Stock Trading Blog
Now that the election is over, investors have begun turning from hopeful optimism to nervous skepticism. The Trump administration was viewed as good for American manufacturing and investors began to buy industrials and materials, while commodity prices in metals like copper enjoyed similar gains. With the actions of the administration early in office, though, investors are beginning to feel a sense of fear.
But fear has never resulted in profit. Smart investors know that high volatility just means more trading opportunities. Instead of panicked trading moves, some investors do the opposite and pull their money out of the markets completely. This can lead to missing out on later gains and under-performing the broader indexes.
But there are more than just two moves investors can make. There’s always a bull market somewhere – not all assets perform equally at the same time.
Play the Fear Trade
When volatility rises and uncertainty becomes the primary factor when determining investment choices, safe haven assets like gold often perform well. Increasing your holdings in gold can be accomplished either through direct gold commodity purchases or gold mining stocks. Silver also falls into this category and actually experiences larger swings in returns, although its performance lags behind gold. When gold prices start moving up, silver won’t be far behind.
Investing in conservative stocks is another way to mitigate risks without sacrificing returns. High-yield dividend payers provide investors with protection from downside movements and do well when the markets trade erratically. They also boost returns when markets are going up, so you don’t miss out on any upside movements, either.
Conservative sectors like healthcare, consumer staples and utilities are good places to invest during uncertain times, as well. These stocks tend to be inversely correlated with the broader indexes and outperform when other sectors are falling. Energy MLP’s and REIT’s can provide investors with protection, too.
Finally, options are a great way to play the market when you’re unsure of its direction. There’s plenty of strategies that allow you to profit from either upside or downside movements through calls and puts. As long as the stock moves out of a certain trading range, you’ll earn a profit.
You can also use options to hedge your current positions. One of the most common, a covered call, will net you upfront gains by selling a call at a higher price on a stock you currently own. You’ll miss out on any upsides above that strike price, but you also hedge your portfolio from downside movements.
While panic almost always leads to poor decision making and negative returns, there’s nothing wrong with hedging your portfolio against new risks. If you have profits in a trade, it might be a smart idea to take your original investment off the table and play with the house’s money. You’re guaranteed to at least break even in the worst case scenario, while still leaving yourself open to more profits.
Wall Street loves volatility – the more chaos, the more opportunities for profit. It’s relatively easy to turn a profit when the market is going up and just as easy when the markets are going down. It’s when volatility dries up and markets trade in a holding pattern that investors see drops in returns. It can often lead to making high risk moves that result in big losses when volatility returns.
But just because the markets aren’t moving doesn’t mean there aren’t moves you can make to keep your portfolio returns up. While high volatility might make it easier to buy and sell stocks, there are other investment strategies you can employ to avoid stagnation. Why let just the bulls and bears make all the money?
One way investors can take advantage of markets that are treading water is to buy dividend paying stocks. Not only will it help mitigate your downside risk, it also boosts returns through quarterly dividend payments. While dividend stocks are primarily thought of as conservative investments, investors can use them to increase their overall portfolio returns when growth is hard to come by.
MLPs in particular are good alternative options when the markets aren’t doing much. They typically offer higher dividend yields than you might find in stocks with more consistency. Many offers yield in excess of 5 percent, which means even limited growth of just 5 percent would result in a 10 percent overall annual gain.
Options are another great way to take advantage of stagnant markets. Many strategies allow investors to make money as long as the underlying stock doesn’t go up or down by a specified amount. It also allows investors to leverage their money and mitigate risk.
One of the most common option strategies known as a covered call can be a good way to increase your returns as well. By selling a call at a higher price on a stock you own, you can immediately earn a profit. It also provides some downside protection if the stock dips at the cost of limiting your total upside potential.
Find the Niche that Works
Underneath the seemingly calm surface waters of neutral markets, there are often raging currents taking place unseen by investors who aren’t looking for them. There’s always a bull market happening somewhere. Even when it seems as if the broader indexes aren’t experiencing much activity, there can be certain sectors or asset classes that are.
Macroeconomic events can create opportunities that won’t affect the market as a whole. For example, a biotech company could be experiencing gains due to a new drug they’ve developed or a commodity like gold or silver may be rising in value for a number of various reasons.
It’s important to keep diversification in mind when designing a portfolio for sideways markets. Investing heavily in dividend paying stocks might seem like a good, conservative way to generate a steady stream of income and boost your portfolio returns, but they’ll under-perform in a bull market when growth stock outpace income stocks. Regardless of how the market is performing, there’s always a strategy available for investors to make a profit.
