lecture 9: Relative Strength & Flow of Funds

Question 1

Relative Strength

Answer 1

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

Question 2

how to calculate Relative Strength?

Answer 2

calculated by a simple ratio, dividing one market by another

Question 3

When the Relative Strength ratio is rising?

When the ratio is falling?

Answer 3

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.

Question 4

The presumption behind Relative Strength

Answer 4

that strength will continue, similar to how trends will continue

Question 5

How to interpret relative strength

Answer 5

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

Question 6

The simplest (and most utilized) form of Relative Strength

Answer 6

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

Question 7

A stock that is moving laterally while the market is trending lower will, by definition, possess a strong or weak relative strength curve

Answer 7

possess a strong relative strength curve

Question 8

A stock that is moving laterally while the market moves laterally will possess flat, or in-line relative strength trend.

true or nah

Answer 8

true

Question 9

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?

Answer 9

Groups that act well in the tail end of a bear market, often emerge as the new bull market’s leaders

Question 10

Leaders in a bull market may show signs of losing their status if relative strength “divergence” begins to do what?

Answer 10

profile a mature trend

Question 11

Relative strength is an important technical tool, but like any other technical tools RS analysis should probably not be a sole application

why?

Answer 11

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

Question 12

Flow of Funds At the beginning of a major uptrend

Answer 12

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

Question 13

when is An uptrend is started?

how does this affect traders

Answer 13

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

Question 14

For supply and demand to work in any market, money must be available

what happens when it is not

Answer 14

When money is unavailable or expensive, the supply of stock increases as investors sell their stock to raise funds for other purposes

Question 15

There are 4 major topics in the study of flow of funds

Answer 15

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

Question 16

money available: MONEY MARKET MUTUAL FUNDS

Answer 16

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

Question 17

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?

Answer 17

a contrarian indicator that the market will rally

Question 18

Money Available: Margin debt

Answer 18

the amount of funds that customers at brokerage firms borrow to buy stocks

has historically been considered a contrarian sentiment indicator

Question 19

theory behind Margin debt

Answer 19

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

Question 20

Money Available: secondary offerings

Answer 20

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

Question 21

why are secondary offerings bearish?

Answer 21

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

Question 22

Funds outside the securities market: HOUSEHOLD FINANCIAL ASSETS

Answer 22

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).

Question 23

what does A ratio of liquid financial assets to total financial assets show us?

Answer 23

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

Question 24

Funds outside the securities market: Money supply

Increases in the money supply have been historically associated with what?

Answer 24

with increases in economic growth and productivity

Expansion in the money supply is a measure of potential demand for stocks

Question 25

what does M1 measure

Answer 25

measures the most liquid assets: currency and chequing accounts

Question 26

what does M2 measure

Answer 26

slightly broader and includes: M1 + various forms of savings accounts

Question 27

The year over year change in the ratio of M1 to M2, is analyzed to determine what?

Answer 27

liquidity

Question 28

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?

Answer 28

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

Question 29

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?

Answer 29

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.

Question 30

The cost of funds: long term interest rates

The historic relationship between the stock market and long term bonds is:

Answer 30

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

Question 31

The cost of funds: long term interest rates

Answer 31

the misery index is an attempt to measure the social and economic cost of high inflation and unemployment

Question 32

How is the misery index is an index calculated for any country

Answer 32

simply summing up the country’s inflation and unemployment rates together

Question 33

A high misery index indicates what

Answer 33

investors are in a stressful market environment and a poorly acting stock market

Question 34

The Fed policy

what is the federal reserve

Answer 34

the independent federal organization that determines and implements monetary policy for the United States

Question 35

the principal determinant of short-term interest rates

Answer 35

The Federal Reserve’s policy regarding the money supply

Question 36

how can the fed adjust the money supply

Answer 36

It can adjust money supply by “Conventional Monetary Policy”

1. Changing the amount of reserves that banks are required to hold
2. Changing the discount rate
3. Buying & selling US treasuries

Question 37

the “Conventional Monetary Policy” that the fed uses the most

why?

Answer 37

3. 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

Question 38

The Federal Open Market Committee (FOMC)

Answer 38

meets every 6 weeks to establish a fed funds target rate

Question 39

why is the target rate very important?

Answer 39

unexpected changes to this rate have instantaneous and drastic effects on the equity market

Question 40

The Fed policy: three steps and stumble

Answer 40

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

Question 41

The Fed policy: two stumbles and a jump

Answer 41

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

Question 42

The Fed policy: yield curve

Answer 42

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

Question 43

two types of yield curves

Answer 43

Normal yield curve

Inverted yield curve

Question 44

Normal yield curve

Answer 44

Upward sloping (longer term rates greater than shorter term rates)

–> Banks are profitable and make money on the spread

–> Favorable for the stock market

Question 45

Inverted yield curve

Answer 45

downward sloping (shorter term rates greater than shorter term rates)

–> Unfavorable for the stock market, and may predict a recession

Question 46

The Fed policy: Non-conventional Monetary Policy

New tools that have been used since the Financial Crisis of 2008 to jump start the economy

Answer 46

1. Quantitative Easing (QE)
2. Zero Interest Rate Policy (ZIRP)
3. Negative Interest Rate Policy (NIRP)
4. Helicopter Money