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WEALTH FOREVER - The Analytics of Stock Markets

World Scientific Publishing Co. Pte. Ltd.

http://www.worldscibooks.com/economics/5329.html

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


0

4,000

8,000

12,000

0

1,000

2,000

3,000

4,000

5,000


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


6,000

7,500

9,000

10,500

12,000Dow Jones Industrial

Average (rightscale)

Dow JonesWorld StockIndex (right scale)

100

150

200

250

300


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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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%


20001999

19984%

U.S.

5%

3%

2%

1%

0%


19981999

2000 (f)4%

U.S.

5%

3%

2%

1%

0%


20001999

19984%

U.S.

5%

3%

2%

1%

0%


20001999

1998

US

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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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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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WEALTH FOREVER - The Analytics of Stock Markets World Scientific Publishing Co. Pte. Ltd.


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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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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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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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.

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1H[WULFKHVW

2WKHUV

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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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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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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)


open account

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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


open account

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*Market Orders Limit orders are on average $25 additional costs.

Note: IRA accounts on average requires an initial minimum deposit of $2000.


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


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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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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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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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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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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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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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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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



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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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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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



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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



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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



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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



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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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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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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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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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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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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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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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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.

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