Oil has been a sore spot for investors over the past couple of years. The Organization of the Petroleum Exporting Countries (OPEC) decided to maximize oil production regardless of global demand, driving prices down in an attempt to bankrupt foreign competitors, like U.S. shale oil, and keep control over the oil market. In the summer of 2014, oil took a hit and fell precipitously to the upper $30’s back in early 2016.
For years, oil struggled to break out of the $40 price range, leaving energy investors on the sidelines wondering when the crisis would end. Protracted low oil had a detrimental effect on companies that needed oil at a higher price to justify their cost of operations. But OPEC’s war had the unintended side effect of streamlining the companies that were able to weather the storm, making them leaner and more efficient.
The Winds are Changing
Non-OPEC oil producers met OPEC’s challenge head-on. The companies that were able to adapt only became more competitive, to the point that even OPEC-producing countries like Saudi Arabia could no longer sustain oil at such low values.
With oil beginning to tick higher toward the end of 2016 and trade based on macroeconomic fundamentals rather than OPEC cartel influences, a historic deal was made. An agreement to cut production by 1.8 million barrels a day was made for 2017 with the first cuts already enacted. Saudi Arabia surprised analysts by cutting more than expected in January, helping lift oil prices to the mid-$50’s – a level not seen in two years.
But the production deal isn’t the only tailwind for oil right now. Oil production in the United States is ramping up again thanks to development in the Permian Basin in west Texas. Activity in the region is responsible for more than half of all U.S. oil rigs with 267 currently in operation.
Total rig count is growing as well, with more being added every week. Total rig count is up to 655, up from a historic low of 404 back in March, less than a year ago. Compared to the growth in the Permian Basin, the next most active drilling site is Eagle Ford shale, which is home to 47 rigs.
Oil is now trading steadily above $50 per barrel with most analysts expecting prices to continue to rise as the year goes on. But the industry still faces some challenges that may be hard to overcome.
Despite Cuts, Challenges Remain
U.S. shale producers were a major factor along with the OPEC overproduction in 2014 that sent oil prices crashing. Since then, though, surviving oil producers have managed to become far more efficient and are able to produce oil at a much lower cost.
That means oil companies are able to increase production with oil at much lower prices than before, effectively canceling out the OPEC production cut for 2017. New developments like the Keystone XL and Dakota Access are set to come online this year, as well, which could easily provide enough oil to overshadow the cuts, despite growing concerns of the tribe people who live there, who rely on safe, clean drinking water and who have been protesting its development for months.
In the end, investors need to be careful with future oil price expectations. The OPEC deal to cut production seems to balance out the increase in U.S. shale oil production. While OPEC’s market cartel might officially be on its way out, the forces of supply and demand aren’t forgiving. Oil will start to trade more in line with fundamentals moving forward, and as the environmental ramifications of oil drilling continue to shape public opinion, global growth will be one of the major factors in how oil prices perform.
Stock indexes are near all-time highs with the average price-to-earnings ratio of the S&P 500 over 25 times earnings. Even traditionally conservative sectors like consumer staples are getting overpriced, making it difficult to find good deals and value buys in this market.
But despite the highs the domestic markets are hitting, that doesn’t mean value can’t be found. Globalization has changed the way investors make trades and diversification means expanding your portfolio to include overseas markets.
Going overseas to find new investment opportunities can be a good strategy, but with so many possibilities, it might be difficult to find real value. Emerging markets offer the most returns to investors and recent developments have churned up value opportunities that Wall Street hasn’t quite caught on to yet.
The New BRIC
The BRIC countries – Brazil, Russia, India and China – have been the leading emerging markets for investors to put their money for the past decade and more. But deep recessions in Russia and Brazil have made investments there unwise and unprofitable. Emerging market BRIC funds have been experiencing huge outflows as investors lose faith in these countries’ economies and a new paradigm begins to emerge.
Despite the decelerating economy, China remains a profitable investment option. GDP growth is still nearly triple that of the US’s economy while India continues to grow through radical political reforms that’s opening its economy up to foreign investment.
That leaves two unaccounted for though. The new replacements are Taiwan and South Korea – affectionately known as TICKS. The big energy companies of Russia and Brazil are no longer the engine of growth. Instead, technology is the new generator and Taiwan and South Korea deliver big. Companies like Samsung – a South Korean company – are making waves in the technology world with innovative ideas that are changing the way the world works.
