Econ 135

Front 1

Over determination

Back 1

 It is the idea that stock prices are caused by lots of factors, such as the company’s earnings performance, the prior expectation of investors and the general market condition.
 Although we may identify some trends in a company, we can’t single out just one factor (as many business newspapers do) and say only this factor causes the stock to rise or fall

Front 2

Secular bull market

Back 2

a bull market occurs over many years

Front 3

Leverage

Back 3

 Borrow money to do investment. When the market is up, the rate of return to equity can be “leveraged” or magnified. However, when the market is down, the loss will also be magnified.
 If the leverage ratio is very high, then even a small decline of the market price is able to wipe out all the equity, thus leading to bankruptcy.

Front 4

Counterparty Risk

Back 4

 The risk to each party of a contract that the counterparty will not live up to its contractual obligations.
 For example, Lehman Brothers serve as insurers of many bonds. Therefore, when Lehman Brothers filed for bankruptcy, it has risk for those who get the insurance, which are holders of bonds.
 Banks are worried about other banks that set up these SIVs. Actually some of them collapsed e.g. UK Northern Rock. And UBS and Citibank take huge write-off. So, they hesitate to extend loans to other banks. This is the concern about counterparty risk. Note that this can have chain effects, spreading to the whole financial system.

Front 5

Bull Market

Back 5

 When the stock market is going up, usually an increase of more than 20%. It is an extended period of higher-high and higher-low

Front 6

Correction

Back 6

 A 10-20% decline during a bull market

Front 7

Bear Market

Back 7

 When the stock market is going down, usually by more than 20%

Front 8

Short Sale

Back 8

 Normally people buy stocks, and then sell them later.
 But in short sale, people sell stocks first, and then buy.
 People who short sell expect the stock price to go down, so that they can buy the stock at a lower price after they sell it.
 Note that if the stock price increases, short-selling will have a loss. The potential loss of short sale is unlimited.

Front 9

Total Return

Back 9

 = capital gains + dividend yield
 Historically, dividend yield is an important part of total returns.



 percent of price increase + dividend yield over 1 year
 Example: a stock has dividend yield 4% and its price increase is 10%. Then, its total return = 14%

Front 10

EPS

Back 10

 a company’s earnings divided by the number of outstanding shares
 Note: Earnings = Revenue – All costs. It’s also known as corporate profit.
 e.g. Co. A earns $800m, and has 400m shares. Then its EPS = $2

Front 11

Shareholders’ equity

Back 11

 = total assets – total liabilities

Front 12

Book Value (BV)

Back 12

 = stockholders’ equity / Number of shares outstanding
 BV gives you liquidation value
 For some companies (e.g. real estate companies), BV is a key indicator. For example, if stock price = 1/2 of BV, then the stock looks attractive.
 For companies with huge intellectual capital (e.g. patents), BV is not so important (e.g. Microsoft)

Front 13

PEG ratio

Back 13

 = PE ratio divided by earnings growth rate
 Example: PE = 12, and Earning Growth = 15%. Then, PEG = 12/ 15 = 0.8
 Rule of thumb: PEG below one is usually attractive

Front 14

Payout ratio

Back 14

 The percent of earnings paid out to investors
 = Dividend per share/ Earnings per share

Front 15

Value Stocks

Back 15

 Stocks with low PE ratios and/or low price-book ratio

Front 16

GAAP earnings

Back 16

 GAAP earnings: reported earnings based on the Generally Accepted Accounting Principles
 It may not be relevant to stock investment because it includes many one-time and unrepeatable earnings items

Front 17

Operating earnings

Back 17

based on on-going revenues and expenses. It is adjusted for one-time events

Front 18

Company with good earnings quality

Back 18

minimize special (one-time) events and benefits.

Front 19

Derivatives

Back 19

 financial assets whose prices are based on the prices of other financial assets
 Examples: call options, put options, stock futures, warrants, credit default swaps

Front 20

Call Option

Back 20

 A security that gives you the right (but not the obligation) to buy a stock at a specified price by a specified date.
 If you believe a stock will go up, you can buy the call option of the stock, instead of the stock itself.

Front 21

Put Option

Back 21

 It is a mirror image of call option.
 It gives you the right (but not the obligation) to sell stocks at a specific price until a specific date.
 You can hedge against the downside risk of your stock holding by buying a put option

Front 22

LEAPS

Back 22

 Long-Term Equity Anticipation Securities - LEAPS
 Publicly traded options with expiration dates are longer than one year. Structurally, LEAPS are no different than short-term options, but the later expiration dates offer the opportunity for long-term investors to gain exposure to prolonged price changes without needing to use a combination of shorter-term option contracts.
 The premiums for LEAPs are higher than for standard options in the same stock because the increased expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit.
 LEAPS are an excellent way for a longer-term trader to gain exposure to a prolonged trend in a given security without having to roll several short-term contracts

Front 23

REITs

Back 23

 Real Estate Investment Trusts
 A security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.
 Some REITs invest in shopping malls, office buildings, apartments, warehouses and hotels. Some REITs will invest specifically in one area of real estate, e.g. shopping malls
 REITs avoid taxation at corporate level if they pass at least 90% of their income to shareholders. Therefore, it avoids double taxation.
 REITs typically offer high yields, as well as a highly liquid way of investing in real estate.

