Understanding Bond Yields

Bond yields are a tricky concept for most investors to grasp initially because they are calculated based on a few moving parts and the mainstream media seems to roll back and forth between discussing bond yields and bond prices.

[VIDEO] Understanding Bond Yields

The first, and most important, concept you need to understand when discussing bond yields is that bond prices and bond yields have an inverse correlation. Picture a seesaw with bond prices on one side and bond yields on the other side. When bond prices are going up, bond yields are going down. When bond prices are going down, bond yields are going up. While it may seem counter-intuitive, understanding this relationship will help you avoid a lot of confusion when dealing with bonds.

So How Does It Work?

Bond yields are a measure of the profit you will make from your bond investment. The less you pay for a bond, the greater your profit will be and the higher your yield will be. Conversely, the more you pay for a bond, the smaller your profit will be and the lower your yield will be. If you’re interested in learning How to Calculate Bond Yields, check it out. For now, just understanding the concept is what is important.

Why Should You Care?

You may be thinking to yourself, “I’m not a bond investor. Why should I care what bond yields are doing?” And that’s a fair question. The reason you should care is bond yields are a good indicator of how strong the stock market is and how much interest there is in the US Dollar. If bond yields are going down, it is because bond prices are going up. Now, the only reason bond prices go up is if there is an increase in demand for the bonds.

Typically, you will see an increase in demand for bonds when stock investors are concerned about the safety of their stock investments and they decide to seek more safety for their money by investing in bonds and other US Dollar-backed investments. This will usually cause the USD to rise against the majors.

On the other hand, if bond yields are going up, it is because bond prices are going down. Now, the only reason bond prices go down is if there is a decrease in demand for the bonds. Typically, you will see a decrease in demand for bonds when bond investors feel their money would better serve them if it was invested in the stock market because the stock market is, or is about to, go up. This can actually weaken the dollar.

 

Image courtesy Horia Varland.

Understanding Unexpected Volume

When you are looking for stocks with the potential of making big price moves, it pays to go where the crowds are. Typically, when you can get a large number of stock traders interested in the same stock, you will see significant price moves.

[VIDEO] Understanding Unexpected Volume

It’s like trying to find the hottest new product. You want to look for the stores that have people lining up to buy whatever it is they are selling, not for the stores with empty parking lots.

What is Volume?

Volume is a measure of the number of stock shares that have been exchanged during a particular trading session. For instance, if the daily volume number for Apple (NSDQ: AAPL) is 25,000,000, it means that 25,000,000 shares of AAPL stock changed hands during the most recent trading day.

What Volume — Especially Unexpected Volume — Tells Us

Volume tells us how much market support there is for a particular price movement. Here are the four basic messages volume tries to send us:

  • Increasing volume pushing prices higher tells us there is a lot of support for the current price movement and the uptrend has a high likelihood of continuing.
  • Decreasing volume pushing prices higher tells us there is very little support for the current price movement and the uptrend has a low likelihood of continuing.
  • Increasing volume pushing prices lower tells us there is a lot of support for the current price movement and the down trend has a high likelihood of continuing.
  • Decreasing volume pushing prices lower tells us there is very little support for the current price movement and the down trend has a low likelihood of continuing.

How You Can Use Unexpected Volume

When you see stocks with unexpected volume, you can act on that information either by placing new trades or by protecting or exiting your current trades.

For instance, if you see a huge volume spike on Google (NSDQ: GOOG) and the price of GOOG shoots up, you may want to consider buying GOOG because the most recent move appears to have a lot of support behind it and will most likely continue in the future.

On the other hand, if you own ExxonMobil (NYSE: XOM) and see a huge volume spike on it, and the price of XOM drops lower, you may want to consider selling your position in XOM—or at least setting a stop-loss order to protect your position.

Misconceptions About Volume

Novice investors will often say there are more buyers in the market when volume is high and the price of the stock is going up. They will also say there are more sellers in the market when volume is high and the price of the stock is going down. This, however, is inaccurate.

