lecture 9: Relative Strength & Flow of Funds Flashcards
Relative Strength
One of the oldest approaches of technical analysis, and still one of the most widely used
action of a stock, or a group of stocks, is often compared to the market as a whole, so that it can be determined whether or not the stock or the group is acting better than, or worse than the market in general
how to calculate Relative Strength?
calculated by a simple ratio, dividing one market by another
When the Relative Strength ratio is rising?
When the ratio is falling?
When the Relative Strength ratio is rising = the numerator price is stronger than the denominator.
When the ratio is falling = the denominator price is stronger than the numerator.
The presumption behind Relative Strength
that strength will continue, similar to how trends will continue
How to interpret relative strength
If the numerator is rising, you would buy the numerator and sell the denominator. If the opposite is true, you would sell the numerator and buy the denominator
can be used to determine intermarket relationships.
–> It can be used to compare investments, sectors, industries, index averages, commodities etc. to determine which is outperforming the other
The simplest (and most utilized) form of Relative Strength
when the daily (or weekly) close of as stock (or sector group) is divided by a market average or index, the latter being most often the S&P 500
A stock that is moving laterally while the market is trending lower will, by definition, possess a strong or weak relative strength curve
possess a strong relative strength curve
A stock that is moving laterally while the market moves laterally will possess flat, or in-line relative strength trend.
true or nah
true
Many times the technical analyst will use relative strength to determine future market leadership, or the potential loss of leadership
what could this mean at the end of bear market?
Groups that act well in the tail end of a bear market, often emerge as the new bull market’s leaders
Leaders in a bull market may show signs of losing their status if relative strength “divergence” begins to do what?
profile a mature trend
Relative strength is an important technical tool, but like any other technical tools RS analysis should probably not be a sole application
why?
it should be noted that, without utilizing any other technical disciplines, one could find a stock “topping” out while maintaining a strong relative strength curve — or it could bottom out while relative strength appears poor
While these two characteristics would more than likely be an infrequent development, it is nevertheless advisable to input other technical guide lines, like trend analysis, support/resistance analysis
Flow of Funds At the beginning of a major uptrend
investors are risk averse; they have only a small percentage of their financial assets in stocks and have a high percentage in bonds and cash.
Traders are either out or they are short, trying to exploit the downside
when is An uptrend is started?
how does this affect traders
started by investors, people with long-term horizons, willing to look beyond current uncertainties
They are motivated by price and value.
Traders, on the other hand, are motivated by the trend, and tend to gain greater and greater confidence as a trend persists
For supply and demand to work in any market, money must be available
what happens when it is not
When money is unavailable or expensive, the supply of stock increases as investors sell their stock to raise funds for other purposes
There are 4 major topics in the study of flow of funds
Money Available
Availability of Funds Not Currently Invested in the Market
The Cost of Funds
Influence of the U.S. Federal Reserve’s Policy on these variables
money available: MONEY MARKET MUTUAL FUNDS
This indicator shows the liquidity or illiquidity available to the stock market.
However, having large amounts of cash on the sidelines available for investment does not necessarily mean that the funds will be committed to the stock market, though it can be
According to Ned Davis Research (NDR) (p.197) a high level of money invested in money market mutual funds (13-week ROC above 17.9%) is viewed as what?
a contrarian indicator that the market will rally
Money Available: Margin debt
the amount of funds that customers at brokerage firms borrow to buy stocks
has historically been considered a contrarian sentiment indicator
theory behind Margin debt
when markets became speculative and attract the less sophisticated and less knowledgeable investors who began to trade on margin, the market was at a top
Money Available: secondary offerings
The number of secondary offerings is a sign of increasing supply of stock being sold on the market
considered bearish
The number of offerings is more important than the dollar amount, since the dollar amount can be skewed by a few offerings
why are secondary offerings bearish?
First, it is a sign that more supply is coming into the market, soaking up available funds.
–> This excess supply pushes prices down.
Secondly, the sellers who are usually insiders, are liquidating.
