Potential Exam Questions for ECN 335X

I have gone through the questions submitted for potential inclusion on the final exam. Here are the questions I will choose from (there will be at least one and possibly two selected).


1. Outline the underlying basis of the relationship between bond and commodity prices. Give an example of how this relationship can change based on occurrences in the other two intermarkets that would contradict this "traditional" relationship.

2. Explain the effects of a weakening US Dollar in an intermarket context.

3. Can the stock market and commodities move in opposite directions? Explain the basis of your answer.

When you take the final exam tomorrow, MAKE SURE THAT EACH OF YOUR RESPONSES ANSWERS THE SPECIFIC QUESTION IT IS ADDRESSED TO. I strongly suggest that before you hand in your exam, read each question again then make sure that your response is to the specific question posed and not just a series of statements that might be correct overall but that don't really answer the question.

Final Paper Citations

The forecast paper for ECN 335 that is due Friday MUST include correctly formatted footnotes and bibliographies. You should get into the habit of doing this for every paper you write. In order to make this process a bit less daunting for you, I have located an easy-to-use link that illustrates the appropriate footnote and corresponding bibliographic entries for various types of sources you might reference. I have chosen the Chicago style for this.

Finally, all of you need to avoid using incorrect words that unfortunately have the effect of making your writing and/or you appear to be "dumb" to persons who don't know you. I am referring to the confusion between "effect" and "affect," and "to" versus "too." I have a handout for you detailing this. If you confuse these words in your papers, you will be penalized a +/- on your paper grade.

What are Interest Rates Telling Us?

As we outlined in class yesterday, interest rates and the bond market have a great deal of predictive ability concerning future levels of economic activity. The simple yet very powerful model of interest rates you should use is:

interest rate = f(expected inflation, economic growth, monetary policy)

As I noted, inflation expectations and growth expectations are not necessarily independent of each other, so the time frame you are considering becomes relevant to seeing which matters more. You can use the TIP:TLT ratio in StockCharts.com as one proxy for expected inflation, while a preferable way is to calculate (and track through time) the TIPS spread (= nominal interest rate - TIP rate with same maturity). This is available daily (in real time) from Bloomberg.com. Here is a link to the web page to use for this. As of today (4/21/10), the 10-year US Treasury bond has a rate of 3.79%, while the 10-year Inflation Indexed Security (TIP) has a rate of 1.43%. So:

TIPS SPREAD = 3.79% - 1.43% = 2.36%

Historical data on this is available from the Federal Reserve Economic Data (FRED).

If you want to find a proxy for the level of economic activity and income, you can use consumer cyclicals ($CYC) in Stockcharts.com. Where is support for this? Resistance? Are there any leading indicators from technical analysis that can be of help in the short-term (ex: bullish or bearish divergences based on the RSI)? 

So, you should use the interest rate model above whenever you need to explain interest rate changes or to make interest rate forecasts. To do this, you will need to generate a forecast for each explanatory factor. Possibly, over the time period of your forecast, a factor that usually matters will not matter much. Or possibly, a factor that normally doesn't matter much will be influential. Remember: NOBODY KNOWS THE FUTURE (except CNBC, of course).

For those of you who have taken ECN 327 with me, you can expand the basic interest rate model substantially. Using general macroeconomic models such as the IS-LM and AD-AS, you can identify a fairly large set of factors that determine either economic growth (Ye in those models) or inflation (changes in Pe in the AD-AS model). Basically, those factors are the "other things" of the relevant curves.

Looking at a chart (click to enlarge) of the 10-year rate ($TNX), resistance at 4% becomes readily apparent (note: you must divide the number on the right axis by 10 to get the interest rate). Short-term support is at roughly 3.5%. Why has resistance held over the one-year period covered by this graph? Rates fell twice from 4% (a double top, by the way). What causes interest rates to decline? To answer this question, use the interest rate model.