At the forefront of IoT, Samsung is a leader with its new smart-fridge, which allows consumers to literally see what’s inside their fridge and place orders for meals all from the kitchen. But it’s not just technology that’s driving these economies. South Korean make-up company AmorePacific gained more than 150 percent in the past year, revealing just how much the emerging middle class means to emerging market growth.
The former BRIC economies are giving way to an explosion of middle class growth and the TICKS countries are well prepared to supply the demand. The new technological revolution, combined with the growth in the middle class from former BRIC economies should drive growth going forward.
Investing overseas carries unique risks that investors need to be aware of. Currency fluctuations can add or subtract to real world gains and with the dollar hovering near all-time highs, loss due to exchanges is a real concern. Additionally, technological growth is decidedly unsteady, making markets unpredictably unstable, as well.
The current bull market has been alive and well as of March 2009, which means it’s coming up on 8-years-old. Considering that the average bull market lasts about 4 years, many investors are beginning to wonder if we’ll see a correction soon, or if the bull still has plenty of room left to run.
It’s now the second longest bull market on record, with the longest being the internet-fueled dotcom bull that lasted for 4,494 days spanning from 1987 to 2000 – more than 12 years. Now after 8 years, investors worry about what lies ahead and whether they should start preparing for the worst. Luckily, there are ways to objectively examine a market and see how strong the bull actually is and what dangers it may face.
One of the simplest ways to check the status of the stock market is to take a look at how expensive stocks are. This can be done by examining the price-to-earnings ratio of a broad index like the S&P 500. It will tell us what multiple investors are paying for future company earnings – a higher than average multiple could mean that stocks are getting unreasonably expensive and could face a correction back to the mean.
The historic S&P 500 P/E mean average is 15.64 times earnings and right now it’s reading 25.41. That’s a considerable premium and should trigger a red flag for investors. But, bear in mind, that markets can stay at high premiums for an extended period of time before correcting. The average P/E of the S&P 500 stayed above this level for years in the late 1990’s and early 2000’s going as high as 44 times earnings before finally correcting back down.
One of the most tried and true methods for predicting market corrections comes from looking at investor debt margin levels in the markets. Investors that are bullish tend to buy stocks on margin and leverage their money to achieve higher returns. When margins get too high though, it means that investors have hit the peak and the amount of money available to buy stocks and keep prices high runs out causing stocks to fall.
Historically, margins peaked right before major events like the Great Depression in 1929 and again more recently prior to the 2008 financial crisis. The most recent margin data from November 2016 shows margin debt over $500 billion – one of the highest on record and double the level back in 2010. But interestingly, debt levels have more or less stayed the same for the past three years now drifting from the mid $450 billion range to $500 billion. Normally that would indicate that investors are neutral about the market but the gains we’ve seen in the S&P 500 over the past three years tell a different story.
It’s important to note that correlation doesn’t equal causation. High margins don’t always mean a collapse is inevitable nor does a high P/E ratio mean that the market is overpriced. But with a number of red flags coming in from multiple data points, it seems prudent to be cautious about this bull market right now. With the change in political administrations, investors might want to consider taking any gains off the table for now but not withdraw from the markets completely.
If you watch any financial news program or read investment-based articles, you might notice something interesting – they’re usually about stocks. There might be a bit about currencies, commodities and bonds, but by and large stocks get the most coverage.
There’s a good reason for it: stocks tend to be the first type of asset class anyone can invest in, generally through mutual funds and 401k’s. When you open up a brokerage account, you’ll likely trade stocks and not get access to more complex investments, like futures and currencies. The problem is that this unequal distribution can lead to investors neglecting other assets like bonds in favor of stocks. A portfolio made up of just one asset class – even if it’s internally diversified – can lead to big losses for those that aren’t aware of the risk they’re taking on.
Allocation and Risk Tolerance
Having a diverse set of assets in your portfolio is the key to maximizing returns without taking on undue risks. But, in order to know what kind of setup you need to have, you need to first ask yourself what kind of risk you’re willing to take on. You need to know what your risk tolerance is.
While there are a number of tools online that will help you figure out what type of investor you are, there’s a good chance you already know if you’re conservative or aggressive. A good rule of thumb for building a portfolio is to take your current age and subtract it from a number to figure out what percentage you should have in stocks and bonds.
Conservative investors should subtract their current age from 100 and use that number as the percentage of their portfolio that should be invested in stocks. For example, if you’re 30 years old and fairly conservative, you should have 70 percent of your portfolio in stocks and 30 percent in bonds.
More aggressive investors can subtract from 115. In that case, you would want 85 percent in stocks and 15 percent in bonds.
