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MACROECONOMICS-The Government’s Influence Over our Investment Success

You’ve screened your stocks both fundamentally and technically. You been diligent to only select equities in the greatest performing industries. Even subtle decisions like factoring in earnings reports and companies that report same store monthly retail sales cannot guarantee that an equity will appreciate in value. The reality is that there are a litany of factors that cannot be quantified by our computers that can influence the successes and failures of our investments. Market psychology and globalization are two factors many of you have heard me talk about during my seminars and in my book. Certainly, the study of the economy as a whole or macroeconomics is something all investors should be familiar with. I decided to make this the topic of my most recent article because of what transpired this past Wednesday.Here’s what happened:

The Federal Reserve announced a 1/2% rate cut in the Fed Funds Rate to 1% and a 1/2% rate cut in the Discount Rate to 1.25%. The market was strong prior to the announcement because it anticipated this exact decision. So instead of going up even more once confirmed, the market went down; then up; then down again; then down dramatically; and finally back up slightly to finally end the day down 74 points. I was so dizzy from watching these market fluctuations that I thought I was developing an inner ear infection. As I was reaching for a bottle of Amoxicillin, I had the calming thought that this was, in fact, only the third time in October that the blue chips had JUST a double-digit loss.

So what’s up with Fed Funds and Discount Rates and why are they so important that CNBC even had a count-down timer in the lower right portion of the screen leading up to the announcement? It certainly wasn’t important enough for the financial media to explain to the average investor (Joe the Plumber?) what this all means. They don’t speak to us; we’re not the folks with the big bucks. Sometimes I think they should have some guy with a sign exlaining the terminology being thrown around on these shows. This could be analogous to the signers for the hearing impaired. Joe Kernen throws out the term Keynesian economics, Becky Quick cracks up at the reference, and Sid the sign guy shows us the definition….could work.

I should give credit to Jim Cramer who stated to his viewers that evening, “today’s rate cut means individuals and businesses will find it cheaper to borrow money because the federal funds rate is tied to the banks’ prime rate”. But he also tells us to do our homework. In my view, this applies to macroecenomics as well as individual stocks.

Let’s take a Blue Collar look at macroeconomics and give some meaning to what transpired on Wednesday. The U.S. Government has a myriad of tools and policies that it can utilize to manage the economy. They fall under two general categories:

FISCAL POLICIES:

The government’s taxation and spending programs designed to promote economic growth and maintain high levels of employment. Much of this policy is based on the Keynesian economic theory alluded to above. It states that greater government spending is needed during economic downturns and that higher levels of taxation are called for during times of expansion. The former would combat insufficient private demand and head off a path to recession and the latter would hedge against inflation. Currently both presidential candidates are calling for decreased taxes thereby allowing consumers to spend more and stimulate our sagging economy.

MONETARY POLICIES:

These are methods used by our central bank to control the money supply. This will impact interest rates, inflation, and therefore the economy. Here are the key players:

1- The Federal Reserve System (the Fed): The central bank of the U.S. consisting of 12 regional Federal Reserve banks and numerous member banks. All are under the supervision of the Federal Reserve Board which formulates and executes monetary policy. Fed policies have immediate and significant economic impact and therefore are closely watched by investors like ourselves.

2- The Money Supply: Broken down into categories based on the degree of liquidity:

 – M1- currency in circulation plus demand deposits(like checking accounts).
 – M2- all money in M1 plus time deposits under $100,000 (CDs, savingsetc.).
 – M3- all money in M2 plus time deposits over $100,000 and some institutional
              holdings.

The value of money is determied by supply and demand.  If supply is too great, the value of money declines thereby driving up prices and interest rates. The Fed has numerous tools to control the money supply. One is Reserve Requirements.

3- Reserve Requirements: The % of customer deposits that commercial banks must maintain in cash as mandated by the Fed. By lowering the reserve requirement, the Fed can increase the amount of money that banks can lend, thereby increasing the amount of money in the economy. Conversely, raising the reserve requirement will shrink the money supply.