The stock market always has an equal number of buyers and sellers. For every stock that is sold, someone has to be on the other side of the trade buying the stock, and vice versa.

To be accurate, traders should say the price at which buyers and sellers are agreeing to trade is moving up or down. The number of buyers and sellers has nothing to do with it.

 

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How to Determine Where to Set a Stop Loss

Many investors struggle with the task of determining where to set their stop loss levels. Investors don’t want to set their stop loss levels too far away and lose too much money if the stock moves in the wrong direction. On the other hand, investors don’t want to set their stop loss levels too close and lose money by being taken out of their trades too early.

So where should you set your stop losses?

Let’s take a look at the following three methods you can use to determine where to set your stop losses:

  • The percentage method
  • The support method
  • The moving average method

The Percentage Method for Setting Stop Losses

The percentage method for setting stop losses is one of the most popular methods investors use in their portfolios.

[VIDEO] The Percentage Method Stop Loss

One reason for this method’s popularity is its simplicity. All you have to do when using this method is determine the percentage of the stock price you are willing to give up before you exit your trade.

For instance, if you decide you are comfortable with a stock losing 10 percent of its value before you get out, and you own a stock that is trading at $50 per share, you would set your stop loss at $45—$5 below the current market price of the stock ($50 x 10% = $5).

The Support Method for Setting Stop Losses

The support method for setting stop losses is slightly more difficult to implement than the percentage method, but it also allows you to tailor your stop loss level to the stock you are trading.

[VIDEO] The Support Method Stop Loss

To use this method, you need to be able to identify the stock’s most recent level of support. [Learn more about Support and Resistance.] Once you have done that, all you have to do is place your stop loss just below that level.

For instance, if you own a stock that is currently trading at $50 per share and you identify $44 as the most recent support level, you should set your stop loss just below $44.

You may be wondering why you wouldn’t just set your stop loss level at $44. The reason is you want to give the stock a little bit of wiggle room before deciding to exit your trade. Support and resistance levels are rarely accurate to the penny so it is important to give the stock some space to come down and bounce back up off of its support level before pulling the trigger.

The Moving Average Method for Setting Stop Losses

The moving average method for setting stop losses is more simple than the support method, but it also allows you to tailor your stop loss to each stock.

[VIDEO] The Moving Average Method Stop Loss

To use this method, you need to apply a moving average to your stock chart. Typically, you will want to use a longer-term moving average as opposed to a shorter-term moving average to avoid setting your stop loss too close to the price of the stock and getting whipped out of your trade too early.

Once you have inserted the moving average, all you have to do is set your stop loss just below the level of the moving average.

For instance, if you own a stock that is currently trading at $50 and the moving average is at $46, you should set your stop loss just below $46.

Just as in the example above using the support method, you should set your stop loss just below the moving average to give the stock a little room to breathe.

 

Image Courtesy of Randy Son of Robert.

What Are Bonds and How Do They Work?

If you have ever spoken with a financial advisor or read a general investing article, you know that most advisors believe you should put part of your money into bonds. But why?

Financial advisors love bonds because they are conservative, reliable investments that provide stability to any portfolio. But how exactly do they do that? Let’s take a look.

[VIDEO] What Are Bonds and How Do They Work?

What is a Bond?

A bond is debt instrument that a government or a company issues to raise money. Basically it is a contract between a government or a company—who is acting as the borrower—and investors like you—who are acting as the lender.

When you buy a bond, you are lending money to the government or company that issued the bond, and in return, the government or company that issued the bond is agreeing to pay your money back, with interest, at some point in the future.

Think of it this way. When you buy a house, a bank creates a contract—a mortgage in this case—wherein the bank lends you money and you agree to pay the bank back, with interest, at some point in the future. Well, with a bond, you are like the bank, the government or company is like the home buyer and the bond is like the mortgage contract.