Rates decline for some combination of declining expected inflation, less expected future growth, or monetary easing. Obviously, we can rule out monetary easing. That leaves us with declines in expected growth and inflation.

Will the 10-year re-test resistance or support? Again, use the interest rate model to answer this question. Anyone doing their forecast on interest rates will have to do this.

Read the relevant chapters in John Murphy's Intermarket Analysis to further help you with an understanding of this topic.

Financial Sector Plunges on Goldman News

On Friday, news about the SEC bringing charges against Goldman Sachs and one of its VP's for fraud charges shook the markets. According to the SEC, Goldman created Collateralized Debt Obligations (CDOs), a collection of parts of mortgage backed bonds, which were destined to fail, then sold them to entities without fully disclosing the facts concerning how these were constructed (toxic) and that a major hedge fund (of Paulson) was betting against them. Here is a link to a story about this. And, in an amazing intermarket application of all of this, there is a potential basis to associate the difficulties with Goldman Sachs with future gold prices. Here is a story about this.

Technical analysis of the ETF for financials (XLF) shows how significant Friday's events were. The chart (click to enlarge) shows how the sharp decline in price on Friday broke a very steep trendline, while still preserving (for now at least) the overall uptrend (based on RSI >= 40). This decline did not lack conviction (sorry for the pun), as it was based on extremely high volume.

Based on Fibonacci Analysis, the next potential support for XLF occurs at the 38.2% retracement  level with a price of $15.77 (Friday's close was $16.36). On the chart, note that the 50% retracement occurs at a prior high (from early January of this year) of $15.35. At this point, a 50% retracement can not be ruled out, as more news will no doubt emerge next week, much of which will involve negatives for Goldman Sachs and (potentially) other similar firms as well. Also, markets tend to overreact in the short-term to such momentous news events.

The question now becomes how financials react and whether this trend for XLF is broken convincingly. For extra credit due at the beginning of class next Tuesday, create a PerfChart of the S&P sectors (as I did in class on Thursday) with a time period that starts at the beginning of April this year. Based on this, which sector has led this "leg" of the rally? What does the chart above signify about any potential changes in what the PerfChart shows? Should the defensive sectors see money flowing in as the result of Friday's news? Paste the PerfChart and brief answers to these questions in a Word document.

One way to assess how financials will do in the near term is to perform technical analysis on the overall stock market. Prior to Friday, the S&P 500 was very overbought, as the RSI(9) was well above 70. After Friday, the RSI fell to below 70, so it is no longer overbought. I also recommend that you look at the economic "numbers" that will be coming out this week. Other than the Leading Economic Indicators on Monday, the only major number with market moving potential is Durable Goods, which is released next Friday morning. So, for much of this week, the market overall and financials in particular will be driven by further news concerning the SEC's case against Goldman Sachs.

Picking Stocks to Invest In

As you probably know, there are different sized firms (small, medium, and large capitalization), and there are different emphases among them in ETF's. In this post I focus on growth and value orientations.

To get the symbols for these, I went to the ishares.com web site, which has an easy navigation method. On the left, select the US Market Cap/Style tab. Sub-tabs appear giving the different market cap possibilities, and when you click on one of these, you get the symbols for the market cap and emphasis of that ETF.

You can use these symbols to determine the size/orientations that are outperforming (hopefully) the market using PerfCharts in StockCharts.com. I have done this for you. Click on the following link to get the PerfChart for this.

You will need to convert this to a bar chart, so click on the bar designation below the graph on the bottom left.
- To compare performance to the S&P click on the S&P tab above the bar chart.
- On the bottom right below the graph, drag the bar to select the time period you will investigate. NOTE that the dates you end up with are given in the top left of the graph.

Once this is done, you will be able to see which sizes are performing best, or which orientation is doing better than others. I used the most recent low for the S&P 500 which occurred on February 5. Using this as the starting date (through the most recent date), small cap growth is the most rapidly growing ETF.

