Markets Cheer Calls to Overhaul Global Finance
By Bruce Crumley / Paris Monday, Oct. 20, 2008
In normal times, a French President's call for an overhaul of the world's financial system would cause eye-rolling and dyspepsia among the world's free market purists. But these are not normal times: on the weekend, U.S. President George W. Bush echoed Nicolas Sarkozy's push for an international summit to that end, and on Monday world markets seemed to endorse the initiative with a positive fillip. Though the specific goals, attendees, and even exact date and venue of such a meeting have yet to be determined, the mere agreement by U.S. and European leaders to update the Bretton Woods system — which has overseen international finance for the past 64 years — reaffirmed hopes that a collective, long-term approach to the worst economic crisis since the Great Depression was on the way.
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Alongside European Commission President José Manuel Barroso, Bush and Sarkozy called world leaders to join them at a monumental summit meeting in a U.S. city — probably at the United Nations in New York — shortly after the Nov. 4 U.S. presidential election. Following their huddle at Camp David Saturday, the trio issued a statement saying the extraordinary international congress would "review progress being made to address the current crisis and to seek agreement on principles of reform needed to avoid a repetition and assure global prosperity in the future."
That language scarcely matches the drama of the world financial crisis, but it did at least contribute to the modest optimism with which markets have attacked a new week of trading. Japan's Nikkei index climbed 3.6%, Hong Kong's Hang Seng rose 5.3%, and South Korea's Kospi jumped for the first time in a week: a 2.3% hike inspired in part by a $130 billion government assistance plan for banks announced in Seoul on Sunday.
Europe's leading bourses also began stronger, with London's FTSE 100 1.67% higher nearing mid-day Monday, while Paris CAC 40 gained 1.46% and Frankfurt's DAX up .8%. Futures trading in the U.S. similarly pointed to 2.4% opening advance Monday on Wall Street, though that early action could change as a series of company earnings figures are released, giving investors a better idea of how quickly U.S. economic growth has slowed.
Fears of a serious economic decline or even recession in the U.S. and world-wide explain the deep losses markets experienced last week after initially reacting with euphoria to the rash of government efforts to prevent finance and banking systems from imploding. As the week closed out, the global outlook was simply confused, as European indices generally finished higher, the Dow slumped 1.4%, and Asia's national markets featured both gains and losses.
Despite Monday's mostly rosier mood, there were developments that could have given markets as much to choke on than cheer about. Over the weekend the heads of French savings bank Caisses d'Epargne were forced to resign following revelations that unauthorized derivatives trading last week produced a $810 million loss. On Sunday, meanwhile, the Netherlands said it would inject a further $13.5 billion into troubled finance company ING — another indication that European banks may not yet have entirely accounted for all the toxic debt they assumed.
Still, markets were more inclined to take heart in the international summit agreement Sarkozy had obtained from Bush. Despite that advance, questions remain how much the U.S. and its free-market fans will the more invasive regulatory approach that Europe seems to favor. Even as they face dire economic crisis, Americans are quicker than Continentals to distrust perceived market "socialism." Indeed, even Bush and Sarkozy seemed to clash Saturday in how each weighed the virtues of regulation against the liberty of markets.
Not that it seemed to matter. "The fact that these are two conservative politicians that business leaders feel they can trust had a lot of impact," says French economist Bernard Maris, who also thinks markets were comforted by the decision to hold the conference in the U.S. — with an eye to historical continuity with the 1944 conference in Bretton Woods, NH, that established the International Monetary Fund. But Maris also notes those same markets — whose boom years relied largely on minimalist regulation — should logically be freaking out at Sarkozy's calls to "moralize" finance and limit pay to the world's biggest earners. So why the calm?
"For now, markets are getting into life boats on the short-term imperative of saving their lives, and will work to restore 'good old days' rules once the economy is back on solid ground," Maris says. "There is a school of thought that the best way of doing nothing at all is to demand everything be changed — and what we've been hearing from Sarkozy and Bush has been totally counter to what they'd constantly maintained before." Perhaps for that reason, the new tone hasn't struck fear into the markets, but there are still plenty of grounds for volatility as further details are worked out.
http://www.time.com/time/business/article/0,8599,1851963,00.html?xid=rss-business
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Thursday, 1 January 2009
A Brief History of Bretton Woods System
Delegates attend the Bretton Woods conference in July of 1944 at the Mt. Washington Hotel in Bretton Woods, New HampshireAlfred Eisenstaedt / Time & Life Pictures / Getty
A Brief History of
Bretton Woods System
By M.J. Stephey Tuesday, Oct. 21, 2008
time:http://www.time.com/time/business/article/0,8599,1852254,00.html
Bretton Woods System
By M.J. Stephey Tuesday, Oct. 21, 2008
time:http://www.time.com/time/business/article/0,8599,1852254,00.html
Since the end of World War II, the U.S. dollar has enjoyed a unique and powerful position in international trade. But perhaps no more.
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Before boarding a plane on Saturday to meet President George W. Bush, French President Nicolas Sarkozy proclaimed, "Europe wants it. Europe demands it. Europe will get it." The "it" here is global financial reform, and evidently Sarkozy won't have to wait long. Just hours after their closed-door meeting had finished, Bush and Sarkozy, along with European Commission President Jose Manuel Barroso, issued a joint statement announcing that a summit would be held next month to devise what Barroso calls a "new global financial order."
The old global financial order is, well, old. Established in 1944 and named after the New Hampshire town where the agreements were drawn up, the Bretton Woods system created an international basis for exchanging one currency for another. It also led to the creation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development, now known as the World Bank.
The former was designed to monitor exchange rates and lend reserve currencies to nations with trade deficits, the latter to provide underdeveloped nations with needed capital — although each institution's role has changed over time. Each of the 44 nations who joined the discussions contributed a membership fee, of sorts, to fund these institutions; the amount of each contribution designated a country's economic ability and dictated its number of votes.
In an effort to free international trade and fund postwar reconstruction, the member states agreed to fix their exchange rates by tying their currencies to the U.S. dollar. American politicians, meanwhile, assured the rest of the world that its currency was dependable by linking the U.S. dollar to gold; $1 equaled 35 oz. of bullion. Nations also agreed to buy and sell U.S. dollars to keep their currencies within 1% of the fixed rate. And thus the golden age of the U.S. dollar began.
For his part, legendary British economist John Maynard Keynes, who drafted much of the plan, called it "the exact opposite of the gold standard," saying the negotiated monetary system would be whatever the controlling nations wished to make of it. Keynes had even gone so far as to propose a single, global currency that wouldn't be tied to either gold or politics. (He lost that argument).
Though it came on the heels of the Great Depression and the beginning of the end of World War II, the Bretton Woods system addressed global ills that began as early as the first World War, when governments (including the U.S.) began controlling imports and exports to offset wartime blockades. This, in turn, led to the manipulation of currencies to shape foreign trade. Currency warfare and restrictive market practices helped spark the devaluation, deflation and depression that defined the economy of the 1930s.
The Bretton Woods system itself collapsed in 1971, when President Richard Nixon severed the link between the dollar and gold — a decision made to prevent a run on Fort Knox, which contained only a third of the gold bullion necessary to cover the amount of dollars in foreign hands. By 1973, most major world economies had allowed their currencies to float freely against the dollar. It was a rocky transition, characterized by plummeting stock prices, skyrocketing oil prices, bank failures and inflation.
It seems the East Coast might yet again be the backdrop for a massive overhaul of the world's financial playbook.
It seems the East Coast might yet again be the backdrop for a massive overhaul of the world's financial playbook.
U.N. Secretary-General Ban Ki-moon publicly backed calls for a summit before the new year, saying the agency's headquarters in New York — the very "symbol of multilateralism" — should play host. Sarkozy concurred, but for different reasons: "Insofar as the crisis began in New York," he said, "then the global solution must be found to this crisis in New York."
**Consumer Confidence: A Killer Statistic
Consumer Confidence: A Killer Statistic
by Investopedia Staff, (Investopedia.com) (Contact Author Biography)
Story Tools
Consumer spending is the one key to any market economy. On the airwaves, there's never a shortage of data, analysis and cable commentary regarding consumer behavior. So what are the key fundamental consumption indicators in a good economy? How about in a bad economy? The following article will recap the vital economic indicators of overall consumption, outlining what trends to look for and when to look for them.
There is no doubt that consumer spending is the most vital component of any economy.
Why? Depending on the economy's sheer breadth, consumer spending can range anywhere from 50-75% of GDP. In the U.S. and most highly industrialized nations, this percentage is about 65% of total spending.
The first part of measuring total consumption is measuring consumer sentiment, which is derived completely from a consumer's standpoint.
Consumer Sentiment
The two numbers expressing consumers' feelings about the economy and their subsequent plans to make purchases are the Consumer Confidence Index, prepared by the Conference Board, and the Consumer Sentiment Index, prepared by the University of Michigan. Both indexes are based on a household survey and reported on a monthly basis. In analyzing any consumer sentiment index, it is most important to determine the trend of the index over several months. Simply put, the trend graphed out over four or five months is critical. Keeping this in mind, one needs to remain astute and block out news bits such as "the index is at 80 so things look gloomy" or "the level of consumer sentiment is up slightly from last month". The trend over several months - not a comparison of this month to the same month last year- is the undeniable benchmark. Commentary that focuses only on the single monthly figures, without looking at the developing trend, is misleading.
For many, the importance of the trends of consumer sentiment rests in the fact that the consumer sentiment indices originated in the middle of the 20th century, when it was safer to assume that the concept of the "typical" consumer was more homogeneous. Acknowledging this historical fact, as well as potential sampling bias and possible subjectivity across regions, the safe bet is to focus on trends forming some sort of linear progression, whether upwards or downwards, (or the progression can hit a general plateau, which sometimes happens when the economy shifts from stages in the business cycle).
Business Spending: A Leading Indicator
Though not as powerful an indicator as consumer spending, business capital spending can be a killer statistic - since things can get ugly in a hurry when overall business investment precipitously cuts back: the impact on the economy can be felt at an even faster pace than as if the cut occurred purely along consumer lines. The rationale is that today's sophisticated and large inventory-lean corporations often can gauge future demand before policy makers can implement changes, which often take months to kick in due to embedded policy lags.
Corporate spending is therefore very similar today to the role the stock market has played in most recoveries: improvements can be foreseen as a leading indicator for things to come. On the flip-side, cutbacks in corporate capital spending are indeed an ominous indicator.
The PMI, or Purchasing Managers Index, is a representation of the progress in corporate spending. For analyzing consumer spending, ascertainable trends are more telling than actual figures. The opposite is true for analyzing corporate spending through the PMI: there is a concrete threshold level for analyzing corporate investment spending and subsequent production. A PMI below 50 designates a contracting manufacturing sector, while above 50 highlights expansion across corporate spending and investment. Obviously, clear awareness of the current trend analysis is always better than a stand-alone result; nevertheless, the 50 threshold can be utilized as a simple benchmark to assess corporate activity.
In good times, the index is roaring in the high 50s, while in slow times the index can fall towards the low 40s.
Other Spending Items
There are other spending indicators, such as purchases of durable goods orders and overall auto sales; however, in terms of aggregating the data, these metrics are narrowly defined extensions of overall individual consumption. Trends across personal consumption will usually be reflected and correlated across these two metrics as well as others.
For instance, during the end of 2001, while the world economy was suffering on many fronts, steady consumer spending helped fuel auto sales that originated from generous no-financing from Detroit. This stimulus ultimately helped erode the three-quarter recession that had developed from the beginning of the year. Awareness of these symbols of consumption can give you more insight into exactly why and how consumption is impacting the economy. This awareness will help you judge the sustainability of these trends.
From a pure corporate standpoint, auxiliary spending, besides durable orders and big-ticket items such as auto purchases, can often indicate a great deal about overall corporate sentiment. Recall from above that the PMI for corporate spending is a definite quantitative measure, and the consumer sentiment index is a qualitative metric. In the eyes of large corporations and from a sheer qualitative standpoint, auxiliary spending on services such as advertising, consulting and information technology may reveal information about attitude and sentiment, just like the consumer sentiment indices reveal information about personal and individual consumption.
Just as a murky outlook will depress consumer sentiment, a weak forecast for the demand for goods and services will sidetrack corporate spending on auxiliary measures that can be budgeted away if necessary. The end-victims are advertising/marketing, media campaigns, consulting fees and information technology overhauls.