4- Federal Funds (Fed funds): Money lent or borrowed overnight between banks in order to meet their reserve requirements. The rate at which these funds are lent is known as the Fed funds rate (Wednesday lowered to 1%). The Fed establishes a “target” Fed funds rate and increases or decreases the money supply to move the actual rate closer to the target. The Fed can also influence the money supply by altering the Discount Rate.

5- Discount Rate: This is the rate at which the Fed itself loans money to banks that are members of the Federal Reserve System. On Wednesday it was dropped to 1.25%.  These are the lowest rates available in the economy. Banks then set their own rates at a level above discount. By raising or lowering discount rates, the Fed influences the degree of difficulty for businesses to borrow money. Investors get a look into the Fed’s evaluation of our economy based on it’s decisions regarding discount rate.. The Fed can also control money supply on a daily basis via open market operations.

6- Open Market Operations: This refers to the Fed’s purchases and sales of government securities in order to adjust the money supply. When the Fed buys Treasury securities from banker-dealers, money is injected into the banking system. When the Fed sells them back, money is withdrawn from the banks. If the economy is expanding too rapidly and inflation is becoming an issue, the Fed might raise interest rates. If the economy is in (or heading towards) a recession (hello!) the Fed can lower interest rates in an effort to encourage new borrowing which will lead to renewed growth. That is precisely what we encountered on Wednesday.

Click on the link below to see a chart summarizing the above discussion:

federal-reserve-actions-and-consequences

  

Monitoring the Health of the Stock Market: 

 Last week I responded to a readers question about what I look for in market conditions before I started selling options again. Here was my response:

A- I am looking for an upturn in the housing and financial sectors as well as a loosening of credit requirements. Once this occurs, there is a strong likelihood that the institutional investors will start re-investing all that cash that is currently on the sidelines. One technical indicator I check is the VIX which is the Volatility Index that tracks the S&P 500. It is a measurement of market risk and is often referred to as the “investor fear gauge”. Values greater than 30 is indicative of investor fear and uncertainty while values under 20 infer calmer, less stressful times in the market. Needless to say, the current chart below is above 30 and approaching the planet Pluto! Use the ticker symbol $VIX to pull up the chart:

VIX 10-25-08

VIX 10-25-08

 

Now take a look at the chart of the VIX as of now. You see a dramatic improvement and thus a positive sign:
VIX 10-31-08

VIX 10-31-08

 

I have also prepared for you the charts of the housing and financial industries which are improving but still need some work:
Housing and Building Services 10-31-08

Housing and Building Services 10-31-08

Financial Services 10-31-08

Financial Services 10-31-08

 

Financial Services seems to be strengthening first. That makes sense to me as money has to be available before builders have the financing to get back to work and consumers can get the financing to buy their homes. Let’s continue to monitor the markets together. Whether you use the same parameters that I use or others, this sure is a better way to plan your strategy than to hope and pray or completely depend on others. As I say adnauseam, I listen to EVERYONE collectively, but NO ONE individually.
________________________________________________________________________________________________
Last Week’s Economic News:
___________________________
GDP declined .3% for the third quarter, the worst performance in 7 years. By technical terms we are NOT yet in a recession since the first two quarters rebounded after a contraction in the fourth quarter of 2007. For a true recession, we need two consecutive quarters of negative GDP growth (some economists differ on the precise definition of a recession). Consumer confidence fell to an all-time low. On two positive notes, new-home sales rose 2.7% (although prices kept falling) and durable goods orders got a boost from the airline industry.
_________________________________________________________________________________________________
Industries in the Spotlight:
________________________
In the last several weeks a few industries starting showing some strength:
Schools
    DV
Railroads
    NSC
     GWR
Although I’m not ready to jump in, keep your eye on Financial-Investment banks and Services, an industry surging of late:
     SF
————————————————————————————-
Looking forward to hearing from you,
Alan

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

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5 Responses to “MACROECONOMICS-The Government’s Influence Over our Investment Success”

  1. Dennis November 1, 2008 10:24 pm #

    Hi Alan,

    I just purchased your book on this yesterday and I am looking forward to reading it. Keep up the good work by looking out for us “little guys and gals.”