As an investor, how can you use this procedure for selecting potential ETF's or stocks to invest in? Obviously, any ETF's that outperform the S&P are obvious choices for you to consider. BUT, make sure you check the technicals of each of these ETF's before you decide whether to purchase shares (using the regular SharpCharts in StockCharts.com).

If you want to purchase individual stocks, what can you do? The answer to this is simpler than it might appear: Get the symbol of the ETF that is outperforming (here JKK), return to ishares.com, and investigate it there. Enter the symbol on the ishares home page or go to the tab to get to that ETF's page. There you will find the primary holdings in that ETF. You can click to find all holdings if desired), and its sector breakdown. If you click on View All Holdings in ishares.com, symbols for each holding are given. Get the symbols for the 10 largest holdings (PerfCharts can only deal with 10 things at a time). Return to PerfCharts, enter those symbols, then determine which individual stocks have outperformed the other ETF holdings.

Once you identify those, the final step consists of charting these and performing a technical analysis of each (or CandleGlance for the entire group). Based on your results, decide which if any you want to purchase (you should also have a sense of where the overall market is going).

February's Employment Report

February's employment report was better than expected. Even though there was a loss of 36,000 jobs, weather factors had been fully expected to exacerbate the final number. More importantly, when weather-distorted values of employment such as February occur, the jobs number in the following month almost always shows a significant rise, as some of the weather-related loss is "made up." This is clearly the expectation going forward, that March will show a rise in employment (not just because of the addition of Census workers). The unemployment rate remained at 9.7 percent, also better than anticipated, leading some to conjecture that we have already. Gseen the peak unemployment rate (I am not convinced of this yet). Here is an article about the report, and two videos from CNBC about the employment report. The first is pre-report, the second occurred after the data were released. The bond market hated the employment news, selling off, as the 10-year bond rose 8 basis points (remember: when bond prices fall, interest rates rise).

Most of the time, when an employment number is released, the stock market tends to bounce around, as bulls and bears battle throughout the day. Generally, this leads to a small daily change for the market that day. This was not the case on Friday, as the market shot higher and sustained its momentum throughout the trading day. The result was a large candle, a large real body, and almost no shadow (tails). Here is the chart for Friday (click to enlarge). Note that resistance in terms of the RSI(9) remains above 60, but it is now slightly overbought. So, will we make it to the next resistance at 1150 without a short-term pullback? Check next week's economic releases and see if there are any major releases that can materially affect the stock market.

 I believe that the stock market sustained its earlier momentum as the day wore on because in addition to the jobs report, there was a report that consumer credit had risen, painting a potential picture of how a recovery will gain traction. Of course, time will tell if that perception turns out to be correct, but I believe the market is pricing this in.

There was a good video on CNBC that discusses sectors (a bit) and the interest rate to look at (2-year US Treasury) as a signal that the market will break out from its recent sideways action.

Finally, I didn't mention it in class Thursday, since I want to see who reads the blog postings, but our exam will be on Tuesday, March 16. So, dig in, do the assignment, and study for the upcoming exam.

Three Different Resistance Measures

The S&P 500 has stalled around its 50-day moving average, as was true the other day (see the previous post). Now that a few more days have passed since then, we saw a couple of spinning tops, which indicate indecision, then a large down day (yesterday) followed by a significant up day (today). Today's bullish candlestick was not as large as yesterday's bearish candle, and today the market opened from a higher level than yesterday's close. In OHLC charting, this is referred to as an inside day. Overall, I think it is safe to say that there is no definitive direction for future price change at this time. As I stated in class, at times like this, it is advisable to consult the economic calendar for the remainder of this week and next week, identify the "biggie" releases that will occur, then attempt to determine what each of these will do and how the market will react. Nobody can know this with certainty, so don't be intimidated. Actually, if you listen to the "talking heads" on the financial stations and keep track of what they predict, you'll probably be surprised by how inaccurate these persons are. So, don't be afraid to venture out and try this, you probably won't do any worse than the "talking heads."