When the headlines indicate that layoffs and slowdowns are rampant in any of these fields, it can be safe to bet that corporate appetite for auxiliary spending is weak. Because the performance of these industries is largely tied to the level of corporate sentiment, a savvy investor should keep an eye out for companies within these industries and how they are performing.
Conclusion
Consumption is ultimately the stimulant behind almost every fundamental aspect of the worldwide economy. In sophisticated economies, the impact of consumption may be less than in emerging economies that are largely import-export driven, but the consumption magnitude is even more pronounced due to both a greater wealth effect and standard of living that enable individuals to spend more freely with disposable income.
The data for analyzing overall consumption contains many underlying factors. To scrutinize the daily volumes of indicators, focus on the indicators according to the above ranking system. This will help you capture the main elements and the interaction between the various areas of spending.
by Investopedia Staff, (Contact Author Biography)Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including more than 1,200 original and objective articles and tutorials on a wide variety of financial topics.
http://www.investopedia.com/articles/fundamental/103002.asp
by Investopedia Staff, (Investopedia.com) (Contact Author Biography)
Story Tools
Consumer spending is the one key to any market economy. On the airwaves, there's never a shortage of data, analysis and cable commentary regarding consumer behavior. So what are the key fundamental consumption indicators in a good economy? How about in a bad economy? The following article will recap the vital economic indicators of overall consumption, outlining what trends to look for and when to look for them.
There is no doubt that consumer spending is the most vital component of any economy.
Why? Depending on the economy's sheer breadth, consumer spending can range anywhere from 50-75% of GDP. In the U.S. and most highly industrialized nations, this percentage is about 65% of total spending.
The first part of measuring total consumption is measuring consumer sentiment, which is derived completely from a consumer's standpoint.
Consumer Sentiment
The two numbers expressing consumers' feelings about the economy and their subsequent plans to make purchases are the Consumer Confidence Index, prepared by the Conference Board, and the Consumer Sentiment Index, prepared by the University of Michigan. Both indexes are based on a household survey and reported on a monthly basis. In analyzing any consumer sentiment index, it is most important to determine the trend of the index over several months. Simply put, the trend graphed out over four or five months is critical. Keeping this in mind, one needs to remain astute and block out news bits such as "the index is at 80 so things look gloomy" or "the level of consumer sentiment is up slightly from last month". The trend over several months - not a comparison of this month to the same month last year- is the undeniable benchmark. Commentary that focuses only on the single monthly figures, without looking at the developing trend, is misleading.
For many, the importance of the trends of consumer sentiment rests in the fact that the consumer sentiment indices originated in the middle of the 20th century, when it was safer to assume that the concept of the "typical" consumer was more homogeneous. Acknowledging this historical fact, as well as potential sampling bias and possible subjectivity across regions, the safe bet is to focus on trends forming some sort of linear progression, whether upwards or downwards, (or the progression can hit a general plateau, which sometimes happens when the economy shifts from stages in the business cycle).
Business Spending: A Leading Indicator
Though not as powerful an indicator as consumer spending, business capital spending can be a killer statistic - since things can get ugly in a hurry when overall business investment precipitously cuts back: the impact on the economy can be felt at an even faster pace than as if the cut occurred purely along consumer lines. The rationale is that today's sophisticated and large inventory-lean corporations often can gauge future demand before policy makers can implement changes, which often take months to kick in due to embedded policy lags.
Corporate spending is therefore very similar today to the role the stock market has played in most recoveries: improvements can be foreseen as a leading indicator for things to come. On the flip-side, cutbacks in corporate capital spending are indeed an ominous indicator.
The PMI, or Purchasing Managers Index, is a representation of the progress in corporate spending. For analyzing consumer spending, ascertainable trends are more telling than actual figures. The opposite is true for analyzing corporate spending through the PMI: there is a concrete threshold level for analyzing corporate investment spending and subsequent production. A PMI below 50 designates a contracting manufacturing sector, while above 50 highlights expansion across corporate spending and investment. Obviously, clear awareness of the current trend analysis is always better than a stand-alone result; nevertheless, the 50 threshold can be utilized as a simple benchmark to assess corporate activity.
In good times, the index is roaring in the high 50s, while in slow times the index can fall towards the low 40s.
Other Spending Items
There are other spending indicators, such as purchases of durable goods orders and overall auto sales; however, in terms of aggregating the data, these metrics are narrowly defined extensions of overall individual consumption. Trends across personal consumption will usually be reflected and correlated across these two metrics as well as others.
For instance, during the end of 2001, while the world economy was suffering on many fronts, steady consumer spending helped fuel auto sales that originated from generous no-financing from Detroit. This stimulus ultimately helped erode the three-quarter recession that had developed from the beginning of the year. Awareness of these symbols of consumption can give you more insight into exactly why and how consumption is impacting the economy. This awareness will help you judge the sustainability of these trends.
From a pure corporate standpoint, auxiliary spending, besides durable orders and big-ticket items such as auto purchases, can often indicate a great deal about overall corporate sentiment. Recall from above that the PMI for corporate spending is a definite quantitative measure, and the consumer sentiment index is a qualitative metric. In the eyes of large corporations and from a sheer qualitative standpoint, auxiliary spending on services such as advertising, consulting and information technology may reveal information about attitude and sentiment, just like the consumer sentiment indices reveal information about personal and individual consumption.
Just as a murky outlook will depress consumer sentiment, a weak forecast for the demand for goods and services will sidetrack corporate spending on auxiliary measures that can be budgeted away if necessary. The end-victims are advertising/marketing, media campaigns, consulting fees and information technology overhauls.
When the headlines indicate that layoffs and slowdowns are rampant in any of these fields, it can be safe to bet that corporate appetite for auxiliary spending is weak. Because the performance of these industries is largely tied to the level of corporate sentiment, a savvy investor should keep an eye out for companies within these industries and how they are performing.
Conclusion
Consumption is ultimately the stimulant behind almost every fundamental aspect of the worldwide economy. In sophisticated economies, the impact of consumption may be less than in emerging economies that are largely import-export driven, but the consumption magnitude is even more pronounced due to both a greater wealth effect and standard of living that enable individuals to spend more freely with disposable income.
The data for analyzing overall consumption contains many underlying factors. To scrutinize the daily volumes of indicators, focus on the indicators according to the above ranking system. This will help you capture the main elements and the interaction between the various areas of spending.
by Investopedia Staff, (Contact Author Biography)Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including more than 1,200 original and objective articles and tutorials on a wide variety of financial topics.
http://www.investopedia.com/articles/fundamental/103002.asp
How do government issued stimulus checks improve the economy?
Investment Question
How do government issued stimulus checks improve the economy?
Stimulus checks are payments given to individuals by the government based on taxes paid in the previous year. The hope is that the recipients of these checks will increase spending, thus stimulating the economy.
So how does it improve the economy?
A slow economy will have less flow of capital. This means less people spend, less businesses get money and therefore the businesses can not pay wages. Some businesses might even layoff workers. This creates a bad cycle and a slower economy.
A good economy will have a higher flow of capital; residents spend more, businesses make money, and employ more people who spend more.
Of course economies are much more complex with factors, such as inflation, international sales and standard of living. (To learn more check out Economic Basics and Macroeconomic Analysis.)By infusing money into an economy the government is attempting to increase the spending habits of individuals and general consumer confidence.
Ideally they will go out and spend the money which will help businesses maintain adequate cash flows to pay their bills and employ their workers. If placed into a savings account the banks will be able to lend out more money to more spenders. If used to pay debts the stimulus check could reduce the risks of defaulting on loans. It is a short run solution, primarily used in a lagging economy.
(To read more on consumer confidence and how it affects the economy, read Consumer Confidence: A Killer Statistic.)
http://www.investopedia.com/ask/answers/08/stimulus-checks-economy.asp?ad=feat_fincrisis
How do government issued stimulus checks improve the economy?
Stimulus checks are payments given to individuals by the government based on taxes paid in the previous year. The hope is that the recipients of these checks will increase spending, thus stimulating the economy.
So how does it improve the economy?
A slow economy will have less flow of capital. This means less people spend, less businesses get money and therefore the businesses can not pay wages. Some businesses might even layoff workers. This creates a bad cycle and a slower economy.
A good economy will have a higher flow of capital; residents spend more, businesses make money, and employ more people who spend more.
Of course economies are much more complex with factors, such as inflation, international sales and standard of living. (To learn more check out Economic Basics and Macroeconomic Analysis.)By infusing money into an economy the government is attempting to increase the spending habits of individuals and general consumer confidence.
Ideally they will go out and spend the money which will help businesses maintain adequate cash flows to pay their bills and employ their workers. If placed into a savings account the banks will be able to lend out more money to more spenders. If used to pay debts the stimulus check could reduce the risks of defaulting on loans. It is a short run solution, primarily used in a lagging economy.
(To read more on consumer confidence and how it affects the economy, read Consumer Confidence: A Killer Statistic.)
http://www.investopedia.com/ask/answers/08/stimulus-checks-economy.asp?ad=feat_fincrisis
Recession-Proof Your Portfolio
Recession-Proof Your Portfolio
by Eric Petroff (Contact Author Biography)
While it would be utopian to have the economy grow at a stable rate, economic recessions are a fact of life and are as unavoidable as the setting of the sun. Like the sun, the economy goes through periods of rising (growth and expansion) and periods of setting (decline and recession).
In this article, we will look at how to properly invest as the economy moves through the setting phase - recession.
What is a Recession?
A recession can be defined as an extended period of significant decline in economic activity including negative gross domestic product (GDP) growth, faltering confidence on the part of consumers and businesses, weakening employment, falling real incomes, and weakening sales and production. This is not exactly the environment that would lead to higher stock prices or a sunny outlook on stocks.
Other aspects of recessionary environments as they relate to investments include a heightened risk aversion on the part of investors and a subsequent flight to safety. However, on the bright side, recessions do eventually lead to recoveries and follow a relatively predictable pattern of behavior along the way. (To read more about this, check out Recession: What Does It Mean To Investors?)
Keep an Eye on the Horizon
The real key to investing before, during and after a recession is to keep an eye on the big picture, as opposed to trying to time your way in and out of various market sectors, niches and individual stocks. Even though there is a lot of historical evidence of the cyclicality of certain investments throughout recessions, the fact of the matter is that this sort of investment acumen is beyond the scope of the ordinary investor. That said, there's no need to be discouraged because there are many ways an ordinary person can invest to protect and profit during these economic cycles. (To learn more about investing in cycles, read Understanding Cycles - The Key To Market Timing.)
To begin with, consider the macroeconomic issues of a recession and how they affect capital markets. When a recession hits, companies slow down business investment, consumers slow down their spending, and people's perceptions shift from being optimistic and expecting a continuation of recent good times to becoming pessimistic and uncertain about the future. As such, people get understandably frightened, become worried about prospective investment returns and rationally scale back risk in their portfolios. The results of these psychological factors manifest themselves in a few broad capital market trends.
Within equity markets, the results are pretty obvious. As people become uncertain about prospective earnings, they perceive a greater amount of risk in their investments, which broadly leads investors to require a higher potential rate of return for holding equities. Of course, for expected returns to go higher, current prices need to drop, which occurs as investors sell their higher risk investments and move into safer securities including government debt. This is why equity markets tend to fall, often precipitously, prior to recessions as investors shift their investments.
Recessions and Specific Investments
In fact, history shows us that equity markets have an uncanny ability to serve as a leading indicator for recessions. For example, the markets started a steep decline in mid-2000 before the economic recessionary period between March 2001 and November 2001. But even in a decline, there are pockets of relative outperformance to be found in equity markets.
Stocks
When investing in stocks during recessionary periods, the relatively safest places to invest are in high-quality companies with long business histories, as these should be companies that can handle prolonged periods of weakness in the market.
For example, companies with strong balance sheets, including those with little debt and strong cash flows, tend to do much better than companies with significant operating leverage (or debt) and poor cash flows. A company with a strong balance sheet/cash flow is better able to handle an economic downturn and should still be able to fund its operations as it moves through the weak economic times. In contrast, a company with a lot of debt may be damaged if it can't handle its debt payments and the costs associated with its continuing operations. (To learn how to read these documents, see What Is A Cash Flow Statement? and Breaking Down The Balance Sheet.)
Also, traditionally, one of the safe places in the equity market is consumer staples. These are typically the last products to be removed from a budget. In contrast, electronic retailers and other consumer discretionary companies can suffer as consumers hold off on these higher end purchases. (To learn more, read Cyclical Versus Non-Cyclical Stocks.)