    I have one question though, are the CD’s for listening only or do they have graphics on them? I am trying to decide if I should get the CD’s or the DVD’s, along with the Companion Book after I read your book.

  2. admin November 1, 2008 11:20 pm #

    Hi Dennis,

    Your book was shipped yesterday to your home state of Wisconsin. It is the power of education that will make us “little guys and gals” forces to be reckoned with.

    The CDs are audio only. The DVDs are filmed presentations of 4- three hour seminars I hosted along with a 1-on-1 coaching DVD where I perform my methodology in real time. The Companion Workbook contains all charts, graphs, and slides referenced in those seminars.

    Welcome to our family of Blue Collar Investors and we look foward to hearing about your future successes.

    Alan

  3. admin November 2, 2008 6:12 pm #

    Email question from Dennis:

    I saw an article in the Motley Fool that is over a year old. I saw some comments to the article later on favoring Covered Call Writing from this year. I am curious on your take of the article. Here is the article:

    http://www.fool.com/investing/dividends-income/2007/07/12/stay-away-from-covered-calls.aspx

    My response:

    I did see this article previously as it was brought to my attention by other Blue collar Investors. Over the years, there have been other similar commentaries on cc strategies. I never tell others how to invest their hard-earned money. I simply relate how I invest mine. Bottom line….I respect other points of view and then do what works for me based on my own decisions. That being said, consider these points:

    1- The article is based on a buy-and-hold portfolio. My portfolio turns over 20-80% each month based on my system criteria. If we had purchased GM (one of our country’s greatest blue-chip companies) in 1953, we would actually be losing money 55 years later. So much for buy-and-hold portfolios.

    2- It references selling predominantly out-of-the-money strike prices. This is way too limiting an approach as market conditions and technical analysis may CRY for selling an in-the-money strikes.

    3- It speaks to paying excessive commissions. For the educated investor who knows what he or she is doing, a discount-online broker will suffice. I pay $5.95 per trade (slightly more for options). Commissions are a NON-EVENT. Next….

    4- It talks about giving up price appreciation… the first valid point. But this is the only major disadvantage of this strategy and, in my view, the positives far outweigh the one negative.

    5- Regarding the Reliance example: Your calls would be exercised only if you allow this to happen. If you choose not to allow assignment, simply buy-back the option and you will still own the stock. It is possible for assignment to occur before the expiration date. This is rare but should it happen, you can simply buy back the shares (if it makes sense to do so) or use the cash for another stock. Smart investors never fall in love with a stock, just the deal.

    6- Regarding taxes: I currently do my cc trading in sheltered accounts….no tax consequences at this time. If you need the cash right away, be happy to pay the tax for profits hard to generate with other strategies.

    7- If an expert recommends only stocks that they don’t expect to rise dramatically for this strategy, the term “expert” should be forever expunged from their resume. If you buy a stock @ $58 and sell the $60 call, and you earn a 1-month return of 6%, who cares if the stock went to $65. I’m happy with the 6%. How would you feel?

    To sum up, I suggest investors never follow the edict of one person and that includes me. This is an example of an article that comes to a strong conclusion without considering other critical elements. I have every confidence that by paper-trading the cc strategy, you will come to the right decision for your investment future.

    Alan

  4. admin November 4, 2008 11:53 am #

    Those of you following the overall tone of the market know that the volatility index is one of the criteria I look at (see above). Today the VIX hit a 1-month low which is a positive, reflecting a calming of emotions by investors. You can follow the VIX by typing in the ticker symbol $VIX. In an ideal world, we would like to see it drop below 20. Currently, it is not there yet but certainly heading in the right direction.

    Alan

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  1. RECESSION- A NORMAL Part of the Business Cycle - November 23, 2008

    […] horrific predicament our economy is currently experiencing. I recently wrote an article entitled MACROECONOMICS-The Government’s Influence Over our Investment Success that has received national attention from Reuters. This exposure, along with the feedback that I […]

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