Front 24

Short Selling

Back 24

 Normally people buy stocks, and then sell them later.
 But in short sale, people sell stocks first, and then buy.
 People who short sell expect the stock price to go down, so that they can buy the stock at a lower price after they sell it.
 Note that if the stock price increases, short-selling will have a loss. The potential loss of short sale is unlimited.

Front 25

Margin Buying

Back 25

 Borrow money to buy stocks, so that you can buy stocks with less than the full amount of money required
 Margin buying can be very risky because both gains and losses are amplified. While the potential for greater profit exists, this comes at a price - the potential for greater losses.
 When the stock price falls below a limit, margin buyers will receive margin calls, i.e. to deposit more money into their margin accounts.

Front 26

Leverage (Final)

Back 26

 The use of borrowed money to increase the potential return of an investment.
 Margin buying is an example of using leverage
 Leverage can be created through options, futures, margin and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of ABC stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.
 Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity.

Front 27

Contrarian Investing

Back 27

 To do the opposite as most investors do.
 For example, sell stocks when the market has a parabolic rise. The logic is that at this moment the buyers have used up their “buying power”. Therefore, the rise is unlikely to continue.
 It is most useful when the market condition is extreme – extremely bullish or extremely panic.

Front 28

Value Investing

Back 28

 A way of investing which focuses on value stocks, i.e. stocks with relatively low PE ratios, PEG ratios or price-to-book ratios.
 Historical records show that in the long run, value investing outperforms growth-stock investing.

Front 29

Asset Allocation

Back 29

 Allocation of funds into different asset classes (e.g. stocks, bonds and cash)
 A “normal” allocation may be 60% in stocks, 30% in bonds and 10% in cash
 The actual allocation depends on market condition. Usually when the economic outlook is good, more stocks and less bonds/ cash. If economic outlook is not good, just do the opposite.

Front 30

GARP Strategy (Growth at a Reasonable Price)

Back 30

 An investment strategy to both growth investing and value investing to find individual stocks.
 GARP investors look for companies that are showing consistent earnings growth above broad market levels while excluding companies that have very high valuations
 The overarching goal is to avoid the extremes of either growth or value investing; this typically leads GARP investors to growth-oriented stocks with relatively low price/earnings (P/E) multiples in normal market conditions.
 In a bear market, the returns of GARP investors to be higher than those of pure growth investors, but subpar to strict value investors who generally purchase shares at P/Es under broad market multiples.
 PEG ratio is a useful tool for this strategy

Front 31

Beige Book

Back 31

 A Federal Reserve economic report published 8 times per year.
 Each Federal Reserve Bank gathers anecdotal information on current economic conditions in its District through reports from Bank and Branch directors and interviews with key business contacts, economists, market experts, and other sources. The Beige Book summarizes this information by District and sector.
 The Beige Book is a key source of information for Federal Reserve monetary policy meetings.
 It is released 2 weeks prior to each monetary policy meeting

Front 32

Consumer Sentiment

Back 32

 Consumer confidence and outlook for the future.
 Typically consumers will spend more if consumer sentiment is high, and spend less when consumer sentiment is low

Front 33

Window Dressing

Back 33

 The practice of fund managers to buy the best-performing stocks and sell the worst-performing stocks in the reporting period, just before the ending of the reporting period. The objective is to make their portfolio holdings look impressive.
 Because of window dressing, the best performing stocks tend to rise by the end of the reporting period (e.g. quarter end, year end, etc.). On the other hand, the worst-performing stocks tend to decrease.

Front 34

Moving Average

Back 34

 the average value of a stock’s price over a set period (e.g. 10 days, 50 days).
 An indicator frequently used in technical analysis showing possible support and resistance.
 Typically, upward momentum is confirmed when a short-term average (e.g.15-day) crosses above a longer-term average (e.g. 50-day). Downward momentum is confirmed when a short-term average crosses below a long-term average.

Front 35

Investor Sentiment

Back 35

 The outlook of investors about the stock markets.
 If investor sentiment is high, stock market tends to rise. If sentiment is low, stock markets usually perform poorly.

Front 36

Stockholders vs. Stakeholders Interests

Back 36

 Stockholders care about maximizing EPS
 Stakeholders: e.g. senior managers of the company, general employees of the company, suppliers of the company.
 Usually the stakeholders have different interests than those of shareholders. For example, employees care about their salaries and benefits.

Front 37

Operating EPS

Back 37

 Operating earnings: based on on-going revenues and expenses. It is adjusted for one-time events
 Compared with GAAP EPS, operating EPS usually has a higher quality of earnings, because it better measures the underlying business performance of a company.

Front 38

GAAP EPS

Back 38

 EPS according to the GAAP accounting rules
 It is the EPS as reported by companies
 It does not make adjustment to one-off items. Therefore, it is less useful than operating earnings, which exclude all the non-repeatable items.