Fixed Income
Fixed-income markets are no exception to this line of reasoning. Again, as investors become more concerned about risk, they tend to shy away from it. Practically speaking, this means investors steer clear of credit risk, meaning all corporate bonds (especially high-yield bond) and mortgage-backed securities because these investments have higher default rates than government securities.
Again, as the economy weakens, businesses have a more difficult time generating revenues and earnings, which can make debt repayment more difficult and could lead to bankruptcy as a worst case scenario.
Moreover, as investors sell these assets, they seek safety and move into U.S. Treasury bonds. In other words, the prices of risky bonds go down as people sell (or the yields increase) and the prices on Treasury bonds go up (or the yields decrease).
Commodities
Another area of investing you want to consider in the context of a recession is commodity markets. The general rule to understand about these investments is to keep in mind that growing economies need inputs, or natural resources. As economies grow, the need for natural resources grows, and the prices for those resources rise. Conversely, as economies slow, the demand slows and prices go down. So, if investors believe a recession is forthcoming, they will sell commodities, driving prices lower.
However, commodities are traded on a global basis, and U.S. economic activity is not the sole driver of demand for resources such as oil, gas, steel, etc. So don't necessarily expect a recession in the U.S. to have a direct impact on commodity prices, at least not as strong of an effect as we have seen in the past. At some point in time, the world's various economies will separate from the U.S., creating a demand for resources that is increasingly less sensitive to U.S. growth in GDP.
If you expect a recession, positioning your portfolio is quite simple. Shift assets away from equities, especially the riskiest equities like small stocks. You should also move away from credit risk in fixed-income markets and into Treasuries.
Investments and Recovery
So, what to do during a recovery? It sounds too simple, but investing for an economic recovery entails doing the exact opposite of what was described earlier.
Why?
Again, keep an eye ton the macroeconomic factors. For example, one of the most often used tools to reduce the impact of a recession is monetary policy that leads to a reduction in interest rates with the purpose of increasing the money supply, discouraging people from saving and encouraging spending. This helps to increase economic activity.
One of the side effects of low interest rates is they tend to creates demand for higher return, higher risk investments. So, as recessionary expectations bottom out, pessimism fades away and optimism works its way back into people's minds. Moreover, investors re-examine opportunities for riskier investments in the context of what is usually a low interest rate environment. They also embrace risk.
As a result, equity markets tend to do very well during economic recovery. Within equity markets, some of the best performing stocks are those that use operating leverage as part of their ongoing business activities, especially as these are often extremely undervalued after being beat up during the market downturn. Remember, leverage works great during good times, and these firms tend to grow earning faster than companies without leverage, but they also face real risks during weakening times. Moreover, growth stocks and small stocks tend to do well as investors embrace risk during an economic recovery. (To learn more about operating leverage, read Operating Leverage Captures Relationships.)
Similarly, within fixed-income markets, increased demand for risk manifests itself in a higher demand for credit risk, meaning the corporate debt of all grades and mortgage-backed debt tends to attract investors, driving prices up and yields down. Logically, U.S. Treasuries tend to go down in value as investors shift out of these assets and yields go back up.
The same logic holds for commodity markets in that faster economic growth means higher demand for materials, driving prices up. However, remember that commodities are traded on a global basis, and U.S. economic activity is not the sole driver of demand for resources.
Will the Sun Come Out Tomorrow?
To conclude, the best advice to investing during recessionary environments is to focus on the horizon and manage your exposures. It is important to minimize the risk in your portfolio and maintain your capital to invest in the recovery. Of course, you're never going to time the beginning or end of a recession to the day or the quarter, but seeing a recession far enough in advance isn't as hard as you might think. The real trick here is to simply have the discipline to step away from the crowd and shift away from risky, high-returning investments during times of extreme optimism, wait out the oncoming storm, and have an equal discipline to embrace risk at a time when people are shying away from it to get ahead of the cycle.
To keep reading about market recessions, check out Panic Selling - Capitulation Or Crash? and The Greatest Market Crashes.
by Eric Petroff, (Contact Author Biography)Eric Petroff is the director of research of Wurts & Associates, an institutional consulting firm advising nearly $40 billion in client assets. Before joining Wurts & Associates, Petroff spent eight years at Hammond Associates in St. Louis, another institutional consulting firm, where he was a senior consultant and shareholder. Prior to Hammond Associates, he spent five years in the brokerage industry advising retail clientele and even served as an equity and options trader for three of those years. He speaks often at conferences and has published dozens of articles for Investopedia.com and the New Zealand Investor Magazine.
http://www.investopedia.com/articles/08/recession.asp
by Eric Petroff (Contact Author Biography)
While it would be utopian to have the economy grow at a stable rate, economic recessions are a fact of life and are as unavoidable as the setting of the sun. Like the sun, the economy goes through periods of rising (growth and expansion) and periods of setting (decline and recession).
In this article, we will look at how to properly invest as the economy moves through the setting phase - recession.
What is a Recession?
A recession can be defined as an extended period of significant decline in economic activity including negative gross domestic product (GDP) growth, faltering confidence on the part of consumers and businesses, weakening employment, falling real incomes, and weakening sales and production. This is not exactly the environment that would lead to higher stock prices or a sunny outlook on stocks.
Other aspects of recessionary environments as they relate to investments include a heightened risk aversion on the part of investors and a subsequent flight to safety. However, on the bright side, recessions do eventually lead to recoveries and follow a relatively predictable pattern of behavior along the way. (To read more about this, check out Recession: What Does It Mean To Investors?)
Keep an Eye on the Horizon
The real key to investing before, during and after a recession is to keep an eye on the big picture, as opposed to trying to time your way in and out of various market sectors, niches and individual stocks. Even though there is a lot of historical evidence of the cyclicality of certain investments throughout recessions, the fact of the matter is that this sort of investment acumen is beyond the scope of the ordinary investor. That said, there's no need to be discouraged because there are many ways an ordinary person can invest to protect and profit during these economic cycles. (To learn more about investing in cycles, read Understanding Cycles - The Key To Market Timing.)
To begin with, consider the macroeconomic issues of a recession and how they affect capital markets. When a recession hits, companies slow down business investment, consumers slow down their spending, and people's perceptions shift from being optimistic and expecting a continuation of recent good times to becoming pessimistic and uncertain about the future. As such, people get understandably frightened, become worried about prospective investment returns and rationally scale back risk in their portfolios. The results of these psychological factors manifest themselves in a few broad capital market trends.
Within equity markets, the results are pretty obvious. As people become uncertain about prospective earnings, they perceive a greater amount of risk in their investments, which broadly leads investors to require a higher potential rate of return for holding equities. Of course, for expected returns to go higher, current prices need to drop, which occurs as investors sell their higher risk investments and move into safer securities including government debt. This is why equity markets tend to fall, often precipitously, prior to recessions as investors shift their investments.
Recessions and Specific Investments
In fact, history shows us that equity markets have an uncanny ability to serve as a leading indicator for recessions. For example, the markets started a steep decline in mid-2000 before the economic recessionary period between March 2001 and November 2001. But even in a decline, there are pockets of relative outperformance to be found in equity markets.
Stocks
When investing in stocks during recessionary periods, the relatively safest places to invest are in high-quality companies with long business histories, as these should be companies that can handle prolonged periods of weakness in the market.
For example, companies with strong balance sheets, including those with little debt and strong cash flows, tend to do much better than companies with significant operating leverage (or debt) and poor cash flows. A company with a strong balance sheet/cash flow is better able to handle an economic downturn and should still be able to fund its operations as it moves through the weak economic times. In contrast, a company with a lot of debt may be damaged if it can't handle its debt payments and the costs associated with its continuing operations. (To learn how to read these documents, see What Is A Cash Flow Statement? and Breaking Down The Balance Sheet.)
Also, traditionally, one of the safe places in the equity market is consumer staples. These are typically the last products to be removed from a budget. In contrast, electronic retailers and other consumer discretionary companies can suffer as consumers hold off on these higher end purchases. (To learn more, read Cyclical Versus Non-Cyclical Stocks.)
Fixed Income
Fixed-income markets are no exception to this line of reasoning. Again, as investors become more concerned about risk, they tend to shy away from it. Practically speaking, this means investors steer clear of credit risk, meaning all corporate bonds (especially high-yield bond) and mortgage-backed securities because these investments have higher default rates than government securities.
Again, as the economy weakens, businesses have a more difficult time generating revenues and earnings, which can make debt repayment more difficult and could lead to bankruptcy as a worst case scenario.
Moreover, as investors sell these assets, they seek safety and move into U.S. Treasury bonds. In other words, the prices of risky bonds go down as people sell (or the yields increase) and the prices on Treasury bonds go up (or the yields decrease).
Commodities
Another area of investing you want to consider in the context of a recession is commodity markets. The general rule to understand about these investments is to keep in mind that growing economies need inputs, or natural resources. As economies grow, the need for natural resources grows, and the prices for those resources rise. Conversely, as economies slow, the demand slows and prices go down. So, if investors believe a recession is forthcoming, they will sell commodities, driving prices lower.
However, commodities are traded on a global basis, and U.S. economic activity is not the sole driver of demand for resources such as oil, gas, steel, etc. So don't necessarily expect a recession in the U.S. to have a direct impact on commodity prices, at least not as strong of an effect as we have seen in the past. At some point in time, the world's various economies will separate from the U.S., creating a demand for resources that is increasingly less sensitive to U.S. growth in GDP.
If you expect a recession, positioning your portfolio is quite simple. Shift assets away from equities, especially the riskiest equities like small stocks. You should also move away from credit risk in fixed-income markets and into Treasuries.
Investments and Recovery
So, what to do during a recovery? It sounds too simple, but investing for an economic recovery entails doing the exact opposite of what was described earlier.
Why?
Again, keep an eye ton the macroeconomic factors. For example, one of the most often used tools to reduce the impact of a recession is monetary policy that leads to a reduction in interest rates with the purpose of increasing the money supply, discouraging people from saving and encouraging spending. This helps to increase economic activity.
One of the side effects of low interest rates is they tend to creates demand for higher return, higher risk investments. So, as recessionary expectations bottom out, pessimism fades away and optimism works its way back into people's minds. Moreover, investors re-examine opportunities for riskier investments in the context of what is usually a low interest rate environment. They also embrace risk.
As a result, equity markets tend to do very well during economic recovery. Within equity markets, some of the best performing stocks are those that use operating leverage as part of their ongoing business activities, especially as these are often extremely undervalued after being beat up during the market downturn. Remember, leverage works great during good times, and these firms tend to grow earning faster than companies without leverage, but they also face real risks during weakening times. Moreover, growth stocks and small stocks tend to do well as investors embrace risk during an economic recovery. (To learn more about operating leverage, read Operating Leverage Captures Relationships.)
Similarly, within fixed-income markets, increased demand for risk manifests itself in a higher demand for credit risk, meaning the corporate debt of all grades and mortgage-backed debt tends to attract investors, driving prices up and yields down. Logically, U.S. Treasuries tend to go down in value as investors shift out of these assets and yields go back up.
The same logic holds for commodity markets in that faster economic growth means higher demand for materials, driving prices up. However, remember that commodities are traded on a global basis, and U.S. economic activity is not the sole driver of demand for resources.
Will the Sun Come Out Tomorrow?
To conclude, the best advice to investing during recessionary environments is to focus on the horizon and manage your exposures. It is important to minimize the risk in your portfolio and maintain your capital to invest in the recovery. Of course, you're never going to time the beginning or end of a recession to the day or the quarter, but seeing a recession far enough in advance isn't as hard as you might think. The real trick here is to simply have the discipline to step away from the crowd and shift away from risky, high-returning investments during times of extreme optimism, wait out the oncoming storm, and have an equal discipline to embrace risk at a time when people are shying away from it to get ahead of the cycle.
To keep reading about market recessions, check out Panic Selling - Capitulation Or Crash? and The Greatest Market Crashes.
by Eric Petroff, (Contact Author Biography)Eric Petroff is the director of research of Wurts & Associates, an institutional consulting firm advising nearly $40 billion in client assets. Before joining Wurts & Associates, Petroff spent eight years at Hammond Associates in St. Louis, another institutional consulting firm, where he was a senior consultant and shareholder. Prior to Hammond Associates, he spent five years in the brokerage industry advising retail clientele and even served as an equity and options trader for three of those years. He speaks often at conferences and has published dozens of articles for Investopedia.com and the New Zealand Investor Magazine.
http://www.investopedia.com/articles/08/recession.asp
Inflation: some insight into inflation and its effects.