Characteristics of a Bond

When most people envision a bond, they picture a certificate that states how much the bond is worth, the interest rate that will be paid out on the bond and the date on which the bond will mature, and they are exactly right.

Let’s take a look at the following characteristics of a bond:

  • Face value is the amount the bond will be worth at maturity and the amount the bond issuer uses when calculating interest payments.
  • Coupon rate is the interest rate the bond issuer will pay on the face value of the bond.
  • Coupon dates are the dates on which the bond issuer will make interest payments.
  • Maturity date is the date on which the bond will mature and the bond issuer will pay the bond holder the face value of the bond.
  • Issue price is the price at which the bond issuer originally sells the bonds.

Buying and Selling Bonds

Many investors mistakenly believe that once you buy a buy a bond you have to hold onto it until it matures. That is simply not the case.

You can buy and sell bonds on the open market just like you buy and sell stocks. In fact, the bond market is much larger than the stock market.

Here are a few terms you should be familiar with though when buying and selling bonds:

  • Market price is the price at which the bond trades on the secondary market.
  • Selling at a premium is the term used to describe a bond with a market price that is higher than its face value.
  • Selling at a discount is the term used to describe a bond with a market price that is lower than its face value.

 

Image courtesy Horia Varland.

Understanding Price Patterns on Your Stock Charts

Price patterns are a lot like the brake lights on the cars around you when you are driving in traffic. When you see the brake lights come on in the car in front of you, you know that the car is slowing down and that you need to slow down too unless you want to crash into it. What you don’t know is whether the car is going to accelerate and continue moving in the same direction after it slows down, or if the car is going to come to a complete stop and change direction.

[VIDEO] Understanding Price Patterns

When you see a price pattern starting to form on a stock chart, you know the stock is starting to slow down, or consolidate, and that you need to slow down, take a step back and evaluate what may happen to it. What you don’t know, is whether the stock is going to breakout and continue moving in the same direction after it slows down, or if the stock is going to turn around and change direction.

Price patterns are an underutilized and extremely valuable tool in your stock-trading arsenal. It may take a little while to get comfortable with dealing with the subtle nuances and occasional ambiguity that are a part of price patterns, but once you do, you will feel like you are able to see into the future.

Price patterns are visual representations of market psychology. They tell you when traders in the market are excited and moving, when they need to take a moment and catch their breath and regroup and when they are ready to get moving again.

Attributes of Price Patterns

All price patterns are made of the following four pieces:

  1. Old trend: the trend that the stock is in as it starts to form the price pattern
  2. Consolidation zone: a constrained area defined by set support and resistance levels where the trend is undefined or channeling
  3. Breakout point: the point which the stock breaks the consolidation zone
  4. New trend: the trend the stock enters coming out of the consolidation zone
Price Pattern Attributes

Types of Price Patterns

Price patterns are divided into two major categories: continuation patterns and reversal patterns.

Continuation patterns tell you that the new trend is going to continue in the same direction that the old trend was moving. [Learn more about continuation patterns here.]

Reversal patterns tell you that the new trend is going to reverse directions and move in the opposite direction that the old trend was moving. [Learn more about reversal patterns here.]

The only real difference between continuation patterns and reversal patterns is which direction the new trend is moving. Both types of patterns have an old trend, a consolidation zone, a breakout point and a new trend.

 

Image courtesy makdune.

Why Investors Care About Retail Sales

Why does everybody seem to care so much about retail sales? Why does the stock market seem to fall off a cliff when we get negative retail numbers?

The answer: The Commerce Department’s Retail Sales Report provides investors, economists and politicians with an advanced look at how the economy and individual companies are doing right now and where they might be headed in the future.

Of course, you don’t want to read news like the Retails Sales news in a vacuum, but the announcement can tell you quite a bit.

[VIDEO] Why Investors Care About Retail Sales

Retail Sales and the Economy

The Retail Sales report is an important leading indicator because it gives us a glimpse into what the upcoming quarterly Gross Domestic Product (GDP) number—a number that tells us how fast the economy is growing or shrinking—might look like. You see, consumers make up approximately 70 percent of the United State’s GDP.