Following this simple rule can help you avoid unexpected losses without disregarding the importance of exposing your portfolio to profitable investments.
One thing to keep in mind when constructing a portfolio is what type of financial instrument you should be using. With stocks, there are a number of options, such as mutual funds, ETF’s and individual equities. But bonds are a little trickier to invest in. Typically, bonds are purchased in lots of $10,000 each per bond. So unless you have a large nest egg built up, you probably won’t get the kind of diversification you need by investing directly in bonds.
Instead, you should use mutual funds to get exposure to bonds. These investment vehicles hold portfolios made up of different types of bonds in multiple industries with a diverse range of maturity dates.
Finally, you should check your portfolio allocation at least once a year. Because stocks typically outpace bonds, over time your portfolio will become more heavily weighted in stocks, which could throw off your balance. You should make adjustments as needed so your portfolio doesn’t get off track as you approach retirement.
If you’re looking for another way to make your dollar grow, you might consider doing away with the dollar entirely and investing in foreign currencies. The Forex market, once the home of large institutional brokerages and hedge funds, is now available to everyday investors through margin accounts.
While it may sound risky and exotic, foreign currency exchanges are now part of the financial globalization process with instant access to virtually any type of currency to anyone with a computer. If foreign currencies sound like they might be for you, there are a number of ways you can invest in them right from your home.
The Foreign Currency Market
Most investors are accustomed to basing gains and losses on the value of the U.S. dollar, but thanks to globalization, there are now ways to profit from other currencies. The dollar’s value fluctuates on a daily basis against other foreign currencies like the euro and the yen.
A strong dollar means goods from overseas become cheaper by comparison, while a weak dollar means more goods can be exported as foreign currencies go further to buy American-made products. Investors can take advantage of these differences by holding foreign currencies and taking advantage of appreciation against the dollar or by shorting, or selling, those currencies against a rising dollar.
As the global marketplace becomes more interconnected, holding currencies of other countries can be a good way of diversifying against domestic economic downturns.
Here are a few ways you can invest in foreign currencies:
Forex Trading – If you want to invest in foreign currencies directly, you can open a Forex account. Initial deposits are generally very low, under $1,000, and allow you to trade leveraged currencies to boost returns. Investors should note, however, that many currency leverages can be in excess of 200:1, making it a high risk trade that could result in big gains or losses in a single trading day.
Exchange-Traded Funds – If taking on all the risk of Forex trading is too extreme for you, consider using ETF’s instead. These investment vehicles trade like stocks and are very liquid, letting you make changes easily. They’re also somewhat diversified, reducing risk while still giving you exposure to the foreign currency of your choosing.
Foreign Companies – Finally, you can get exposure to foreign currencies by investing in companies that operate overseas. Because their profits are calculated in their local currency, you can take advantage of arbitrage opportunities. When those profits are translated into U.S. dollars, you could see additional gains due to relative currencies value fluctuations.
As with all other investments, foreign currencies are inherently risky. Investors should be aware of what macroeconomic factors influence currency values and understand the relationship between them and interest rates before investing. Government policies can also impact currency valuations, since they’re the basis of export and import trade. Investors should make sure that their entire portfolio is diversified in order to avoid unexpected losses.
It’s no secret that one of the primary focal points of the new Trump administration is going to be China. His ideals regarding the One-China Policy are just one of the many controversial plans he has regarding U.S. foreign policy. His recent telephone call with the Taiwanese leader was the first contact a U.S. President or (President-Elect) has had with Taiwan since the late 1970’s and has set the stage for what many believe could be a series of progressive economic escalations.
Business negotiation or thinly-veiled threat?
One of Trump’s platforms is to renegotiate trade deals the United States has with foreign nations in order to foster better terms for the U.S. On the surface, there’s nothing wrong with wanting to get the best deal possible, but Trump’s approach is abrasive and thoughtless when it comes to the potential ramifications his trade deals could have on the global economy and trade.
By using Taiwan as leverage, Trump hopes to negotiate trade deals with China, but the plan has many pitfalls. The benefits of fighting back against devaluation stemming from China seem to be outweighed by the possible negatives that could happen in retaliation.
While the United States might have Taiwan to use as leverage against China, China has many economic tools to use against the U.S. For one, Boeing is expected to deliver $11 billion worth of planes to China to service its growing airline industry. But China could easily cancel the deal and go with its European competitor, Airbus. China could also use its anti-monopoly laws to hurt American businesses, like it did with the $975 million fine on Qualcomm, which cited licensing infringements.