Inflation: some insight into inflation and its effects.
For starters, you now know that inflation isn't intrinsically good or bad. Like so many things in life, the impact of inflation depends on your personal situation.
Table of Contents
1) Inflation: Introduction
2) Inflation: What Is Inflation?
3) Inflation: How Is It Measured?
4) Inflation: Inflation And Interest Rates
5) Inflation: Inflation And Investments
6) Inflation: Conclusion
For starters, you now know that inflation isn't intrinsically good or bad. Like so many things in life, the impact of inflation depends on your personal situation.
Some points to remember:
- Inflation is a sustained increase in the general level of prices for goods and services.
- When inflation goes up, there is a decline in the purchasing power of money.
- Variations on inflation include deflation, hyperinflation and stagflation.
- Two theories as to the cause of inflation are demand-pull inflation and cost-push inflation.
- When there is unanticipated inflation, creditors lose, people on a fixed-income lose, "menu costs" go up, uncertainty reduces spending and exporters aren't as competitive.
- Lack of inflation (or deflation) is not necessarily a good thing.
- Inflation is measured with a price index.
- The two main groups of price indexes that measure inflation are the Consumer Price Index and the Producer Price Indexes.
- Interest rates are decided in the U.S. by the Federal Reserve. Inflation plays a large role in the Fed's decisions regarding interest rates.
- In the long term, stocks are good protection against inflation.
- Inflation is a serious problem for fixed income investors. It's important to understand the difference between nominal interest rates and real interest rates.
- Inflation-indexed securities offer protection against inflation but offer low returns.
Table of Contents
1) Inflation: Introduction
2) Inflation: What Is Inflation?
3) Inflation: How Is It Measured?
4) Inflation: Inflation And Interest Rates
5) Inflation: Inflation And Investments
6) Inflation: Conclusion
What is GDP and why is it so important?
Investment Question
What is GDP and why is it so important?
The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country's economy.
It represents the total dollar value of all goods and services produced over a specific time period - you can think of it as the size of the economy. Usually, GDP is expressed as a comparison to the previous quarter or year. For example, if the year-to-year GDP is up 3%, this is thought to mean that the economy has grown by 3% over the last year.
Measuring GDP is complicated (which is why we leave it to the economists), but at its most basic, the calculation can be done in one of two ways: either
The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non incorporated firms, and taxes less any subsidies.
The expenditure method is the more common approach and is calculated by adding total consumption, investment, government spending and net exports.
As one can imagine, economic production and growth, what GDP represents, has a large impact on nearly everyone within that economy. For example, when the economy is healthy, you will typically see low unemployment and wage increases as businesses demand labor to meet the growing economy.
A significant change in GDP, whether up or down, usually has a significant effect on the stock market. It's not hard to understand why: a bad economy usually means lower profits for companies, which in turn means lower stock prices. Investors really worry about negative GDP growth, which is one of the factors economists use to determine whether an economy is in a recession.
For more on this topic, see this section of our Economic Indicators tutorial and the article Macroeconomic Analysis.
http://www.investopedia.com/ask/answers/199.asp?ad=feat_fincrisis
What is GDP and why is it so important?
The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country's economy.
It represents the total dollar value of all goods and services produced over a specific time period - you can think of it as the size of the economy. Usually, GDP is expressed as a comparison to the previous quarter or year. For example, if the year-to-year GDP is up 3%, this is thought to mean that the economy has grown by 3% over the last year.
Measuring GDP is complicated (which is why we leave it to the economists), but at its most basic, the calculation can be done in one of two ways: either
- by adding up what everyone earned in a year (income approach), or
- by adding up what everyone spent (expenditure method).
The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non incorporated firms, and taxes less any subsidies.
The expenditure method is the more common approach and is calculated by adding total consumption, investment, government spending and net exports.
As one can imagine, economic production and growth, what GDP represents, has a large impact on nearly everyone within that economy. For example, when the economy is healthy, you will typically see low unemployment and wage increases as businesses demand labor to meet the growing economy.
A significant change in GDP, whether up or down, usually has a significant effect on the stock market. It's not hard to understand why: a bad economy usually means lower profits for companies, which in turn means lower stock prices. Investors really worry about negative GDP growth, which is one of the factors economists use to determine whether an economy is in a recession.
For more on this topic, see this section of our Economic Indicators tutorial and the article Macroeconomic Analysis.
http://www.investopedia.com/ask/answers/199.asp?ad=feat_fincrisis
What causes a recession?
Investment Question
What causes a recession?
According to the National Bureau of Economic Research (NBER), recession is defined as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in
More specifically, recession is defined as when businesses cease to expand, the GDP diminishes for two consecutive quarters, the rate of unemployment rises and housing prices decline.
In an inflationary environment, people tend to cut out leisure spending, reduce overall spending and begin to save more. But as individuals and businesses curtail expenditures in an effort to trim costs, this causes GDP to decline. Unemployment rates rise because companies lay off workers to cut costs. It is these combined factors that cause the economy to fall into a recession.
For further reading, see
Recession-Proof Your Portfolio and
Recession: What Does It Mean To Investors.
This question was answered by Chizoba Morah.
http://www.investopedia.com/ask/answers/08/cause-of-recession.asp?ad=feat_fincrisis
What causes a recession?
According to the National Bureau of Economic Research (NBER), recession is defined as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in
- real gross domestic product (GDP),
- real income,
- employment,
- industrial production and
- wholesale-retail sales".
More specifically, recession is defined as when businesses cease to expand, the GDP diminishes for two consecutive quarters, the rate of unemployment rises and housing prices decline.
Many factors contribute to an economy's fall into a recession, but the major cause is inflation. Inflation refers to a general rise in the prices of goods and services over a period of time. The higher the rate of inflation, the smaller the percentage of goods and services that can be purchased with the same amount of money. Inflation can happen for reasons as varied as
- increased production costs,
- higher energy costs and
- national debt.
In an inflationary environment, people tend to cut out leisure spending, reduce overall spending and begin to save more. But as individuals and businesses curtail expenditures in an effort to trim costs, this causes GDP to decline. Unemployment rates rise because companies lay off workers to cut costs. It is these combined factors that cause the economy to fall into a recession.
For further reading, see
Recession-Proof Your Portfolio and
Recession: What Does It Mean To Investors.
This question was answered by Chizoba Morah.
http://www.investopedia.com/ask/answers/08/cause-of-recession.asp?ad=feat_fincrisis
How do central banks inject money into the economy?
Investment Question
How do central banks inject money into the economy?
Central banks use several different methods to increase (or decrease) the amount of money in the banking system. These actions are referred to as monetary policy. While the Federal Reserve Board (the Fed) could print paper currency at its discretion in an effort to increase the amount of money in the economy, this is not the measure used.
Here are three methods the Fed uses in order to inject (or withdraw) money from the economy:
To learn more about central banks and their role in monetary policy, check out Formulating Monetary Policy.
http://www.investopedia.com/ask/answers/07/central-banks.asp?ad=feat_fincrisis
How do central banks inject money into the economy?
Central banks use several different methods to increase (or decrease) the amount of money in the banking system. These actions are referred to as monetary policy. While the Federal Reserve Board (the Fed) could print paper currency at its discretion in an effort to increase the amount of money in the economy, this is not the measure used.
Here are three methods the Fed uses in order to inject (or withdraw) money from the economy:
- The Fed can influence the money supply by modifying reserve requirements, which is the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able loan more money, which increases the overall supply of money in the economy. Conversely, by raising the banks' reserve requirements, the Fed is able to decrease the size of the money supply.
- The Fed can also alter the money supply by changing short-term interest rates. By lowering (or raising) the discount rate that banks pay on short-term loans from the Federal Reserve Bank, the Fed is able to effectively increase (or decrease) the liquidity of money. Lower rates increase the money supply and boost economic activity; however, decreases in interest rates fuel inflation, so the Fed must be careful not to lower interest rates too much for too long.
- Finally, the Fed can affect the money supply by conducting open market operations, which affects the federal funds rate. In open operations, the Fed buys and sells government securities in the open market. If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply. Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account, thus taking in cash and removing money from the economic system.
To learn more about central banks and their role in monetary policy, check out Formulating Monetary Policy.
http://www.investopedia.com/ask/answers/07/central-banks.asp?ad=feat_fincrisis
Where do investors tend to put their money in a bear market?
Investment Question
Where do investors tend to put their money in a bear market?
A bearish market is traditionally defined as a period of negative returns in the broader market to the magnitude of between 15-20% or more. During this type of market, most stocks see their share prices fall, often substantially. There are several strategies that are used when investors believe that this market is about to occur or is occurring, which depend on an the investor's risk tolerance, investment time horizon and objectives. (For related reading, see Surviving Bear Country.)
One of the safest strategies, and the most extreme, is to sell all of your investments and either hold cash or invest the proceeds into much more stable financial instruments, such as short-term government bonds. By doing this, an investor can reduce his or her exposure to the stock market and minimize the effects of a bear market.
For investors looking to maintain positions in the stock market, a defensive strategy is usually taken. This type of strategy involves investing in larger companies with strong balance sheets and a long operational history, which are considered to be defensive stocks. The reason for this is that these larger more stable companies tend to be less affected by an overall downturn in the economy or stock market, making their share prices less susceptible to a larger fall. With strong financial positions, including a large cash position to meet ongoing operational expenses, these companies are more likely to survive downturns. These also include companies that service the needs of businesses and consumers, such as food businesses (people still eat even when the economy is in a downturn). On the other hand, it is the riskier companies, such as small growth companies, that are typically avoided because they are less likely to have the financial security that is required to survive downturns.
These are just two of the more common strategies and there is a wide range of other strategies tailored to a bear market. The most important thing is to understand that a bear market is a very difficult one for long investors because most stocks fall over the period, and most strategies can only limit the amount of downside exposure, not eliminate it.
http://www.investopedia.com/ask/answers/06/investduringbearmarket.asp?ad=feat_fincrisis
Most Popular Questions
http://www.investopedia.com/features/financial-credit-crisis.aspx?partner=NTU
Are all bank accounts insured by the FDIC?
Can a creditor seize my retirement savings?
Where do investors tend to put their money in a bear market?
How do central banks inject money into the economy?
What causes a recession?
If my mortgage lender goes bankrupt, do I still have to pay my mortgage?
How do government issued stimulus checks improve the economy?
Is there a form of insurance on my investments?
How does a credit crunch occur?
What is GDP and why is it so important?
Where do investors tend to put their money in a bear market?
A bearish market is traditionally defined as a period of negative returns in the broader market to the magnitude of between 15-20% or more. During this type of market, most stocks see their share prices fall, often substantially. There are several strategies that are used when investors believe that this market is about to occur or is occurring, which depend on an the investor's risk tolerance, investment time horizon and objectives. (For related reading, see Surviving Bear Country.)
One of the safest strategies, and the most extreme, is to sell all of your investments and either hold cash or invest the proceeds into much more stable financial instruments, such as short-term government bonds. By doing this, an investor can reduce his or her exposure to the stock market and minimize the effects of a bear market.
For investors looking to maintain positions in the stock market, a defensive strategy is usually taken. This type of strategy involves investing in larger companies with strong balance sheets and a long operational history, which are considered to be defensive stocks. The reason for this is that these larger more stable companies tend to be less affected by an overall downturn in the economy or stock market, making their share prices less susceptible to a larger fall. With strong financial positions, including a large cash position to meet ongoing operational expenses, these companies are more likely to survive downturns. These also include companies that service the needs of businesses and consumers, such as food businesses (people still eat even when the economy is in a downturn). On the other hand, it is the riskier companies, such as small growth companies, that are typically avoided because they are less likely to have the financial security that is required to survive downturns.
These are just two of the more common strategies and there is a wide range of other strategies tailored to a bear market. The most important thing is to understand that a bear market is a very difficult one for long investors because most stocks fall over the period, and most strategies can only limit the amount of downside exposure, not eliminate it.
http://www.investopedia.com/ask/answers/06/investduringbearmarket.asp?ad=feat_fincrisis
Most Popular Questions
http://www.investopedia.com/features/financial-credit-crisis.aspx?partner=NTU
Are all bank accounts insured by the FDIC?
