASDAQ is also a value-weighted index,
like the S&P, and is an index.
The conservative investor with a rather narrow portfolio of traditional
stocks (old time securities) would look at the DJIA as a good indicator of
price movements for the portfolio. The investor with a broader portfolio
would look at the S&P 500. That with a high tech portfolio would look
at the NASDAQ for direction or at any of its subparts as shown in
Exhibit 1.15. The specific industry indices are very helpful for those
who do not have a diversified portfolio across sectors. It is wise to look
at all of the indices and try to develop a sense of where the market is.
One should also consider whether the market is advancing or falling based
on heavy or weak volume, and whether the advance is persistent in face
of some bad news, or some good news, if the direction is downward.
The financial markets have developed instruments that track these
and other indices that are traded just like any stock is. The NASDAQ is
tracked by a stock called QQQ, which mirrors its movements. We discuss
these issues in the next chapter.
The market indicators are not limited to these three. Exhibit 1.15presents a rather exhaustive list of indices, their coverage and the method
used for their calculation.
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Dow Jones Industrial 30 blue-chip US stocks The sum of all
Average by the divisoetc.).
Dow Jones 20 stocks of airline, trucking, railroad, The sum of all
Transportation and shipping business by the diviso
Average etc.).
Dow Jones Utilities 15 stocks of gas and electric utilities The sum of all
Average industries by the diviso
etc.).
Dow Jones Global 3000 separate indexes; 2900 companies The sum of all
Average in 33 countries, ten world regions, nine by the diviso
market sectors containing 122 industry dividends, e
groups
Dow Jones STOXX Joint venture with French, German, and The sum of all
Average Swiss stock exchanges by the diviso
NYSE Composite Includes subgroups: industrial, Tracks aggrega
transportation, utility, and finance capitalizatio
individual mmultiplied b
NASDAQ 100 Includes major industry groups: computer Market-value w
hardware and software, retail, component s
telecommunications, and biotechnology value accoun
Exhibit 1.15: Major stock market indices, their coverage and the
Market index Coverage
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NASDAQ Composite 5000 domestic companies and non-US Market-value wbased common stocks component
value accoun
NASDAQ 100 largest financial companies Market-value w
Financial 100 component s
value accoun
NASDAQ Bank All types of banks Market-value w
component s
value accounNASDAQ 100+ companies engaged in biomedical Market-value w
Biotechnology research component
value accoun
NASDAQ Computer 600+ computer hardware and software Market-value w
companies component
value accoun
NASDAQ Insurance 100 insurance companies: life, health, Market-value w
property, etc component svalue accoun
NASDAQ 100+ railroads, trucking, etc Market-value w
Transportation component s
value accoun
Exhibit 1.15 (Continued)
Market index Coverage
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NASDAQ 170+ telecommunications companies Market-value Telecommunications component
value accou
NASDAQ National 2000 agricultural, mining, construction, Market-value
Market Industrial etc component
value accou
NASDAQ Industrial 3000 agricultural, mining, construction, Market-value
etc component
value accouS&P 500 Composite Price performa
S&P Midcap 400 Midsize company
S&P 100 (OEX) large company US stock market Market capital
performance
AMEX Composite Any company Aggregate ma
times numb
stock divide
Wilshire 5000 Equity Performance of all US headquartered Closing price
equity securities (7000 capitalization
weighted security returns)
Wilshire Large Cap 750 Large stocks Market capital
Exhibit 1.15 (Continued)
Market index Coverage
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Wilshire Mid Cap 500 Mid-sized stocks Cap-weighted:
501st larges
Wilshire Small Cap 1750 Small stocks Cap-weighted:
Wilshire Micro Cap Small stocks Cap-weighted:
Wilshire Large Value Large-cap stocks Market cap we
Wilshire Large Growth Large-cap stocks Market cap we
Wilshire Mid Cap Value Mid-cap stocks Market cap we
Wilshire Mid Cap Growth Mid-cap stocks Market cap we
Wilshire Small Value Small-cap stocks Market cap we
Wilshire Small Growth Small-cap stocks Market cap we
Wilshire All Value Measures all value stocks Combination o
Small Value
Wilshire All Growth All growth stocks Combination o
Small Grow
FORTUNE 500 500 biggest companies in US Market capital