Front 39

Fed Model of market valuation

Back 39

 This model believes that returns on long-term government bond yields should be similar to the S&P 500 earnings yield. Differences in these returns identify an over-priced or under-priced securities market.
 Earnings yield much greater than LT govt. bond yields  stocks undervalued
 Earnings yield much smaller than LT govt. bond yields  stocks overvalued
 Now, PE ratio of S&P 500 index is about 12
 Therefore, earnings yield is about 8% (=1/12)
 LT govt. bond yield is about 3%
 Therefore, stocks are quite undervalued relative to LT govt. bonds.

Front 40

Correction

Back 40

 Decrease of stock prices, usually after a prolonged period of rallies so that the stock is over valued

Front 41

Technical Analysis

Back 41

 Analysis of a company ONLY based on its past stock prices and trading volumes
 Usually look at the chart pattern of the stock prices & volumes

Front 42

Fundamental Analysis

Back 42

 Includes everything not covered by technical analysis
 Examples: a company’s earnings outlook, cost of production, debt levels, competitors’ performance, changes in laws and regulations, effect of foreign exchange rates, etc

Front 43

Efficient Market Hypothesis (EMH)

Back 43

 Everything publicly knowable about the company is immediately reflected into the stock price. Only new information will change the stock price.
 According to EMH, technical analysis is worthless, because past stock-price performance does not give you any new information.

Front 44

Pricing Power

Back 44

 It is the ability of a company to charge a price higher than the one in a perfectly competitive market.
 For industries with high barriers to entry, the companies are usually in a good position to charge a high price. This ability is usually favorable to its shareholders

Front 45

Impact of Rising Interest Rates on the Stock Market

Back 45

 Higher interest rates are typically harmful to the stock markets for the following reasons:
 (1) Higher rates will discourage economic activities, notably those interest-sensitive ones (e.g. housing market, automobiles, durable goods). This will mean slower economic growth, thus resulting in slowdown of corporate earnings growth.
 (2) Money can be attracted from stocks into bond markets (because of higher opportunity cost)
 (3) Corporate interest expenses rise (and therefore profits fall).
 (4) Higher rates discourage margin buying, because the margin buyers have to bear a higher interest costs.

Front 46

“What’s good for Main Street is bad for Wall Street

Back 46

 For example, strong economic growth and job market are good for Main Street firms and consumers. But this good news may mean higher inflationary threat in coming months. The threat of inflation will prompt the Federal Reserve to raise interest rates, because it is a mandate of the Fed to control inflation. And higher interest rates will be harmful to the stock markets. That is why it is bad for Wall Street.
 The opposite is also true. Suppose economic growth is slowing down and job market deteriorates. This will be bad for Main Street. However, stock investors may expect the Fed to cut interest rates so as to stimulate economic growth. Lower interest rates are usually positive news for stock markets.
 It is true to some extent. But we should not take it to the extreme. For example, in this economic downturn, interest rates are already close to zero. Even if you have more bad news to Main Street, it is unlikely to see substantial decrease in interest rates.

Front 47

Primary Economic Indicators Influencing Stock Prices

Back 47

 Financial markets respond to economic data. The response depends on what happen to the economy/ market condition. For example, if the economy is weak, and economic data indicates weakness, then there is reason for sell-off.
 Market response also depends on market expectation prior to the releases of these economic data
 Market focus: how would the Federal Reserve do with these data?
 The economic figures are subject to later revisions, which can be quite substantial.
 In short, there is no simple rules to interpret these economic data

Front 48

Book Value (BV)

Back 48

 = stockholders’ equity / Number of shares outstanding
 Note: stockholders’ equity = assets – liabilities
 BV gives you liquidation value
 For some companies (e.g. real estate companies), BV is a key indicator. For example, if stock price = 1/2 of BV, then the stock looks attractive.
 For companies with huge intellectual capital (e.g. patents), BV is not so important (e.g. Microsoft)

Front 49

Secular Bull/Bear Market

Back 49

 A relatively long term of the market to go up (bull market) or go down (bear market)

Front 50

Earnings Quality

Back 50

 Quality of earnings is more important that the amount of earnings. For example, Co. A and Co. B both have sales $150m and operating expenses $30m. But A made no R&D investment, and B made $100m R&D investment. A’s earnings (or EPS) would be higher than B. But B’s growth outlook is better.
 The quality of earnings for GAAP earnings may be doubtful. It is because it may not be relevant to stock investment because it includes many one-time and unrepeatable earnings items
 Company with good earnings quality: minimize special (one-time) events and benefits.
 Banks can manage earnings by adding different amounts to loan loss reserves. For example, they can under-estimate the seriousness of non-performing loans and then charge a lower amount in the loan loss reserves account so that the bottom line earnings look better.
 It includes non-recurring items (e.g. a company selling its headquarters building for $100m)  lesson: focus on operating earnings or recurring earnings
 (Please refer to Siegel p. 108-109 for more examples about “Earnings Quality”)
 Another example of earnings quality that is not good: General Electric reported its quarterly earnings. But a large portion of the earnings is due to “tax benefits” that is unlikely to be repeatable. This type of earnings quality is not good.