Can a creditor seize my retirement savings?
Where do investors tend to put their money in a bear market?
How do central banks inject money into the economy?
What causes a recession?
If my mortgage lender goes bankrupt, do I still have to pay my mortgage?
How do government issued stimulus checks improve the economy?
Is there a form of insurance on my investments?
How does a credit crunch occur?
What is GDP and why is it so important?
Wednesday, 31 December 2008
FTSE 100 on course for worst ever year
FTSE 100 on course for worst ever year
The FTSE 100 is almost certain to complete its worst-ever annual performance today.
By Graham Ruddick Last Updated: 11:09AM GMT 31 Dec 2008
In 12 months of volatile trading, the UK's leading index of shares has fallen 32pc – opening the year on 6456.90 and declining to 4392.68 by New Year's Eve – and recorded five of its most dire trading days. The market closes at 12:30pm today.
The overall annual drop puts 2008 ahead of 2002's dotcom crash of 24.48pc and the 16.15pc fall in 2001 after the 9/11 terrorist attacks in New York. Other notable 12-month declines include 11.52pc and 10.32pc in 1990 and 1994 respectively as the UK economy struggled through its last recessionn.
Confidence has deserted stock markets this year as the global banking crisis hammered shares of banks -with Royal Bank of Scotland and HBOS both recording falls of about 90pc - and fears about the depth of the global downturn hitting the previously buoyant mining shares.
David Buik, an analyst at BGC Partners, said that the size of the drop in certain sectors had been exacerbated by the fear that swept investors this year as the crisis unfolded.
"There is nothing more toxic than fear and uncertainty to galvanise equity operators to dump their books unceremoniously," he said. "That's exactly what happened in extreme degrees of volatility that had never before been experienced in the living memory of mature markets."
As the financial crisis escalated following the collapse of US investment bank Lehman Brothers in September, the FTSE recorded five of its worst ever trading days. The sharpest percentage fall of 2008 came on Friday, October 10, when it lost 8.85pc as rattled G7 leaders met in Washington in an effort to bring calm to markets. That week, during which Gordon Brown unveiled the Government's £500bn bail-out of the country's banks, saw the market slump 21.05pc, the biggest weekly fall of 2008.
However, despite the year being a miserable year one for equity markets, the FTSE's largest daily and weekly losses remain from the week of Black Monday in 1987. The market fell 10.84pc on Monday, October 19 and 12.22pc the following day, driving it to a weekly loss of 28.23pc. Overall though, the FTSE actually ended 1987 up 2.01pc.
Ironically, the financial crisis of late 2008 produced the largest four daily gains ever for the FTSE 100. The index, which began in 1984, rose a record 9.84pc on November 24, pre-Budget report day.
The FTSE has ended 2008 relatively strongly, gaining 4pc this week, and Mike Lenhoff, the chief strategist at Brewin Dolphin, predicts next year could see a recovery to the 5,000 mark because of falling inflation and interventionist policies from governments.
"Monetary and fiscal policies are expansionary, in some cases aggressively so," he added. "Not only have we witnessed the biggest financial upheaval of our time, we are also witnessing the biggest policy response of our time from central banks and governments the world over.
"Also, falling inflation worldwide will boost real household incomes and this should provide something of a boost to the growth of consumer spending – worldwide. On the corporate side, commodity deflation should help profit margins – worldwide. Commodity price deflation could end up being a powerful stimulus for global demand growth."
http://www.telegraph.co.uk/finance/markets/4043815/FTSE-100-on-course-for-worst-ever-year.html
The FTSE 100 is almost certain to complete its worst-ever annual performance today.
By Graham Ruddick Last Updated: 11:09AM GMT 31 Dec 2008
In 12 months of volatile trading, the UK's leading index of shares has fallen 32pc – opening the year on 6456.90 and declining to 4392.68 by New Year's Eve – and recorded five of its most dire trading days. The market closes at 12:30pm today.
The overall annual drop puts 2008 ahead of 2002's dotcom crash of 24.48pc and the 16.15pc fall in 2001 after the 9/11 terrorist attacks in New York. Other notable 12-month declines include 11.52pc and 10.32pc in 1990 and 1994 respectively as the UK economy struggled through its last recessionn.
Confidence has deserted stock markets this year as the global banking crisis hammered shares of banks -with Royal Bank of Scotland and HBOS both recording falls of about 90pc - and fears about the depth of the global downturn hitting the previously buoyant mining shares.
David Buik, an analyst at BGC Partners, said that the size of the drop in certain sectors had been exacerbated by the fear that swept investors this year as the crisis unfolded.
"There is nothing more toxic than fear and uncertainty to galvanise equity operators to dump their books unceremoniously," he said. "That's exactly what happened in extreme degrees of volatility that had never before been experienced in the living memory of mature markets."
As the financial crisis escalated following the collapse of US investment bank Lehman Brothers in September, the FTSE recorded five of its worst ever trading days. The sharpest percentage fall of 2008 came on Friday, October 10, when it lost 8.85pc as rattled G7 leaders met in Washington in an effort to bring calm to markets. That week, during which Gordon Brown unveiled the Government's £500bn bail-out of the country's banks, saw the market slump 21.05pc, the biggest weekly fall of 2008.
However, despite the year being a miserable year one for equity markets, the FTSE's largest daily and weekly losses remain from the week of Black Monday in 1987. The market fell 10.84pc on Monday, October 19 and 12.22pc the following day, driving it to a weekly loss of 28.23pc. Overall though, the FTSE actually ended 1987 up 2.01pc.
Ironically, the financial crisis of late 2008 produced the largest four daily gains ever for the FTSE 100. The index, which began in 1984, rose a record 9.84pc on November 24, pre-Budget report day.
The FTSE has ended 2008 relatively strongly, gaining 4pc this week, and Mike Lenhoff, the chief strategist at Brewin Dolphin, predicts next year could see a recovery to the 5,000 mark because of falling inflation and interventionist policies from governments.
"Monetary and fiscal policies are expansionary, in some cases aggressively so," he added. "Not only have we witnessed the biggest financial upheaval of our time, we are also witnessing the biggest policy response of our time from central banks and governments the world over.
"Also, falling inflation worldwide will boost real household incomes and this should provide something of a boost to the growth of consumer spending – worldwide. On the corporate side, commodity deflation should help profit margins – worldwide. Commodity price deflation could end up being a powerful stimulus for global demand growth."
http://www.telegraph.co.uk/finance/markets/4043815/FTSE-100-on-course-for-worst-ever-year.html
Will oil prices recover after tanking in 2008?
Will oil prices recover after tanking in 2008?
The oil price gyrated wildly in 2008 – but what's in store for the price in 2009, asks Garry White.
Last Updated: 5:56AM GMT 30 Dec 2008
Comments 17 Comment on this article
Oil prices have experienced wild fluctuations in 2008
The oil price gyrated wildly in 2008, hitting an all-time high above $147 a barrel on July 3 – followed by four-year lows. The big question now is: Where next?
Until the credit crunch saw global markets freeze, demand for oil had been rocketing, mainly because of rapid development in countries such as India and China.
However, the financial crisis changed that. Demand plummeted in the latter part of 2008 and global inventories grew. In the third quarter of 2008, US oil consumption shrank by about 1m barrels per day (bpd) – or around 5pc. It is likely to have fallen further in the fourth quarter.
To keep the market in balance, Opec cut supply. In December, the cartel, which controls 40pc of global oil output, agreed its deepest cut ever, bringing the total cut in quotas in the second half of 2008 to 4.2m bpd.
But even this failed to support the price, which fell almost 10pc in the next two sessions.
There were two reasons for this fall.
- It is obvious that demand deterioration continues as the global economy falls deeper into recession, but
- the market was also sceptical whether Opec members would comply with the cut.
This followed news that only 85pc of the previous 1.5m barrel quota reduction had been implemented.
The latest cut of 2.2m bpd is due to start on January 1. Analysts are unsure whether members will stick to their production quota, so there is uncertainty about oil supply over the next few months.
Then there's Russia, the world's second-largest oil exporting nation. Opec had hoped the country would join in with co-ordinated cuts in output. Russia sent its highest-level delegation ever to Opec's December meeting, but said it was not going to join in with Opec's actions. US pressure was probably behind Russia's decision. Analysts warned that Congress could campaign to have Russia thrown out of the G8 if it got too close to Opec.
One other cause of the oil-price spike was a slide in the value of the dollar. As the currency weakened investors bought dollar-denominated assets as a hedge against inflation, helping propel oil to close to $150 a barrel.
However, the global economy's deterioration saw investors repatriate assets they saw as risky. This caused a flight back into cash and these positions were unwound.
Over 2009, the currency markets are likely to be volatile and difficult to predict. If dollar strength persists, this is likely to keep the oil price subdued.
However, the Federal Reserve has slashed US interest rates and signalled that it could soon be printing money to try to stop the recession turning into a depression. Many analysts feel that this will be bearish for the dollar, and a dollar fall would once again boost the oil price.
Ultimately, what happens to the oil price depends on whether the recent fiscal stimulus packages work. If they do and economies improve then demand recovery will be bullish for the oil price.
If the packages fail the outlook for a recovery in oil prices is bleak. Economic contagion in the West is already hitting China's manufacturing base.
Earlier this month Merrill Lynch oil analyst Francisco Blanch said the oil price could drop to $25 in 2009 if China falls into recession. He put the chances of this happening at one in three. However, he added: "If we reignite economic growth, we will have a shortage of energy again." In this case, Mr Blanch predicted oil at $150 a barrel in two or three years.
Most analysts are downbeat on the oil price in the short term. Deutsche Bank analyst Michael Lewis said: "Many commodity prices are set to overshoot to the downside in response to the worst downturn in economic activity since the Great Depression."
In the long term, low oil prices could be damaging, as they stop investment in the discovery of new sources. Speaking at a recent summit of energy ministers held in London, Gordon Brown warned that if nations cut investment in oil production, demand will eventually exceed supply again, forcing prices up.
Geo-political issues may also come into play. The escalation of attacks between Israel and Hamas in Gaza caused a spike in the oil price on Monday. If problems persist in the region this is likely to provide a floor for the oil price in the early part of the year.
There are also the actions of the Movement for the Emancipation of the Niger Delta (MEND) in Nigeria. Attacks by the rebels contributed to the oil price spike in early 2008, as the country is the world's eighth-largest crude oil exporter and the US's fifth-largest source for imported oil. Major exporters Iran and Venezuela also continue to sabre rattle with the US, which could prompt more supply fears.
Ultimately, however, the outlook for the oil price in 2009 depends on where or not government action to tackle the economic crisis works. Mervyn King has warned that the UK could flirt with deflation in 2009 – and if deflation becomes a major global problem the outlook for the oil price is decidedly bearish.
Should the stimulus packages start to work and become reflationary this would be bullish for the price of oil. When it comes to the direction of the oil price in 2009, it's quite simple really – as Bill Clinton once said: It's the economy, stupid.
The latest cut of 2.2m bpd is due to start on January 1. Analysts are unsure whether members will stick to their production quota, so there is uncertainty about oil supply over the next few months.
Then there's Russia, the world's second-largest oil exporting nation. Opec had hoped the country would join in with co-ordinated cuts in output. Russia sent its highest-level delegation ever to Opec's December meeting, but said it was not going to join in with Opec's actions. US pressure was probably behind Russia's decision. Analysts warned that Congress could campaign to have Russia thrown out of the G8 if it got too close to Opec.
One other cause of the oil-price spike was a slide in the value of the dollar. As the currency weakened investors bought dollar-denominated assets as a hedge against inflation, helping propel oil to close to $150 a barrel.
However, the global economy's deterioration saw investors repatriate assets they saw as risky. This caused a flight back into cash and these positions were unwound.
Over 2009, the currency markets are likely to be volatile and difficult to predict. If dollar strength persists, this is likely to keep the oil price subdued.
However, the Federal Reserve has slashed US interest rates and signalled that it could soon be printing money to try to stop the recession turning into a depression. Many analysts feel that this will be bearish for the dollar, and a dollar fall would once again boost the oil price.
Ultimately, what happens to the oil price depends on whether the recent fiscal stimulus packages work. If they do and economies improve then demand recovery will be bullish for the oil price.
If the packages fail the outlook for a recovery in oil prices is bleak. Economic contagion in the West is already hitting China's manufacturing base.