(in FORTUNE 500)
FORTUNE e-50 50 companies in Internet sector Closing price t
Exhibit 1.15 (Continued)
Market index Coverage
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Frank Russell 3000 3000 largest US companies based on Capitaliza
total market capitalization ownersh
by the b
Frank Russell 1000 1000 largest companies in Russell Capitaliza
3000; top tier of domestic equity ownersh
market, or companies with market by the b
value of greater than $300 million
Frank Russell Midcap 800 smallest companies in Russell Capitaliza
1000 ownersh
by the b
Philadelphia Semiconductor 16 US stocks from design, Price weig
distribution, manufacture, and sale which i
of semiconductors
Morgan Stanley 35 Measures nine technology subsectors Equal-wei
from computer service to trading semiconductor capital equipment
Exhibit 1.15 (Continued)
Market index Coverage
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32 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
1.4 Types of Accounts
An investor typically opens with his or her broker either a cash account
or a margin account. The cash account requires settlement of the fall
value of the purchase or the delivery of securities in the case of a sale
within three business days. Buying on margin means that one borrows a
portion of the purchase price. The minimum cash currently required is
50%. The remaining 50% are effectively being borrowed from the broker
at a rate tied to the prime rate.
The initial margin requirement is set by the Federal Reserve System
(the Fed) under Regulation T. The margin is also set by the NationalAssociation of Securities Dealers (NASD), and by the brokerage firm.
The initial maximum borrowing allowed against a position is set by the
Fed. It is 50% of the value of the investment. The NASD sets the
maintenance requirements, that is, the minimum required equity level
in the margin account before a margin call is made by the broker and
additional cash is deposited by the investor in her account. The intent
here is for the investment firm to keep some collateral by the investor
against his position and never allow him to play purely with borrowedmoney. A fall in the value of the investment below the amount borrowed
jeopardizes the position of the investment house because the remaining
collateral has a value in this case that will not cover the loan even if the
entire investment is liquidated. The margin call will protect against such
a possibility well before it happens.
Also, a securities firm may require more (never less) than 50% in
margin for securities it deems highly volatile. This is to protect itself
against a market move that negatively impacts the position of the investor.Let us now offer an example. Assume that an investor purchases
$30,000 worth of securities in her margin account. Her position at t= 0
(at the moment of purchase, zero time) is as follows:
cash (equity) $15,000
borrowed funds $15,000
total value of investment $30,000
Assuming that at t = 2 (two days after the purchase) the marketvalue of the portfolio falls to $16,000. The position of the investor is
now as follows:
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33The Fascinating World of the Stock Market
cash $1000
borrowing (constant until the position is closed) $15,000
total value of investment $16,000
But, the NASD requires that the minimum margin does not fall below
25% of the original value of the position. That is, the customers equity
cannot fall below $7500 ($30,000 *25%). Therefore, the customer would
receive a margin call for $6500 ($7500$1000 (existing equity)).
Should the margin call not be met, the investment firm may liquidate
an equivalent amount (almost always higher than the amount dictated
by the 25%, bordering on the 30%) from the investors holdings in theaffected security. The investment firm may grant an extension to a client
to meet the margin call.
The holder of the margin account must note that the extension is
at the option of the firm that leverage works both ways. You double up
on the upside if you are holding a long position. But, you may lose on
the downside more than your initial cash commitment. The investment
firm could also sell securities in your account without notice to you in
order to settle an unanswered margin call. Margin accounts are thereforerisky.
It must be pointed out further that certain transactions, like short
sales, can only be executed in the margin account. Almost every
brokerage firm requires additional documentation and confirmations for
their trading of options and futures contracts in their accounts.