But aside from its impact on domestic businesses, a more disturbing bit of leverage is the amount of American debt China holds. The country holds around $1.3 trillion in United States treasuries and could dump them on the open market. That could cause a sudden jump in interest rates and send America’s economy into a downward spiral almost overnight.
China could also devalue its currency to make Chinese products even cheaper, something that Trump claims the country already does. They could also place embargoes and higher taxes on U.S. goods, as well as pull investments out of our domestic economy.
It’s still too early to tell what impact Trump will have on the Chinese and Asian markets. Certainly, his recent actions prove that he’s going to take an active role in trying to renegotiate trade deals, but his method of doing so seems questionable.
At best, it could simply be a huge bluff intended to bring China to the table. But the dangers of using Taiwan as a political play against one of the largest economies in the world could end up hurting investors in the long run.
If you’ve decided to take control of your own financial future by starting an investment account – congratulations! You’ve taken the first step toward gaining true financial independence. But before you open your first brokerage account and beginning trading stocks, there are a few things you’ll want to know first.
An investment portfolio is more than just stocks and mutual funds. It should work together to serve a common purpose. You might think all you need to do is spread around you money and invest in a number of different things, but there’s more to it than just that. While diversification is something you’ll likely hear repeated over and over, it means nothing if you don’t understand how diversification is supposed to be applied.
When designing your investment portfolio, you’ll want exposure to a diverse range of asset classes. That includes stocks, bonds, currencies, and commodities. Of course, you may find that investing directly in currencies and commodities presents a bit of a challenge. Many of these types of assets trade on the futures market – something that beginning investors are ill-prepared for. But there’s still a way to invest in them through other means.
Stocks are arguably the easiest asset to invest in. You can choose mutual funds to get exposure or invest directly through a brokerage account. Bond exposure is typically gained through mutual funds, although investors with significant assets can choose to buy bonds directly.
Rather than risking the highly volatile futures market, currencies and commodities can be invested in through ETFs, mutual funds, and stocks. Many of these types of commodity or currency-based investment vehicles come with managed portfolios, giving you a level of instant diversification within the asset class.
Many first-time investors skip over the risk tolerance step when setting up their investment accounts. These investors are usually the same ones that end up telling horror stories of losing it all when the market crashes.
In order to determine what your risk tolerance is, you need to first examine what your financial goals are and what kind of volatility you can bear. If the idea of watching your portfolio value drop 10-20% keeps you lying awake at night, you might want to consider a more conservative portfolio approach, limiting your exposure to blue-chip stocks and bonds.
However, if you’re a young investor, you might want to consider a more aggressive portfolio design. Any losses you might incur, you can recover from with a longer-term investment horizon. By focusing on growth investments like stocks, you can boost your returns and slowly allocate to a more conservative portfolio as you reach retirement age.
Putting It All Together
You portfolio shouldn’t be just about getting the most returns. There are other considerations to keep in mind, such as your personal risk tolerance and investment goals. It’s important to keep your long term objectives in mind when setting up your portfolio. Remember to stay diversified and keep a good mix of investments in your portfolio.
Need more stock tips? Check out our Top 5 Stock Trading Companies for more information.
Investors have always looked for an edge in the marketplace. Any detail, no matter how small, is an advantage if it could predict future stock movements. Aside from the obvious, like economic data and stock returns, one element in particular carries a lot of weight when it comes to predicting stock market corrections and crashes: margins.
Trading activity can reveal a lot about the economy – in particular, how leverage and margin accounts are used. Investors with an appetite for risk use leveraged strategies to boost returns by borrowing money at a predetermined interest rate and using it to invest at a higher rate of return.
When margin is high, it generally means that investors have a large risk appetite and are bullish about the future. But it also means there’s far more volatility in the market and a lot more debt. Any slight downward correction when margins are high can mean dramatic declines or even crashes, as investors desperately seek to cover their loans by selling out of their positions.
How Margin Acts as a Prognosticator
Margin levels in the stock market have a long and storied history of being able to predict market crashes. Investment activity in the 1920’s leading up to the Great Depression was a classic example of how margin debt can harm the market. Some levered positions were as high as 10 to 1, which was of the biggest reasons why the markets crashed so quickly.
But the truly insidious thing about high margin debt is the inverse association of available credit to lend to borrowers. When margins begin to be called, financial institutions simply don’t have the money available to lend out to businesses and a shortage of credit is what really takes down the economy. Investors saw a similar problem play out in 2008 when the sub-prime mortgage crisis caused credit to dry up as real estate holdings were being foreclosed on and people could no longer afford their homes.