–> These insiders will try to sell at prices that they feel are relatively high
Funds outside the securities market: HOUSEHOLD FINANCIAL ASSETS
This includes a ratio of liquid family assets (cash, bank deposits, money mkt mutual funds, treasury bonds) to illiquid assets (pension funds, retirement accounts, mortgages, life insurance).
what does A ratio of liquid financial assets to total financial assets show us?
shows us how liquid families are in raising cash if they need it
The more liquid families are, the more they are able to invest in stocks
–> Therefore when household liquidity is high, this is favourable for the stock market, and when it is low, this is a negative for the stock market
Funds outside the securities market: Money supply
Increases in the money supply have been historically associated with what?
with increases in economic growth and productivity
Expansion in the money supply is a measure of potential demand for stocks
what does M1 measure
measures the most liquid assets: currency and chequing accounts
what does M2 measure
slightly broader and includes: M1 + various forms of savings accounts
The year over year change in the ratio of M1 to M2, is analyzed to determine what?
liquidity
Funds outside the securities market: bank loans
Generally, an increase in loan activity – the amount of loans being created and existing, is a sign of what?
increased business activity
can also be viewed as a sign of increased speculation
When loan demand increases, it puts an upward pressure on interest rates; conversely, a decrease in loan demand puts a downward pressure on interest rates
The cost of funds: short term interest rates
If rates increase, then investing in interest bearing securities become more attractive than investing in equities, why?
because of the higher return without incurring the additional risks associated with equities.
The expected equity return must exceed the short term interest rate in order to attract investors.
The cost of funds: long term interest rates
The historic relationship between the stock market and long term bonds is:
Long term bond prices move in the same direction as the stock market (remember the inverse relationship between bond prices and interest rates), so long term rates move in the opposite direction to the stock market
–> higher interest rates = decreasing bond prices = decreasing equity prices
However, the bond market tends to lead the stock market
The cost of funds: long term interest rates
the misery index is an attempt to measure the social and economic cost of high inflation and unemployment
How is the misery index is an index calculated for any country
simply summing up the country’s inflation and unemployment rates together
A high misery index indicates what
investors are in a stressful market environment and a poorly acting stock market
The Fed policy
what is the federal reserve
the independent federal organization that determines and implements monetary policy for the United States
the principal determinant of short-term interest rates
The Federal Reserve’s policy regarding the money supply
how can the fed adjust the money supply
It can adjust money supply by “Conventional Monetary Policy”
- Changing the amount of reserves that banks are required to hold
- Changing the discount rate
- Buying & selling US treasuries
the “Conventional Monetary Policy” that the fed uses the most
why?
- Buying & selling US treasuries
When the Fed buys securities, it adds money to the banking system.
–> Since banks have more cash in their reserves, they are more likely to make loans, and interest rates tend to fall.
–> Another way of looking at this is that if the Fed buys t-bills, their prices increase and short term interest rates decrease
Fed selling of gov’t securities has the opposite effect.
–> Banks have less money in their reserves, so they are less likely to make loans.
–> Or – the Fed sells t-bills, lowering their, resulting in higher short term interest rates
The Federal Open Market Committee (FOMC)
meets every 6 weeks to establish a fed funds target rate
why is the target rate very important?
unexpected changes to this rate have instantaneous and drastic effects on the equity market
The Fed policy: three steps and stumble
This rule states that whenever the Federal Reserve raises either the:
- federal funds target rate
- margin requirements
- reserve requirements
three consecutive times without a decline, the stock market is likely to suffer a substantial, perhaps serious setback
The Fed policy: two stumbles and a jump
if there are two consecutive declines or tumbles in the:
- fed funds target rate
- margin requirements
- reserve requirements
the stock market tends to rise as a result
The Fed policy: yield curve
Shows the relationship of short term, medium term and long term bonds
It can be upward sloping, flat, and downward sloping
It has an acceptable record of anticipating major stock market turns
two types of yield curves
Normal yield curve
Inverted yield curve
Normal yield curve
Upward sloping (longer term rates greater than shorter term rates)
–> Banks are profitable and make money on the spread
–> Favorable for the stock market
Inverted yield curve
downward sloping (shorter term rates greater than shorter term rates)
–> Unfavorable for the stock market, and may predict a recession
The Fed policy: Non-conventional Monetary Policy
New tools that have been used since the Financial Crisis of 2008 to jump start the economy
- Quantitative Easing (QE)
- Zero Interest Rate Policy (ZIRP)
- Negative Interest Rate Policy (NIRP)
- Helicopter Money