1.5 Types of OrdersBuy or sell orders differ in terms of the time limit, price limit, discretion
of the broker handling the order, and nature of the position. All of these
are fodder in the arsenal of Internet traders. There is no broker to guide
them if they wish to receive the lowest commission costs. The sites of
the discount brokers are very user-friendly in this regard.
Time limit orders are of two types: time-limited orders and good-til-
canceled orders (GTC). If not executed, a time-limited order expires atthe end of the specified time period (usually a day). A GTC order is in
effect unless cancelled by the investor.
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34 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
The price limits available to the investor are as follows:
1. Market order: The limit here is set, in a way, by the market.
The investor buys at the ask and sells at the bid. Every stock has
a quoted bid and a quoted ask. The bid is always less than the
ask. The difference between the bid and the ask is referred to as
the spread. The investor could pay more than the observed ask
price, however, as the market may have shifted by the time the
order is executed. The ask price used for execution may be higher
or lower than the one observed by the trader. Market orders are
the quickest but not necessarily the cheapest way to buy or sell asecurity.
2. Limit order: The investor using a limit order specifies the
maximum buy price or the minimum sale price at which the
transaction will be consummated.
3. Stop order: A stop order is an order to buy or sell a security
when a certain price is reached or passed. A stop order can be
used on the sell or on the buy side. A stop order to sell is treated
as a market order after the stop price is reached or passed if thestock is listed on the NYSE. However, a limit may be specified.
Stop orders are used in order to preserve a level of profit in a
security, to purchase a security as it begins a vigorous upward
movement, or to protect the investor from loss.
An investor who purchased a stock at 50 and watched it appreciate
to 90 may wish to lock in at least 35 points if the stock begins
to show weakness. This is done by placing a stop sell order at,
say, 85. This order, however, does not guarantee a sale at 85, for
the stock can fall substantially below 85 before the position of
the investor is closed. Another disadvantage of a stop order
emanates from the unpredictable nature of the stock market. The
stock may fall below 86 causing the order to be executed, and the
stock may then reverse course and rise to 100. The investor in
this case would have missed a 10-point appreciation in the price
of the stock.An investor who had just purchased a security that began to show
weakness after the purchase date may wish to place a stop-loss
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(sell) order at below the current market price in order to limit the
potential loss in the security. Similarly, an investor with a short
position (a position intended to profit from a decline in securitiesprice (see next section)) would place a stop-buy order at above
currently prevailing prices to gain protection against an
appreciation in the price of the underlying security that causes a
loss in a short position.
4. Discretionary order: This type of order gives the broker discretion
over when, at what price, and how an order is executed. The broker
is liable if negligence is proved in the event a good opportunity
in the market is missed. No investor should be encouraged to issue
such an order as it is unwise as a long run proposition.
1.6 Types of Positions
Two positions in securities are available to the investor: a long position
and a short position.
A long position represents actual ownership of the security regardlessof whether personal funds, leverage, or both are used in its purchase.
Profits are realized through appreciation in the price of the security. In
derivative contracts, options and futures, a long position represents a
commitment to buy (a call option) or to sell (a put option) the underlying
security, but does in no way represent an actual position in the underling
asset. The long position is nothing more than a commitment to do
something in the case of derivatives.
A short position, on the other hand, involves a sale first, followed by
a purchase at, it is hoped, a lower price. The anatomy of a short sale is
illustrated in Exhibit 1.16. The process begins with a sale of a borrowed
security from the investment broker, who ordinarily holds a substantial
number of shares in street name and/or who has access to the desired
security from other investment brokers. The securities must be borrowed
as the settlement of the transaction (the delivery of shares and the
payment by the buyer) must be done within three business days. But thetrader is short (does not own the security). That is why the security is
borrowed. The short position holder owes the shares to the broker and
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36 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
nothing more. Once he decides to cover the short position, that is, buy
back the shares, he will deliver the purchased shares to the broker. This
will constitute a full settlement of the loan outstanding. The shortowns a certain number of shares to the broker, and not a certain sum of
money.