Interestingly, margin debt levels pointed to a crash before it happened, just like the Great Depression. From January 2007 to July 2007, NYSE margin debt levels rose 22% before finally peaking in August – a month before the sub-prime mortgage crisis hit the markets.
As of September, margin debt levels are over $501 billion – the second highest level recorded, with June of last year coming in at $507 billion. Margin debt has climbed 12% so far this year and seems to keep climbing, despite the risks. If history is any guide, investors should be wary of their stock holdings and be prepared for a runaway correction if the markets start to decline.
Correlation Doesn’t Equal Causation
While high margins have a high correlation with upcoming stock market crashes, it’s important to remember that correlation doesn’t equal causation. Margin levels have been high for the last several years without any major correction. In fact, margin levels have been around $450 billion and $500 billion for the past two years.
But there also hasn’t been a correction large enough to reach the tipping point that could ultimately send stocks into a downward spiral. The absence of a market crash despite high debt levels shouldn’t be a reason to dismiss the correlation. Right now, investors would be wise to tread carefully with any leveraged positions and be prepared to act quickly should the bull market turn into a bear market.
It’s no secret that commodities have been an outcast asset class for years now. The three year annualized return on the Dow Jones Commodity Index is -12.14% with investors steering clear of anything related to commodities like steel, aluminum, coal, and especially oil. The strength of the US dollar has acted as a further headwind for commodities, and with interest rates on the rise the dollar should remain strong.
The slowing Chinese economy left a demand vacuum in the commodities space with no other economies with strong enough demand to make up for it. While investors have been looking at possible alternative countries like India for a replacement, it seems that any real commodity revival will have to come from some other source.
But despite all the headwinds, some commodities could see gains next year. A new President means a new political administration and policies that could benefit certain sectors of the US economy over others.
For value investors, these commodities could be surprise winners for 2017:
Typically associated with a growing manufacturing base, aluminum has been a bit of a roller coaster for investors lately. But aluminum has been a stealthy gainer so far regardless of its volatility. With Trump in office though, aluminum could be a big winner for 2017.
Aluminum had been gaining before Trump was elected, but after, aluminum spiked even higher. Better than expected data from China has helped fuel the rally and an increased expected demand from the US means aluminum should have a prosperous road ahead.
Oil’s been a blight for the market for the past couple of years but the end is in sight. OPEC’s cartel looks to be permanently broken and oil is beginning to trade more along natural supply and demand curves rather than by political manipulations.
US shale oil was a major reason why OPEC panicked and began depressing prices in order to eliminate competition. But with Trump in office, investors can bank on policies aimed at US energy independence and that means keeping shale oil in production. Keeping oil flowing from domestic reserves will be a key point in the new administration.
Gold and Silver
The traditional safe haven assets have had a red letter year for 2016. Gold is up around 12% while silver has logged even more impressive gains north of 18%. Lately precious metals have fallen but the drop may be merely a correction.
Despite the rise in interest rates, a new administration mean increased volatility in the markets. Trump’s ideas regarding foreign policy could result in higher than expected inflation. That means assets like gold and silver could benefit.
While some may argue that rising interest rates should curb any positive gains in commodity values, the truth is it may not impact them much at all. The small increases of a quarter of a percent on an annual basis won’t derail equity or commodity markets. However, China remains a key part of how commodities are viewed. Better than expected results tend to buoy commodity values, but China is still an economy in deceleration mode. Investors should bear in mind that time is ticking away until the global economy has a reason for improved commodity demand outside of China.
Bonds aren’t the most popular investment to talk about. Investors tend to view them much like a side of broccoli in a steak dinner. The steak (stocks) may garner all the attention, but experienced investors know that it takes a balanced portfolio to be financially healthy.
Maybe you can speak at length about the prospects of XYZ stock or discuss in detail how its valuation multiple makes it an attractive buy right now, but the moment someone mentions bonds, your eyes glaze over and you tune out of the conversation.
You aren’t alone. The bond market is arguably the most misunderstood market on Wall Street simply due to a lack of basic bond know-how. Once you understand what a bond is and how it’s valued, you’ll be able to speak about and invest in bonds with confidence.
Debt isn’t all bad
A bond is a loan issued to governments or corporations that comes with a fixed interest rate over a preset period of time. It works exactly the same as when you take out a loan to finance the purchase of something such as a car except instead of borrowing money from the bank, you become the lender the company or government is borrowing from.