Earlier this month Merrill Lynch oil analyst Francisco Blanch said the oil price could drop to $25 in 2009 if China falls into recession. He put the chances of this happening at one in three. However, he added: "If we reignite economic growth, we will have a shortage of energy again." In this case, Mr Blanch predicted oil at $150 a barrel in two or three years.
Most analysts are downbeat on the oil price in the short term. Deutsche Bank analyst Michael Lewis said: "Many commodity prices are set to overshoot to the downside in response to the worst downturn in economic activity since the Great Depression."
In the long term, low oil prices could be damaging, as they stop investment in the discovery of new sources. Speaking at a recent summit of energy ministers held in London, Gordon Brown warned that if nations cut investment in oil production, demand will eventually exceed supply again, forcing prices up.
Geo-political issues may also come into play. The escalation of attacks between Israel and Hamas in Gaza caused a spike in the oil price on Monday. If problems persist in the region this is likely to provide a floor for the oil price in the early part of the year.
There are also the actions of the Movement for the Emancipation of the Niger Delta (MEND) in Nigeria. Attacks by the rebels contributed to the oil price spike in early 2008, as the country is the world's eighth-largest crude oil exporter and the US's fifth-largest source for imported oil. Major exporters Iran and Venezuela also continue to sabre rattle with the US, which could prompt more supply fears.
Ultimately, however, the outlook for the oil price in 2009 depends on where or not government action to tackle the economic crisis works. Mervyn King has warned that the UK could flirt with deflation in 2009 – and if deflation becomes a major global problem the outlook for the oil price is decidedly bearish.
Should the stimulus packages start to work and become reflationary this would be bullish for the price of oil. When it comes to the direction of the oil price in 2009, it's quite simple really – as Bill Clinton once said: It's the economy, stupid.
Buffett's Investment in Goldman Sach
Some interesting thoughts.
Examples: The similarities between Salomon and GS--Warren never will, and will never need to, take on a role at GS that is similar to the one he did at Salomon. The only way Buffett will lose with the GS deal is if the company goes under--not impossible, but extremely unlikely. In the meantime he is collecting 10% interest, is assured return of capital (except if GS goes under), an is assured a 10% fee if the debt is repaid early. The warrants, if he gets to exercise it for a profit, is icing on the cake.
Another example: his 1999 call of a sideways market until 2016 was brilliant indeed. But remember the SP500 was in the 1300 to 1400 range then. In Nov 2008, with the SP500 around 750, the 1999 call if proven right, means a 1350 or so SP 500 in 2016--or an approximately 80% gain in 8 years. This is a annualized return of about 7 or 8%, plus a dividend of over 3% --for a cumulative return of around 10% for the next 8 years. Perhaps Mr. Cooper considers this inadequate. REMEMBER: Graham defined Investment as "an operation which, upon thorough analysis promises safety of capital and an adequate return"
http://seekingalpha.com/article/112389-buffett-s-biography-is-goldman-sachs-the-new-salomon-brothers
Examples: The similarities between Salomon and GS--Warren never will, and will never need to, take on a role at GS that is similar to the one he did at Salomon. The only way Buffett will lose with the GS deal is if the company goes under--not impossible, but extremely unlikely. In the meantime he is collecting 10% interest, is assured return of capital (except if GS goes under), an is assured a 10% fee if the debt is repaid early. The warrants, if he gets to exercise it for a profit, is icing on the cake.
Another example: his 1999 call of a sideways market until 2016 was brilliant indeed. But remember the SP500 was in the 1300 to 1400 range then. In Nov 2008, with the SP500 around 750, the 1999 call if proven right, means a 1350 or so SP 500 in 2016--or an approximately 80% gain in 8 years. This is a annualized return of about 7 or 8%, plus a dividend of over 3% --for a cumulative return of around 10% for the next 8 years. Perhaps Mr. Cooper considers this inadequate. REMEMBER: Graham defined Investment as "an operation which, upon thorough analysis promises safety of capital and an adequate return"
http://seekingalpha.com/article/112389-buffett-s-biography-is-goldman-sachs-the-new-salomon-brothers
Tuesday, 30 December 2008
Hyperinflation: Dollar is key to Zimbabwe survival
Page last updated at 14:31 GMT, Friday, 19 December 2008
Dollar is key to Zimbabwe survival
Many Zimbabweans do not have access to foreign currency
To get (US) dollars I have to do assignments abroad… there are not many Zimbabweans who can do that
Professor John Makombe, University of Zimbabwe
Zimbabweans queue for the new $500 million banknote in Harare
By Karen Allen BBC News, Zimbabwe
Last week the reserve bank issued a new Zimbabwean banknote - a $500m bill. Its value changes by the day, but a rough estimate of its worth now is about US $50 (£33).
Its release was enough to see a surge of people flock onto the streets and form huge queues outside the banks. Harare's pavements were gridlocked for most of the day.
But increasingly it is only US dollars that are accepted in Zimbabwe's shops. Petrol stations are among those now turning away people who offer fistfuls of local currency.
Even water bills - for what little clean water there is - have to be paid in hard US cash. And bread is now a dollar commodity in many parts of the country.
Dollar is key to Zimbabwe survival
Many Zimbabweans do not have access to foreign currency
To get (US) dollars I have to do assignments abroad… there are not many Zimbabweans who can do that
Professor John Makombe, University of Zimbabwe
Zimbabweans queue for the new $500 million banknote in Harare
Hyperinflation renders Zimbabwean dollars valueless in days. This man's wife tried to buy maize with their last dollars. But they were worthless. He was forced to beg for food for his children.
By Karen Allen BBC News, Zimbabwe
Last week the reserve bank issued a new Zimbabwean banknote - a $500m bill. Its value changes by the day, but a rough estimate of its worth now is about US $50 (£33).
Its release was enough to see a surge of people flock onto the streets and form huge queues outside the banks. Harare's pavements were gridlocked for most of the day.
But increasingly it is only US dollars that are accepted in Zimbabwe's shops. Petrol stations are among those now turning away people who offer fistfuls of local currency.
Even water bills - for what little clean water there is - have to be paid in hard US cash. And bread is now a dollar commodity in many parts of the country.
'Dollarisation'
There has been a surge in cross-border trade in recent weeks with the lifting of restrictions on US dollar transactions.
Consumer goods, food and cars are being brought across from neighbouring South Africa.
To get (US) dollars I have to do assignments abroad… there are not many Zimbabweans who can do that
Professor John Makombe, University of Zimbabwe
There has been a surge in cross-border trade in recent weeks with the lifting of restrictions on US dollar transactions.
Consumer goods, food and cars are being brought across from neighbouring South Africa.
To get (US) dollars I have to do assignments abroad… there are not many Zimbabweans who can do that
Professor John Makombe, University of Zimbabwe
Supermarkets are now stuffed with food, filling shelves that just a month or so ago were empty.
These supermarkets are for Zimbabwe's tiny dollar elite - the type that drive brand new cars into the car parks as others try to fend off starvation. They only accept US dollar bills in these swanky shops.
John Makombe, professor of political science at the University of Zimbabwe, estimates that 80% of the population here has no access to US dollar bills.
"Even I sometimes don't have foreign currency and I'm a university professor. To get dollars I have to do assignments abroad," he says. "There are not many Zimbabweans who can do that."
The value of Professor Makumbe's monthly salary, he reveals, is equivalent to US $30. That is just a little more than the price of a jar of instant coffee in the supermarkets which have become a refuge of the dollar rich.
The "dollarisation" of the Zimbabwean financial system is propping up a collapsed Zimbabwean economy.
But it has created an unwieldy free market where the government, unable to control basic prices, is merely a bystander.
A shortage of change and small US banknotes is now creating a new US dollar inflation.
"Zimbabwe is like a house of cards… one puff and it could come down," says a Zimbabwe-based Western diplomat with a depressed tone. "The problem is… there isn't the puff to blow it down."
It seems to be an accurate observation. Massive food shortages, hyperinflation, cholera and continued political turmoil are a heady cocktail.
In any other country in the world, this combination might have triggered a coup. But not here. People are simply too scared.
These supermarkets are for Zimbabwe's tiny dollar elite - the type that drive brand new cars into the car parks as others try to fend off starvation. They only accept US dollar bills in these swanky shops.
John Makombe, professor of political science at the University of Zimbabwe, estimates that 80% of the population here has no access to US dollar bills.
"Even I sometimes don't have foreign currency and I'm a university professor. To get dollars I have to do assignments abroad," he says. "There are not many Zimbabweans who can do that."
The value of Professor Makumbe's monthly salary, he reveals, is equivalent to US $30. That is just a little more than the price of a jar of instant coffee in the supermarkets which have become a refuge of the dollar rich.
The "dollarisation" of the Zimbabwean financial system is propping up a collapsed Zimbabwean economy.
But it has created an unwieldy free market where the government, unable to control basic prices, is merely a bystander.
A shortage of change and small US banknotes is now creating a new US dollar inflation.
"Zimbabwe is like a house of cards… one puff and it could come down," says a Zimbabwe-based Western diplomat with a depressed tone. "The problem is… there isn't the puff to blow it down."
It seems to be an accurate observation. Massive food shortages, hyperinflation, cholera and continued political turmoil are a heady cocktail.
In any other country in the world, this combination might have triggered a coup. But not here. People are simply too scared.
Critics vanished
Journalists, human rights activists and other critics of Robert Mugabe's presidency have recently vanished.
Many Zimbabweans do not have access to foreign currency
More than 20 people have disappeared in just the past few weeks - people are terrified.
Reporting the Zimbabwe story is risky for all concerned - not least those on the other side of the microphone.
Not surprisingly many are reluctant to speak out - yet thankfully, some still do. Like Elliot and Molly - a retired couple now living on a small farm, whose geographical details I dare not divulge for fear they are punished for speaking to me.
"Africa needs to be responsible for its own problems," says Elliot boldly. "It's about our own mismanagement… we can't blame former colonies like Britain."
It is a sentiment that runs deep here, though few will speak openly about it.
When I arrived tensions were high following the disappearance of Jestina Mukoko - a prominent human rights campaigner and former journalist, who had allegedly been abducted.
Her safety has been playing on the minds of so many here ever since. Yet Zimbabwe's neighbours continue to offer legitimacy to Robert Mugabe.
Despite a power-sharing deal back in September, he still holds all the cards. He is revered as a liberation hero by many influential figures on the continent, with just Botswana and Kenya breaking rank and speaking out.
One political campaigner for the opposition MDC described the present climate in Zimbabwe as "coerced control" - an environment where intimidation rules.
It means that ordinary Zimbabweans, already enduring so much, may still face the prospect of worse to come - resisting the instinct to revolt with a sense of fear.
Journalists, human rights activists and other critics of Robert Mugabe's presidency have recently vanished.
Many Zimbabweans do not have access to foreign currency
More than 20 people have disappeared in just the past few weeks - people are terrified.
Reporting the Zimbabwe story is risky for all concerned - not least those on the other side of the microphone.
Not surprisingly many are reluctant to speak out - yet thankfully, some still do. Like Elliot and Molly - a retired couple now living on a small farm, whose geographical details I dare not divulge for fear they are punished for speaking to me.
"Africa needs to be responsible for its own problems," says Elliot boldly. "It's about our own mismanagement… we can't blame former colonies like Britain."
It is a sentiment that runs deep here, though few will speak openly about it.
When I arrived tensions were high following the disappearance of Jestina Mukoko - a prominent human rights campaigner and former journalist, who had allegedly been abducted.
Her safety has been playing on the minds of so many here ever since. Yet Zimbabwe's neighbours continue to offer legitimacy to Robert Mugabe.
Despite a power-sharing deal back in September, he still holds all the cards. He is revered as a liberation hero by many influential figures on the continent, with just Botswana and Kenya breaking rank and speaking out.
One political campaigner for the opposition MDC described the present climate in Zimbabwe as "coerced control" - an environment where intimidation rules.
It means that ordinary Zimbabweans, already enduring so much, may still face the prospect of worse to come - resisting the instinct to revolt with a sense of fear.
An Introduction to Stock Options
An Introduction to Stock Options
Stock options provide advanced investors with additional opportunities for potentially rewarding returns. But stock options do possess risks that require an in-depth understanding of how they work. This article provides a basic overview of stock options.
Before You Start
Pull out all paperwork describing your workplace benefits coverage to learn whether your employer grants stock options to employees.
Review the expiration dates on any stock options you currently own.
Review the buy/sell prices for your stock options.