The reader must keep in mind, however, that not every security can
be sold short and not every country allows short positions in some
securities or in any security. Listed securities in the US are all eligible,
but only the more risk-averse short sellers are more likely to use some
vehicle to limit their loss in case the price of the security rises instead
of falls. One way to protect a short position is to use the stop-buy orderdiscussed in the preceding section. Other ways to protect a short position
are discussed in Chapter 8. The stop-buy order is placed at 15%, e.g.,
Exhibit 1.16: The anatomy of a short sale.
Source: Taken from the October 26, 1981 issue ofBusiness Weekwith special permission.
Enter a stop -loss order at 115. If the stock price rises
against you, your loss is limited to $1,500, since yourbroker will buy 100 shares at 115 to cover your short saleand close you out.
Your broker borrows 100 shares from anotherbroker to make delivery to the buyer of your 100 shares,using the proceeds of $10,000 as collateral
If the stock price drops, ride it down, shorting morestocks as deposits in your 50% margin account are freed.For example, if the stock drops to 50, you need only$2,500 to maintain your deposit. The other $2,500 isavailable to back another 100 shorted sales.
If the stock price drops, ride it down, shorting morestocks as deposits in your 50% margin account are freed.For example, if the stock drops to 50, you need only$2,500 to maintain your deposit. The other $2,500 isavailable to back another 100 shorted sales.
When you think that the stock has hit bottom, instructyour broker to cover by buying 100 shares and closingyou out. If you sell at 50, your profit is $5,000 lesscommissions.
ABC Corp. isselling at 100$
per share, andyou think itwill go lower.You sell 100shares short at
$100.
Proceeds
= $10,000,
less
commission
Youdeposit 50%of the sale
price, or
$5,000 inyour marginaccount.
Enter a stop-loss order at 115. If the stock price rises
against you, your loss is limited to $1500, since yourbroker will buy 100 shares at 115 to cover your short saleand close you out.
Your broker borrows 100 shares from anotherbroker to make delivery to the buyer of your 100 shares,using the proceeds of $10,000 as collateral.
If the stock price drops, ride it down, shorting morestocks as deposits in your 50% margin account are freed.For example, if the stock drops to 50, you need only$2500 to maintain your deposit. The other $2500 isavailable to back another 100 shorted sales.
If the stock price drops, ride it down, shorting morestocks as deposits in your 50% margin account are freed.For example, if the stock drops to 50, you need only$2500 to maintain your deposit. The other $2500 isavailable to back another 100 shorted sales.
When you think that the stock has hit bottom, instructyour broker to cover by buying 100 shares and closingyou out. If you sell at 50, your profit is $5000 lesscommissions.
ABC Corp. isselling at $100
per share, andyou think itwill go lower.You sell 100shares short at
$100.
Proceeds
= $10,000,
less
commission
Youdeposit 50%of the sale
price, or
$5000 inyour marginaccount.
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37The Fascinating World of the Stock Market
above the price at which the short sale was established and is usually
reduced (trail) as the stock price declines. After the stock price has
fallen sufficiently, the short position is covered; that is, the stock isbought at the prevailing market price and is returned to the investment
broker to settle the loan of shares. The investor could have elected to
increase the size of his or her short position as the stock price moved in
the right direction.
So, what is in it for the brokerage house to lend the stock to the
holder of the short position?
The commission revenue on the sell and on the buy side.
The stocks held in street name do nothing for the revenue of the
broker unless they are put to use. Lending them is one way to
activate the shares. Since the trade is done in a margin account,
the trader will then be borrowing money from the broker (up to
50 P/D of the value of the transaction). The broker will charge
interest on the loan. The interest is a function of the risk profile
of the investor. The riskiness of the position of the brokerage house
is limited through marking to market. As the price of the stockrises, that is, the short is losing money, the broker asks the short
to post more margin (pay more money). The money in the account
at any point in time should cover the loss in the event the short
decides to close his position.