These debt instruments typically pay out interest on a semi-annual basis and are known as fixed-income securities. Investors can trade bonds in several ways. They can hold the bond until maturity and collect the interest, or they can trade the bonds before maturity and take advantage of any price appreciation that occurs.
Bonds are issued with credit ratings as well with higher credit ratings paying less interest than those with lower credit ratings. Bonds that have a rating of AAA to BBB are known as investment grade bonds because the issuer has a high or medium credit quality and there is a low risk that the company will go delinquent on its debt. Bonds with a rating of BB or lower are called high-yield bonds or “junk” bonds because there is a higher risk of a company defaulting on its loans.
Pricing a bond
Bond prices and interest rates have an inverse relationship meaning that as one goes up, the other goes down and vice versa. If you’re buying a bond with no intention of trading it – you’re just holding it for the interest – then pricing changes won’t matter to you. But if you’re trying to take advantage of any opportunity that presents itself, then you’ll want to know how bonds can be profitable beyond yield.
Let’s say you bought a bond with a par value of $1,000 and offers a 5% yield netting you $50 semi-annually. Regardless of what happens with the face value of the bond, the semi-annual amount you’ll earn will not change. Now let’s assume that interest rates are hiked by 1%. In order for the bond to trade at parity, it will need to offer a 6% yield. In order to do that, the value of the bond needs to fall so that the face value will equal a 6% yield. In this case, the value would drop to $833. A 6% yield would then give an investor $50 semi-annually.
Bonds are considered one of the pillars of a balanced portfolio along with stocks and money-market assets. While bonds are often dismissed as an asset class that’s taken for granted, investors who understand how the bond market works can boost returns and improve their portfolio’s efficiency.
The markets have predicted a 50-50 chance that the Fed will raise rates again this December and investors are on the fence as to how this could benefit them. The election cycle has complicated matters leaving many investors on the sidelines until the vote comes in and uncertainty abates a little in the markets.
Last December the Fed raised the Federal Funds rate by 0.25% marking the first increase since 2006 in what was widely believed to be a series of hikes. However, the markets plummeted early in 2016 following the hike and the Fed’s statements have changed from hawkish to dovish with little consistency. Keeping a rate hike on a set schedule is critical to maintaining stability in the markets, but another rate hike in December without seeing a rise in inflation could also tip the scales in a bearish direction.
Regardless of the Fed’s decision next month, investors need to have their portfolio’s prepared for the worst while still positioning it to take advantage of any potential gains.
The relationship between interest rates and stocks
Interest rates impact the cost someone pays for the use of another person’s money. When the Federal Funds rate goes up, it increases the cost banks are charged in order to borrow from the Federal Reserve. The goal is to reduce the money supply in an attempt to curb inflation.
Increased rates have widespread implications though. Higher rates means that borrowers pay more for loans and reduces the amount of money they are able to spend on other goods and services. For businesses, that means there is less capital to put towards investments or growth and reduces earnings due to the increased amount spent on interest payments.
When earnings go down, so do stock prices. So when interest rates go up, the immediate effect is usually a decline in stock values since profits take a hit due to the increased borrowing cost. It also makes more conservative asset classes like treasuries and bonds more desirable since yields go up. Stocks have more risk, while bonds have less.
Stocks need to be more valuable than the less risky bonds and treasuries in order to be more desirable to investors. For investors, that means a stocks return needs to be equal to or greater than the risk-free rate plus a risk premium. For example, let’s say the risk-free rate is 2% while XYZ’s risk premium is 8%. That means investors will expect the stock to generate a 10% return in order to be desirable. If the risk-free rate rise due to a Fed hike to 3% then the stock would need to produce a return of 11% to get the same result. As rates go up, stocks need to produce higher and higher return in order to compensate for the risk.
Not all stocks are affected the same by higher interest rates. Increased rates also mean greater returns on money market accounts and other conservative asset groups. This benefits financial companies the most like banks and insurers who keep significant sums of money in liquid assets in order to make loans and pay out insurance claims.
Investors who worry that a rate hike might hurt their portfolio might consider picking up some financial stocks to hedge against higher interest rates. Investors should also note that once the rate hikes stop, a new equilibrium will settle over financial markets with stocks compensating for the changes and producing higher returns in the long run.
There’s no worse feeling than watching a stock in your portfolio drop in value day after day with no end in sight. If it falls less than 10%, you say the markets are just going through a small correction. After it drops 20%, you tell yourself that it must have finally bottomed, but when it keeps falling, you may start to panic.
There’s one inevitable truth all investors must face: eventually, you will own a losing asset. The key to successful investing isn’t knowing when to buy a stock, it’s knowing when to sell it. That holds true whether the stock goes up or down, but understanding when you need to cut a losing investment loose is what separates good investors from great investors.