How-To Guides
Buying Your First Home
Your Retirement Checklist
Using Credit Wisely
Financing a New Car
View more how-to guides
Calculators
How much will college cost?
Comprehensive mortgage calculator
How much am I spending?
How will payroll adjustments affect my take-home pay?
How much will I need to save for retirement?
View more calculators
Topics
An Introduction to Stock Options
The Basics of Stock Options
Components of an Option's Value
Employee Stock Options
Consider Option Strategies Carefully
1 An Introduction to Stock Options
Options on stocks and stock indexes are derivative instruments. Stock investors may use stock options
2 The Basics of Stock Options
A stock option is essentially a contract that gives one party the right to purchase or sell a stated number of shares of a stock at a specified price. The price at which the shares may be purchased or sold is known as the strike or exercise price. The right to exercise lasts for a stated period of time, which may be months or years, until the expiration date. If not exercised on or before the expiration date, the option expires.
Options come in two forms: calls and puts. A call option gives the option purchaser the right to buy the underlying stock. A put option gives the option purchaser the right to sell the underlying stock.
A call option is valuable to the extent that the exercise price is below the market value of the underlying stock. For example, if a stock is trading at $100 per share and you hold a call option entitling you to buy the stock at $72 per share, your option has an immediate value to you of $100 - $72 = $28, before taking into account any tax consequences or transaction fees.
A put option is the mirror image of a call option. A put option becomes more valuable as the price of the stock moves below the exercise price. For example, if you have purchased a put option with a strike price of $90 and the stock price moves to $80, you may choose to exercise the option and sell the underlying stock at $90 for an immediate unrealized per share gain of $90 - $80 = $10.
With both calls and puts, the purchaser of the option has the right to exercise, while the option seller is obligated to respond if the option is exercised. The option purchaser pays an upfront fee known as the premium to the option seller in return for the right of exercise. The option buyer has a known investment risk -- if the option expires unexercised, the purchaser of the option recognizes the premium paid as a loss. Conversely, the option seller undertakes potentially unlimited market risk in return for the premium received. Back to top
3 Components of an Option's Value
Option contracts are traded on regulated markets, and their values may fluctuate throughout the trading day. The price of an option at any given time is based on several factors, including the current price of the underlying stock, the price volatility of the underlying stock, the time to maturity, and interest rates.
Intrinsic value -- the intrinsic value of the option is the difference between the exercise price and the price of the underlying security. An option is "in the money" when the intrinsic value is positive.
Volatility -- part of an option's value reflects the volatility of the underlying security. If a stock price is highly volatile, there is a relatively greater chance that the option will be "in the money" at expiration, and therefore, the option will carry a higher premium than an option on a less a volatile stock.
Time value -- the more time remaining until the expiration date of the option, the greater the potential for a significant change to occur in the price of the underlying security and the greater the value of the option. Time value diminishes as the expiration date of the option approaches.
Interest rates -- the option premium is a cash payment that can be invested by the option seller to generate interest income. Higher interest rates present opportunities for potentially greater earnings on the option premium.
Intrinsic value, volatility, and time value can significantly affect an option's market value. An option with an exercise price above the current market value of the underlying security may still have considerable potential value.
For example, if you hold a call option with an exercise price of $72 and the current share price is $65, your option would generate a loss if it were exercised today. However, as stated above, option contracts typically are valid for months or years, until the stated expiration date. The time value of the call option is the potential that the share price will rise over time and eventually exceed the option exercise price. Back to top
4 Employee Stock Options
Employee stock options are call options granted by an employer as part of an employee compensation plan. There are two main types of employee stock options: incentive stock options and nonqualified stock options. Incentive stock options offer special income tax benefits to the employee.
An incentive stock option (ISO) must meet a number of criteria to qualify for favorable tax treatment. As long as the shares acquired through an ISO are held for at least one year following exercise and are not disposed of until at least two years after the option is granted, the difference between the option price and the sale price is taxed as a long-term gain. The tax is applied at the sale of the stock. If you don't meet the one-year holding-period requirement, the transaction is considered a "disqualifying disposition" and your gains are taxed as ordinary income.
A nonqualified stock option (NSO) is an option that doesn't meet the ISO criteria. Gains on NSOs are taxed as ordinary income at the time of exercise.
OPTION TERMINOLOGY
Call option
An option that gives the option buyer the right to purchase the underlying security.
Exercise date
The date by which the option must be exercised.
Expiration date
The date that the option will expire (same as the exercise date).
Intrinsic value
The difference between the strike price and the current price of the underlying security.
Premium
An upfront fee paid by the option buyer to the option seller.
Put option
An option that gives the option buyer the right to sell the underlying security.
Strike price
The stated price at which the underlying security can be purchased or sold (also called the exercise price).
Time value
The component of an option's price that reflects the time left to expiration.
Volatility
The tendency of the underlying security to fluctuate in price.Back to top
5 Consider Option Strategies Carefully
Options are leveraged investments that can offer significant potential advantages and risks. As part of an overall investment strategy, put and call options may offer opportunities to temporarily alter the risk/return characteristics of a portfolio. Before investing in options, it is important to thoroughly understand the potential risks and benefits. You should consult a qualified tax advisor as to how option transactions may affect your tax situation. If you are an employee and have received stock options as employee compensation, you will want to carefully consider how exercise of your options may affect your cash flow and tax liability.Back to top
Summary
An option is a contract entitling the option purchaser to buy or sell the underlying stock at the stated exercise price. A call option gives the holder the right to buy the underlying stock; a put option gives the holder the right to sell the underlying stock.
The option purchaser's risk on the option is limited to the premium paid; the option seller's risk on the option is potentially unlimited.
A call option is valuable to the extent that the exercise price is below the market value of the underlying stock at the time you choose to exercise the option by buying shares. The time value of the option is the potential that the share price will rise over time and eventually exceed the option exercise price.
Employee stock options may be tax-qualified incentive stock options (ISOs) or nonqualified stock options (NSOs). If shares acquired through an ISO are held for at least one year following exercise and are not disposed of until at least two years after the option is granted, the difference between the option price and the sale price is taxed as a long-term gain. If you don't meet the one-year holding-period requirement, the transaction is considered a disqualifying disposition and your gains are taxed as ordinary income.
Before implementing an investment strategy using options or before entering into any equity arrangements with an employer, consult your tax advisor.
Checklist
Check the current share prices of the stocks associated with your stock options.
Confirm that you've met holding-period requirements before using employee stock options in order to qualify for more favorable tax treatment.
Conduct a comprehensive investment portfolio review to make sure that your options are part of a well-diversified overall asset allocation.
Consider meeting with a tax advisor or financial professional to understand how your options could affect your tax and investment strategies.
http://finance.yahoo.com/how-to-guide/career-work/12827;_ylt=Apv84a87_jfeohFOdDH4hya7YWsA#c1
Stock options provide advanced investors with additional opportunities for potentially rewarding returns. But stock options do possess risks that require an in-depth understanding of how they work. This article provides a basic overview of stock options.
Before You Start
Pull out all paperwork describing your workplace benefits coverage to learn whether your employer grants stock options to employees.
Review the expiration dates on any stock options you currently own.
Review the buy/sell prices for your stock options.
How-To Guides
Buying Your First Home
Your Retirement Checklist
Using Credit Wisely
Financing a New Car
View more how-to guides
Calculators
How much will college cost?
Comprehensive mortgage calculator
How much am I spending?
How will payroll adjustments affect my take-home pay?
How much will I need to save for retirement?
View more calculators
Topics
An Introduction to Stock Options
The Basics of Stock Options
Components of an Option's Value
Employee Stock Options
Consider Option Strategies Carefully
1 An Introduction to Stock Options
Options on stocks and stock indexes are derivative instruments. Stock investors may use stock options
- to hedge against a price decline,
- to lock in a future purchase price, or
- to speculate on the future price of a stock.
2 The Basics of Stock Options
A stock option is essentially a contract that gives one party the right to purchase or sell a stated number of shares of a stock at a specified price. The price at which the shares may be purchased or sold is known as the strike or exercise price. The right to exercise lasts for a stated period of time, which may be months or years, until the expiration date. If not exercised on or before the expiration date, the option expires.
Options come in two forms: calls and puts. A call option gives the option purchaser the right to buy the underlying stock. A put option gives the option purchaser the right to sell the underlying stock.
A call option is valuable to the extent that the exercise price is below the market value of the underlying stock. For example, if a stock is trading at $100 per share and you hold a call option entitling you to buy the stock at $72 per share, your option has an immediate value to you of $100 - $72 = $28, before taking into account any tax consequences or transaction fees.
A put option is the mirror image of a call option. A put option becomes more valuable as the price of the stock moves below the exercise price. For example, if you have purchased a put option with a strike price of $90 and the stock price moves to $80, you may choose to exercise the option and sell the underlying stock at $90 for an immediate unrealized per share gain of $90 - $80 = $10.
With both calls and puts, the purchaser of the option has the right to exercise, while the option seller is obligated to respond if the option is exercised. The option purchaser pays an upfront fee known as the premium to the option seller in return for the right of exercise. The option buyer has a known investment risk -- if the option expires unexercised, the purchaser of the option recognizes the premium paid as a loss. Conversely, the option seller undertakes potentially unlimited market risk in return for the premium received. Back to top
3 Components of an Option's Value
Option contracts are traded on regulated markets, and their values may fluctuate throughout the trading day. The price of an option at any given time is based on several factors, including the current price of the underlying stock, the price volatility of the underlying stock, the time to maturity, and interest rates.
Intrinsic value -- the intrinsic value of the option is the difference between the exercise price and the price of the underlying security. An option is "in the money" when the intrinsic value is positive.
Volatility -- part of an option's value reflects the volatility of the underlying security. If a stock price is highly volatile, there is a relatively greater chance that the option will be "in the money" at expiration, and therefore, the option will carry a higher premium than an option on a less a volatile stock.
Time value -- the more time remaining until the expiration date of the option, the greater the potential for a significant change to occur in the price of the underlying security and the greater the value of the option. Time value diminishes as the expiration date of the option approaches.
Interest rates -- the option premium is a cash payment that can be invested by the option seller to generate interest income. Higher interest rates present opportunities for potentially greater earnings on the option premium.
Intrinsic value, volatility, and time value can significantly affect an option's market value. An option with an exercise price above the current market value of the underlying security may still have considerable potential value.
For example, if you hold a call option with an exercise price of $72 and the current share price is $65, your option would generate a loss if it were exercised today. However, as stated above, option contracts typically are valid for months or years, until the stated expiration date. The time value of the call option is the potential that the share price will rise over time and eventually exceed the option exercise price. Back to top
4 Employee Stock Options
Employee stock options are call options granted by an employer as part of an employee compensation plan. There are two main types of employee stock options: incentive stock options and nonqualified stock options. Incentive stock options offer special income tax benefits to the employee.
An incentive stock option (ISO) must meet a number of criteria to qualify for favorable tax treatment. As long as the shares acquired through an ISO are held for at least one year following exercise and are not disposed of until at least two years after the option is granted, the difference between the option price and the sale price is taxed as a long-term gain. The tax is applied at the sale of the stock. If you don't meet the one-year holding-period requirement, the transaction is considered a "disqualifying disposition" and your gains are taxed as ordinary income.
A nonqualified stock option (NSO) is an option that doesn't meet the ISO criteria. Gains on NSOs are taxed as ordinary income at the time of exercise.
OPTION TERMINOLOGY
Call option
An option that gives the option buyer the right to purchase the underlying security.
Exercise date
The date by which the option must be exercised.
Expiration date
The date that the option will expire (same as the exercise date).
Intrinsic value
The difference between the strike price and the current price of the underlying security.
Premium
An upfront fee paid by the option buyer to the option seller.
Put option
An option that gives the option buyer the right to sell the underlying security.
Strike price
The stated price at which the underlying security can be purchased or sold (also called the exercise price).
Time value
The component of an option's price that reflects the time left to expiration.
Volatility
The tendency of the underlying security to fluctuate in price.Back to top
5 Consider Option Strategies Carefully
Options are leveraged investments that can offer significant potential advantages and risks. As part of an overall investment strategy, put and call options may offer opportunities to temporarily alter the risk/return characteristics of a portfolio. Before investing in options, it is important to thoroughly understand the potential risks and benefits. You should consult a qualified tax advisor as to how option transactions may affect your tax situation. If you are an employee and have received stock options as employee compensation, you will want to carefully consider how exercise of your options may affect your cash flow and tax liability.Back to top
Summary
An option is a contract entitling the option purchaser to buy or sell the underlying stock at the stated exercise price. A call option gives the holder the right to buy the underlying stock; a put option gives the holder the right to sell the underlying stock.