The net proceeds from the sale of the stock borrowed from the
broker are not, typically, released to the short. They are held in the
account of the short. The broker could use the money in the short
accounts to earn income on the money through money market in-vestments, typically overnight lending to other financial institutions.
The short position in the case of derivative contracts, one must note,
translates into a commitment (creating an obligation on oneself by the
short position holder to deliver something or to take delivery of some-
thing) opposite that of the long. No shares are being borrowed here. There
is simply a contractual commitment to do something: to satisfy the long.
Three facts must be kept in mind with regard to short positions:
1. The security, if qualified, must be available to be borrowed. This
is not usually a problem.
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38 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
2. Short selling can only be effected on an uptick; that is, the
price at which the short position is established must be a price
that is higher than that on the preceding transaction. An order tosell short at 59 1/2 could not be transacted unless the 59 1/2 is an
uptick, that is, the 59 1/2 follows, say, a trade at 59 1/4.
3. The short seller is liable for the dividends on the stocks borrowed.
As the above scenario makes clear, a short position is ordinarily
established if an investor is bearish on the stock. An appreciation in the
price of the stock after the short sale would produce a loss because the
borrowed share would have to be replaced at a higher price. A bad
market is, therefore, not an excuse to stay out of the stock market. In
fact, there is no such thing as a bad market, there is only the wrong
position in a market. Furthermore, short selling is not necessarily riskier
than a long position. The probability of a decline in the price of a security
could be significantly higher than that of an appreciation in its price at
a certain point in time.
Short sales can also be used to lock in profits in a long position and
to postpone the tax liability from one tax year to another. The former
use is best illustrated with an example.
A trader with a long position established at $50 a share would
have a book gain of $20 per share if the stock trades at $70. At $70, the
trader may well decide to go short against the box (the box refers to the
fact that actual shares are actually owned by the trader) as one form of
protection if, e.g., the volatility in the price of the stock increases from
its historical level.
In general, if an investor is convinced that the security is a goodinvestment, but still concerned about its downside risk, the investor can
use one of the following methods to buy varying levels of protection:
Sell the stock and buy it later at a lower price. The danger here is
that immediately after the sale, the stock may move vigorosly
upward instead of falling in price.
Place a stop-sell order. The advantages and the disadvantages of
this type of order were discussed in the previous section.
Buy a put option or sell a call option (see Chapter 8).
Go short against the box, that is, establish a short position for the
same number of shares held long.
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39The Fascinating World of the Stock Market
The last method would require a short position at $70. The investor
now has perfectly offsetting positions. Every $1 appreciation in the price
of the stock yields profits of $1 per share in the long position and asimultaneous $1 loss in the short position. The reverse is true if the
price of the stock falls by $1.
In the event of a price decline, the investors costs of protection are
the transactions costs incurred when the short position is established
and when it is covered. These costs are likely to be lower than those
resulting from depreciation in the price of the security. In the case of
price appreciation, the investor would incur the same costs as above
and would forego in addition the appreciation in the price of the security.The sooner the short position is covered, the smaller the foregone profit
from a price appreciation will be.
Short selling, if wisely used, should prove to be a valuable tool
in portfolio management. Short selling in conjunction with current or
expected long positions has proved to be of great value to hedgers,
spreaders, and arbitragers in the fixed securities and futures markets.
This should become clearer from the chapters to follow.
1.7 Dates to Remember
Three dates are important in trading securities:
1. Trade date: The trade date is the date when the transaction is
consummated.
I hear things
that go bump inthe night . I think
it s m y invest
m e nts h it tingrock bottom.
Copyright 2002
by Randy Glasbergen
www.glasbergen .com
I hear things
that go bump inthe night . I think
it s m y invest-
m e nts h it tingrock bottom.