Look at the following charts and analyze the most recent candlesticks and think about what they indicate about the battle between bulls and bears. Using these, I will now present three different ways to measure resistance.

#1: Fibonacci Retracement: If we apply a Fibonacci Retracement to the most recent high and low of the daily S&P 500 (see chart, click to enlarge), we see something quite interesting: the recent rally stalled at the 61.8% retracement point. The use of Fibonacci Retracement suggests that after a decline, the first possible point of resistance in a rally is when 38.2% of that rally has been erased (retraced). The next possible resistance point is at 50%, while the last occurs at 61.8% retracement.

#2: 50-day Moving Average: The next charts (click to enlarge) shows that the 50-day moving average acted as support for the S&P 500 since last fall, then became resistance in late January of this year. It is fairly common for prior support to become resistance (and vice versa). Note how the most recent rally failed just at the 50-day moving average. At this point, based on the most recent candlesticks, the direction of future price is still a toss up. A definitive move above the 50-day moving average, especially for a major market index, would be very bullish, and we might have a shot at returning to the previous high. If that were to occur, then the market falls below that level, what technical formation do we have? A double top, which is a reversal pattern. More about establishing a down target later this semester if this possibility occurs.

#3: RSI(9) < 60. In this same chart, look at the RSI in the upper portion. Note how the most recent high coincided with the RSI falling below 60 and remaining there. Just as the S&P is now testing its 50-day moving average, so too is it testing the RSI at 60.Often, an RSI value of 60 is used as resistance for a downtrend, while 40 is used to designate support for an uptrend.

So, what will happen from here? As I stated above, look at the economic calendar, identify the "biggie" numbers that can potentially move the market, and attempt to predict what each of these will do. In doing this, you are actually using economic theory, which states (for our purposes at this point):

      Stock Prices = f(interest rates, expected future profit)

In analyzing the future releases, focus primarily on the macroeconomic implications for profit expectations, since Fed Chair Bernanke indicated again today that the fed funds rate will remain low "for the foreseeable future." That reassurance was a fundamental driver of today's rally which erased most of yesterday's losses.

Surprise Discount Rate Announcment

Yesterday, after the markets closed, the Fed announced that it was raising the discount rate by 25 bp. Here is a story about this. The initial reaction after hours was as expected -- the announcement took everyone by surprise. Before this morning's market open, futures pointed to a down day, although the amount kept shrinking. What all of this points to is uncertainty and indecision as market participants digested all of this and formulated their views of the likely consequences.

Which types of candlestick bars depict this? Forget a candle with a long real body and little in terms of shadows (i.e., tails). Look over the candlesticks I covered the other day in class. One would expect either a doji or a spinning top. What actually occurred for the S&P 500 was a spinning top. Here is a chart of the current data (click to enlarge) as of the Friday close.

The RSI is not yet overbought, so potentially there is room for further upward price movement. Note that the RSI is approximately 60, which is the value that some use to indicate resistance for a time of weak price movement. The most striking thing in this chart is the fact that the $SPX closed above its 50-day MA for the first time since January of this  year. If the market were worried about the impact of the Fed raising the discount rate, would the S&P have closed above its 50-day MA today? No, it would not have. So, today's price action, in spite of signaling indecision in terms of a spinning top, does allow for the possibility that it the S&P will remain above its 50-day MA at least for the very near term. The real question is whether former resistance, in terms of the 50-day MA, will now become support.