The option purchaser's risk on the option is limited to the premium paid; the option seller's risk on the option is potentially unlimited.
A call option is valuable to the extent that the exercise price is below the market value of the underlying stock at the time you choose to exercise the option by buying shares. The time value of the option is the potential that the share price will rise over time and eventually exceed the option exercise price.
Employee stock options may be tax-qualified incentive stock options (ISOs) or nonqualified stock options (NSOs). If shares acquired through an ISO are held for at least one year following exercise and are not disposed of until at least two years after the option is granted, the difference between the option price and the sale price is taxed as a long-term gain. If you don't meet the one-year holding-period requirement, the transaction is considered a disqualifying disposition and your gains are taxed as ordinary income.
Before implementing an investment strategy using options or before entering into any equity arrangements with an employer, consult your tax advisor.
Checklist
Check the current share prices of the stocks associated with your stock options.
Confirm that you've met holding-period requirements before using employee stock options in order to qualify for more favorable tax treatment.
Conduct a comprehensive investment portfolio review to make sure that your options are part of a well-diversified overall asset allocation.
Consider meeting with a tax advisor or financial professional to understand how your options could affect your tax and investment strategies.
http://finance.yahoo.com/how-to-guide/career-work/12827;_ylt=Apv84a87_jfeohFOdDH4hya7YWsA#c1
One Billion Dollars
It is really impossible for someone to burn through even one billion dollars.
That is the equivalent of spending $25,000 per hour for ten years.
Investing that amount in T-Bills (1-2%) would guarantee you about $60-120k/day in living expenses.
What that means is that every hour you sleep, relax, shave, poop, or somehow fail to spend money, you delay running out of your $1B.
http://tpmmuckraker.talkingpointsmemo.com/2008/12/almost_since_the_news_broke.php
That is the equivalent of spending $25,000 per hour for ten years.
Investing that amount in T-Bills (1-2%) would guarantee you about $60-120k/day in living expenses.
What that means is that every hour you sleep, relax, shave, poop, or somehow fail to spend money, you delay running out of your $1B.
http://tpmmuckraker.talkingpointsmemo.com/2008/12/almost_since_the_news_broke.php
Let's hope we never see another one like it.
How Not to Ruin Your Life
Lessons from a Very Bad Year
by Ben Stein
Posted on Monday, December 22, 2008, 12:00AM
At last, this horrible year is almost behind us. Let's hope we never see another one like it.
If someone had told me that the market -- adjusted for inflation -- would be down by more than it was in the Great Depression while most Americans still basically had high prosperity, I wouldn't have believed it possible. It goes to show what stupendously bad Treasury stewardship can do.
If someone had told me Treasury and the Fed would allow the fourth- or fifth-biggest investment bank in America to fail, I would've scoffed. But they did it, and we got a stock market crash, a severe recession, and national fear as the result. The night Paulson and Bernanke let Lehman fail was the night they drove old American investors down.
Theoretical Failings
Meanwhile, we look to the future. And we try to learn from the past. What have we learned?
1. Efficient market theory is extremely limited as a market predictor in times like these. Efficient market theory says that at any given moment, the market price of all stocks reflects all that is known about them -- the price at any given moment is the best estimate of future price.
This is true as far as it goes. And, again, in most times, it goes very far. But in times when what is not known lurks below the waterline like the bottom of an iceberg, dwarfing what lies above and can be seen, efficient market theory is not only limited in effectiveness but downright dangerous.
It turned out that what lay waiting unknown to most of us -- and to the market -- was a wild miscalculation about the true liabilities associated with credit in this country. The true liability on subprime included staggering amounts of derivatives, a high multiple of subprime itself. Ditto for credit card debt, and now, as we're seeing, ditto for commercial mortgage debt.
Not only was that debt questionable, but players had added super-sized bets so big that the markets simply couldn't adjust to them without a serious correction.
Mr. Market Gets It Wrong
So efficient market theory is sunk. The problem is that we have nothing else to replace it except the predictions of many different analysts. Some are right and some are wrong, and they're usually not even close to being as helpful as Mr. Market.
But as my pal Jim Grant notes in his masterful new book, "Mr. Market Miscalculates: The Bubble Years and Beyond," the market is far from infallible and can lead the investor to disaster. Efficient market theory is highly fallible, but it may still be better than anything else.
Bye-Bye, Buy and Hold?
Another lesson to be drawn from this year:
2. Buy and hold as a strategy is very questionable, as my pal Robert Lobban says. It's worked in the past, but in times of severe market stress it just doesn't work. We've now gone 10 years -- many of which were banner years for profits -- without a gain in the broad indices. In some areas, such as REITs and commodities and energy and autos, the losses have been breathtaking.
But trading doesn't work well for most investors either. Even for the best hedge fund geniuses (and actually I don't consider them geniuses at all), trading has often been a catastrophe in the last 15 months.
So, what's the solution? Ben Graham, a real genius who mentored Warren Buffett, concluded near the end of his life that stocks were simply too risky and investors should only be in Treasury bonds.
My pal, Phil DeMuth, along with many others, has long said that investors should have half in bonds. He's right, but even bonds, except for Treasuries, have been whacked this year. But his approach is definitely the right one. Ray Lucia, a super-smart investment guru, says you should have seven years of expenses in cash or near-cash to ride out events like this if you're retired or close to retirement. This turns out to be a simply brilliant suggestion. Ray has a lot of them.
What we're left with is maybe that buy and hold is far from perfect, but if we have enough cash to get us through the bad times we might yet see it work. If not, one hardly knows what to suggest.
Historical Ignorance
The final lesson from 2008:
3. We can't count on the people who rule us to have learned a darned thing from past history. "Those who do not know the past are condemned to repeat it," said the famous Harvard philosopher George Santayana.
Of course, that's a cliche by now and has been for decades. But it is true of Henry Paulson, our pitiful Secretary of the Treasury and, very, very sadly, of Ben Bernanke, our Fed chairman.
Paulson is simply an ignorant, bullying fraud. I never expected much from him. But Bernanke is a scholar, or so I thought, and should've known better than to destroy confidence by allowing Lehman to fail. That was a mistake that no real student of the Great Depression, as Bernanke is, should've made. I would never have thought it could happen, but it did.
It makes me wonder what other mistakes and foolishness our rulers have in mind, and it scares me plenty.
Only Human
In the meantime, please don't blame yourself for your losses. We all make mistakes, yours truly especially. My hat is off to those like Doug Kass who saw it all coming. My hat is not off to those who claimed afterward to have seen it coming. I have met so many people who tell me they sold out in October 2007 that I think I must be the only person left in this country with any stock. (That would make me by far the richest man on the planet, and I guarantee that I'm not.)
We're just human beings with human failings. Efficient market theory fooled us. Buy and hold fooled us. Trust in government fooled us. My own failings fooled me. Something else will fool us next time. As my grandmother used to say when her children made a mistake, "Don't worry, you'll do it again." If we learn even a little from what's happened, we're far ahead of Henry Paulson.
In that spirit, have a Merry Christmas, Happy Hanukkah, and Happy New Year.
http://finance.yahoo.com/expert/article/yourlife/130751;_ylt=AgwC136V7Ufr00HLQkr3Mku7YWsA
Lessons from a Very Bad Year
by Ben Stein
Posted on Monday, December 22, 2008, 12:00AM
At last, this horrible year is almost behind us. Let's hope we never see another one like it.
If someone had told me that the market -- adjusted for inflation -- would be down by more than it was in the Great Depression while most Americans still basically had high prosperity, I wouldn't have believed it possible. It goes to show what stupendously bad Treasury stewardship can do.
If someone had told me Treasury and the Fed would allow the fourth- or fifth-biggest investment bank in America to fail, I would've scoffed. But they did it, and we got a stock market crash, a severe recession, and national fear as the result. The night Paulson and Bernanke let Lehman fail was the night they drove old American investors down.
Theoretical Failings
Meanwhile, we look to the future. And we try to learn from the past. What have we learned?
1. Efficient market theory is extremely limited as a market predictor in times like these. Efficient market theory says that at any given moment, the market price of all stocks reflects all that is known about them -- the price at any given moment is the best estimate of future price.
This is true as far as it goes. And, again, in most times, it goes very far. But in times when what is not known lurks below the waterline like the bottom of an iceberg, dwarfing what lies above and can be seen, efficient market theory is not only limited in effectiveness but downright dangerous.
It turned out that what lay waiting unknown to most of us -- and to the market -- was a wild miscalculation about the true liabilities associated with credit in this country. The true liability on subprime included staggering amounts of derivatives, a high multiple of subprime itself. Ditto for credit card debt, and now, as we're seeing, ditto for commercial mortgage debt.
Not only was that debt questionable, but players had added super-sized bets so big that the markets simply couldn't adjust to them without a serious correction.
Mr. Market Gets It Wrong
So efficient market theory is sunk. The problem is that we have nothing else to replace it except the predictions of many different analysts. Some are right and some are wrong, and they're usually not even close to being as helpful as Mr. Market.
But as my pal Jim Grant notes in his masterful new book, "Mr. Market Miscalculates: The Bubble Years and Beyond," the market is far from infallible and can lead the investor to disaster. Efficient market theory is highly fallible, but it may still be better than anything else.
Bye-Bye, Buy and Hold?
Another lesson to be drawn from this year:
2. Buy and hold as a strategy is very questionable, as my pal Robert Lobban says. It's worked in the past, but in times of severe market stress it just doesn't work. We've now gone 10 years -- many of which were banner years for profits -- without a gain in the broad indices. In some areas, such as REITs and commodities and energy and autos, the losses have been breathtaking.
But trading doesn't work well for most investors either. Even for the best hedge fund geniuses (and actually I don't consider them geniuses at all), trading has often been a catastrophe in the last 15 months.
So, what's the solution? Ben Graham, a real genius who mentored Warren Buffett, concluded near the end of his life that stocks were simply too risky and investors should only be in Treasury bonds.
My pal, Phil DeMuth, along with many others, has long said that investors should have half in bonds. He's right, but even bonds, except for Treasuries, have been whacked this year. But his approach is definitely the right one. Ray Lucia, a super-smart investment guru, says you should have seven years of expenses in cash or near-cash to ride out events like this if you're retired or close to retirement. This turns out to be a simply brilliant suggestion. Ray has a lot of them.
What we're left with is maybe that buy and hold is far from perfect, but if we have enough cash to get us through the bad times we might yet see it work. If not, one hardly knows what to suggest.
Historical Ignorance
The final lesson from 2008:
3. We can't count on the people who rule us to have learned a darned thing from past history. "Those who do not know the past are condemned to repeat it," said the famous Harvard philosopher George Santayana.
Of course, that's a cliche by now and has been for decades. But it is true of Henry Paulson, our pitiful Secretary of the Treasury and, very, very sadly, of Ben Bernanke, our Fed chairman.
Paulson is simply an ignorant, bullying fraud. I never expected much from him. But Bernanke is a scholar, or so I thought, and should've known better than to destroy confidence by allowing Lehman to fail. That was a mistake that no real student of the Great Depression, as Bernanke is, should've made. I would never have thought it could happen, but it did.
It makes me wonder what other mistakes and foolishness our rulers have in mind, and it scares me plenty.
Only Human
In the meantime, please don't blame yourself for your losses. We all make mistakes, yours truly especially. My hat is off to those like Doug Kass who saw it all coming. My hat is not off to those who claimed afterward to have seen it coming. I have met so many people who tell me they sold out in October 2007 that I think I must be the only person left in this country with any stock. (That would make me by far the richest man on the planet, and I guarantee that I'm not.)
We're just human beings with human failings. Efficient market theory fooled us. Buy and hold fooled us. Trust in government fooled us. My own failings fooled me. Something else will fool us next time. As my grandmother used to say when her children made a mistake, "Don't worry, you'll do it again." If we learn even a little from what's happened, we're far ahead of Henry Paulson.
In that spirit, have a Merry Christmas, Happy Hanukkah, and Happy New Year.
http://finance.yahoo.com/expert/article/yourlife/130751;_ylt=AgwC136V7Ufr00HLQkr3Mku7YWsA
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