Copyright 2002
by Randy Glasbergen
www.glasbergen .com
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40 WEALTH FOREVER: THE ANALYTICS OF STOCK MARKETS
2. Settlement date: The settlement date refers to the date when the
transaction is settled. For stocks and bonds, it is the third business
day from the trade date.3. Ex-dividend date: This is the date on which the investor buys a
stock with our dividend. The recently declared dividend belongs
to the seller of the stock. The ex-dividend date is the fourth
business day prior to the record date (the date at which the actual
ownership of the stock is confirmed by the corporation).
Open buy and sell stop orders and sell stop-limit orders are reduced
by the value of the dividend on the ex-dividend date. Both the stopprice and the limit price (if any) are reduced by the dividend.
1.8 Conclusion
No matter the investors level of confidence in her choices, it is advisable
to always remember that an ounce of care is better than a pound of
cure. Beware of those promising you the moon. Beware of those who
only speak of doom. Even the chairman of the Federal Reserve System
is often wrong about the stock market. He warned us all in 1996 about
irrational exuberance and the bubble it was creating in asset prices. The
interpretation was that that bubble will burst soon. All the market did
after that was to take off. No one is discounting his insights fully, but
the market is calling its own tune and has been performing admirably,
generally speaking. The lessons from the depression to some are that it
was caused by asset price bubbles. There is no question they were afactor. The driving factors were fiscal and trade policies, and the unwise
Fed policies.
An investor is best advised to recall the twelve golden rules of
investing:
1. Never invest in anything you do not understand.
2. You cannot be right if the market is telling you you are wrong.
The market is always right.
3. Do not just look at returns. Consider always the risk. In fact try
to exaggerate the risk a bit before making the decision. There
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Source: WSJ Market Data Group; Thomson Financial Securities Data; Sanford
C. Bernstein
1. eBays IPO
2. Theglobe.com postpones its IPO because of market turmoil
3. Theglobe.com IPO sets then-record for first day price gain of 606%
4. Henry Blodget puts $400 price target on Amazon.com
5. E*Trades new TV campaign begins
6. SEC chairman Arthur Levitt criticizes online brokers ads
7. eToys IPO
8. Drkoop.com goes public
9. FreeMarkets almost triples filing range on its IPO to $4042
10. VA Linux IPO sets new record for first day price gain of 698%
11. AOL announces merger with Time Warner
12. Accountants question Drkoop.coms ability to remain going concern
13. Settlement talks collapse in Microsoft antitrust case
14. Higher-than-expected inflation number released
15. Lehman credit analyst questions Amazons viability
Exhibit 1.17
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are a lot of risks hidden in the income statements, the balance
sheets and in their footnotes, and there are a lot of risks inherent
in every sector of the US economy. Exhibit 1.17 should giveyou a reason to pause, between March 10 and May 23 (2000),
Internet stocks as a group, valued at $1.4 trillion at their March
peak, have lost 40% of that erasing almost as much paper
wealth as the 1987 crash. (The Wall Street Journal, July 14,
2000)
4. Run with a winning position. Get rid of losing ones.
5. Remember that no one has ever beaten the market consistently.
Warren Buffet lost money in 1999 while the NASDAQ wassetting an all time high.
6. If it sounds too good to be true, it invariably is.
7. Never invest before you figure out what your objectives are.
8. The market has always paid more for those who stuck with it in
the long run than for those who tried to outsmart it.
9. What is perfect for your neighbor is not necessarily even good
for you.
10. Remember that in the best of markets there are stocks making
new lows. Do not try to rationalize every dog in your portfolio.
Dogs do not become lions. Do not wait for this surprise, much
as you desire it.
11. Keep your ear to the ground. Some new company with a better
idea may be speeding by. Fortunes were made in the tech and
the Internet areas. Fortunes were also lost.
12. Stay informed. Your broker does not know better. There is no
virtue, nor profits in ignorance. The overwhelming evidence
suggests that professional investment advisors do not earn their
fees in extra profits in your portfolio. Have you wondered lately
why indexed funds (funds whose fortunes are tied to one of the
market indices) have become so popular.