How can we arrive at a way to answer this question? Using economic theory, we model stock prices. According to economic theory:

                    Stock Price = f(interest rates, expected profits)

Interest rates pertain to asset substitution possibilities in the short-term (review the stock and bond info in the Supply and Demand notes) and product demand in the medium term. Were yesterday's surprise discount rate announcement taken to indicate that Fed tightening was about to begin, not only would the market have failed to clear the 50-day MA today, there would likely have been a noticeable upper shadow (tail) as well. Also, there was a CPI data report today that signaled benign inflation, which signals that interest rates should not rise much.  So, the primary factor to focus on is profit expectations. For extra credit, due at the beginning of class on Tuesday, plot the relative strength of the S&P 500 (a measure of stocks) compared to TLT, a measure of longer-term bond prices using as a chart type a solid line with weekly data. In a short word document, include the chart with annotations from StockCharts.com (not hand written) and a very short discussion of what the relative strength of stocks vs bonds is showing us about expectations for future economic activity (and therefore profits). Feel free to consult John Murphy's text about this.

When you get a chance, you should read two excellent columns on technical analysis by Michael Kahn in Barron's Online. I strongly suggest that you save these and others throughout this semester (and beyond). The first of these, written in early February, talks about the market correction. Follow his reading of candlestick charts and overall analysis. The second, from this past week, analyzes the question of whether the market will be fighting back and trend up.

January Employment Report

 Friday's employment report was multifaceted, to say the least. First, there were the employment change results: -20,000 (a very small amount for the entire country, and not statistically significant). Then there were the employment revisions for 2009 -- very large, making the job loss during "The Great Recession" equal to 8.4 million. Finally, there was the unemployment rate, which fell from 10 percent to 9.7 percent. Recommendation: ALWAYS LOOK AT REVISIONS TO PRIOR PERIOD(S) BEFORE EXAMINING THE NEW DATA (as this establishes a proper context for you).

Much was written about these results. Here's what the WSJ said. Here is the link for a video from CNBC after the results were announced, and another link for the same group discussing things before the release. After reviewing all of these,make sure you understand: (1) that there are two separate surveys used for these results; (2) how can the unemployment rate actually fall if employment falls; and (3) what are the implications of the set of results for the stock market, bond market (interest rates), and the US dollar. As I have said numerous times already this semester, "other things" are seldom "equal." So, as a backdrop to all of this information from Europe, is the ongoing concern about the Sovereign debt of Spain, Ireland, and Portugal (these countries have now come to be referred to as the "PIG" countries). So, the final outcome of the day was the joint effect of the Sovereign debt problems and the US employment/unemployment rate data.

GDP Surprise

Friday's GDP report, the preliminary look at Q4 economic performance, was surprising. The consensus was for about a 4 percent gain, but the number came in at 5.7 percent. This was an excellent example of how "good news" impacts interest rates: good news tends to cause higher interest rates, as we discussed in class the other day. Here is the link for an article discussing this.

Initially the stock market and interest rates rose as the results were released. By the end of the day, however, things had changed.  The chart (click to enlarge), which uses 60-minute OHLC bars, shows how the ten-year US Government bond reacted throughout Friday's trading. First thing to note, the actual interest rate is 1/10 of the value listed on the right scale. So, for example, 36 corresponds to 3.6, etc. Second, note how closing values exceeded opening values for the first two bars (hours). How could we figure that momentum might begin to shift? Look for upper tails, where the bulls were unable to support high levels, and by the end of the time period, bears had pushed values lower. After the second bar (hour), things turned around for the rest of the day, as close was below open each hour. By the last hour, there was essentially a "toss up," as open and close were almost identical.

Why did rates reverse on the "good news." Much of the overall GDP growth was the result of inventory effects (3.7% of the 5.7%), which will not persist in coming quarters.So, while this GDP number was a surprise and good news, interest rates, like asset markets in general, are forward looking. So the news in coming quarters might not necessarily be all that much better than what the markets had been anticipating prior to the GDP release. More data, primarily for this actual quarter, will be needed to move the direction of interest rates from where they were that day. Support, though, appears to be at 3.6 percent. Will this level hold? As the course progresses , I will show you how to use economic models to make an educated guess at questions like this.