It comes down to simple math. If a stock drops 10%, you need to gain 11.11% in order to break even. After a 20% loss, the break-even point jumps to 25%, and if it has lost 50%, it’ll need to double in value just to prevent a loss.
In order to make a rational decision on whether you should keep a stock or sell it, you’ll need to answer three questions first.
Why Did You Buy the Stock?
If the reasoning behind why you bought the stock has changed, then you might consider getting rid of it – especially if its declining in value. If you bought a stock because it had a high dividend yield and management cuts the dividend, then the stocks circumstances have changed. If the stock is dropping in value along with most other stocks, it’s likely a macroeconomic reason and doesn’t affect the fundamentals of the stock you own.
Does Your Portfolio Need to be Re-Balanced?
Every so often your portfolio needs to be readjusted to keep in line with your risk tolerance. Some stocks gain more than others and subsequently take up more weight in your portfolio. As your risk tolerance changes, you may need to adjust how much money you have allocated to riskier stock picks. Investing in high risk speculative companies may be exciting, but too much of them in a portfolio can spell disaster.
Can You Use the Loss to Offset Gains for Tax Purposes?
If you have a losing stock in your portfolio, you might consider using tax-loss harvesting to reduce the amount of taxes you’ll need to pay at the end of the year. Selling a stock at a loss allows you to offset your income up to $3,000 in a single tax year. It might not be a profit, but at least it helps you reduce your tax burden.
One warning for those of you struggling to cut your losses: don’t bail out your money by throwing more money at a losing stock. Averaging down by purchasing more shares of a stock after its declined in value is dangerous. The idea is to lower your average cost per share, which on the surface seems like a good strategy. The problem is that averaging down can be a panicked reaction to seeing a stock drop in value. If its for fundamental reasons, then you’ll end up in a cycle of averaging down until you have a much larger percentage of your portfolio in that stock than you wanted just to bail out your original investment.
Investing the stock market takes discipline in order to be successful. Jumping in blind with no more idea of what to do other than “buy low, sell high” is the quickest way to lose your money. Without some guidelines to help you out along the way, it’s easy to make mistakes and get discouraged.
The good news is that investing isn’t rocket science. Even the smartest Ivy League college graduate knows that successful investing means following the rules. So before you start navigating the waters of Wall Street, here are 10 rules that every investor should be obeying:
- Know What You Own – The hottest new tech company may be all Wall Street and your friends are talking about but if you don’t understand what it is they do or how they actually make a profit, take a pass on it.
- Cash Is Also An Asset Class – Too many investors think that they need to be all-in in order to be a successful trader. Keeping cash on the sidelines though means that when an opportunity presents itself, you can act quickly without having to sell out of another investment before you’re ready.
- Diversify, Diversify, Diversify – This rule cannot be understated. Don’t keep all your eggs in one basket; diversify your investments to avoid getting hit by a single event that only affects a limited part of the stock market.
- Stay Calm And Keep Investing – Panicking when the market is behaving erratically is the quickest way to big losses. Don’t get sucked up in the hype and remember when everyone is selling, you should be buying and vice versa.
- Don’t Fall In Love – Remember that stocks are just investments. You may really like a certain company, but if a better opportunity comes along, you can’t be afraid to chase it down.
- Filter Out The Noise – Wall Street always has a new crisis or a new big opportunity for you to worry about. Ignore the pundits and stay focuses on the fundamentals.
- Explain Why You Own A Stock – Know why you want to own a particular stock. Is there a reason you think it’s going to appreciate? Before buying, be able to explain to a stranger why you think the stock is worth owning.
- Due Diligence – It might not be fun, but sticking to your due diligence will keep you from making costly mistakes. Always do your homework before buying a stock or could end up with an ugly surprise down the road.
- Don’t Be Afraid To Cut Your Losses – It’s never fun to admit defeat and even less fun to sell a stock at a loss. But if you own a loser, you need to cut it loose before it does more damage to your portfolio.
- Hogs Feast, Pigs Get Slaughtered – Once a stock you own has made the profits you expected, it’s time to move on. Don’t hold on and try to squeeze every last drop of profits from a stock or you could end up losing all the gains you thought you had in the bag.
It’s a lot easier to maintain discipline by following these simple rules for trading. As you become more experienced with trading, you may decide on a few more rules to help you stay focused as well. As long as it helps you become the best investor you can be, rules are a great way to keep your portfolio in check.