So if consumers are out there spending their money, we know that the GDP will probably show that the economy is growing. On the other hand, if consumers aren’t out there spending their money, we know that the GDP will probably show the economy is slowing, or even shrinking.

Retail Sales and Unemployment

The Retail Sales report also gives us a glimpse into what the future unemployment picture might look like. Unemployment tends to rise when the economy slows down or shrinks, and it tends to decline when the economy is strong and growing.

Once we get an idea of how the economy is going to be doing by looking at how retail sales might affect GDP, we can then look and see how our projected GDP numbers are going to affect unemployment.

Retail Sales and Company Profits

The Retail Sales report can give us a crucial glimpse into how individual retailers will most likely perform in the future. When retail sales are up, you know that earnings and profits at retailers like Walmart (NYSE: WMT), Home Depot (NYSE: HD) and Macy’s (NYSE: M) are going to be growing.

Conversely, when retail sales are down, you know that earnings and profits at most retailers are going to be down. However, Walmart does seem to be one retailer that is able to buck that trend—thanks to its position as a discount retailer that thrives during difficult economic times.

 

 

Image courtesy Klearchos Kapoutsis.

 

How to Determine if P/E Levels Are Too High or Too Low

Determining whether price-to-earnings (P/E) levels in the stock market are relatively high or relatively low can be extremely difficult if you don’t know where to look. The problem is, most investors try to look inside the stock market to get an objective view of P/E levels. Instead, investors should be looking outside of the stock market and into the bond market, especially the U.S. Treasury market.

[VIDEO] How to Determine if P/E Levels Are High or Low

The bond market and the stock market are closely related because they compete for money from the same pool of investors — all of whom are extremely motivated to make a profit.

Searching for Higher Yields

Investors are always looking for the best return on their money. If they can find a better return in the stock market, they will put their money into the stock market. If they can find a better return in the bond market, they will put their money into the bond market.

Determining the yield on an investment in a bond, like the 10-Year Treasury yield (TREASURE10Y) for instance, is quite simple because the yield is published throughout each and every trading day. In fact, at the time of this writing, the yield on the 10-Year Treasury is 3.74 percent.

Determining the yield on the overall stock market, on the other hand, requires a little more effort.

Using the P/E Ratio to Find the E/P Ratio

You can determine the current yield of the stock market — measured by the S&P 500 in this case — by finding the inverse of the market’s current P/E ratio. After all, the inverse of the P/E ratio is the E/P (earnings-to-price) ratio, and the yield is nothing more than knowing how much the asset is going to produce divided by the price you are paying from the asset.

For instance, if you know an asset you pay $100 for is going to produce $10 in earnings, you know that asset will yield you a 10-percent profit ($10 / $100 = 10%).

So all you have to do to determine the yield on the stock market is find the P/E ratio for the S&P 500 [which can be found here] and then calculate its inverse.

For instance, at the time of this writing, the P/E ratio for the S&P 500 is 58.66. Now that I know that, all I have to do is find the inverse of this number to determine the yield on the S&P 500, which in this case is 1.7 percent (1 / 58.66 = 0.017).

Now, we don’t want to forget about dividends because they play an extremely important role in your overall profitability in the stock market. Once again, at the time of this writing, the dividend yield for the S&P 500 is 2.63 percent.

If you add the yield on earnings from the S&P 500 — which is 1.7 percent — and the yield on dividends from the S&P 500 — which is 2.63 percent — you get a total yield of 4.33 percent (1.7 + 2.63 = 4.33).

Interpreting P/E Ratios and Yields

As you look at these numbers, it is important you remember the following:

  • As P/E levels increase, yields decrease
  • As P/E levels decrease, yields increase

In other words, when we see investors who are willing to pay a higher price for a stock, we know they are willing to accept a lower yield on the current earnings of the company represented by that stock. In most cases, investors would only do this if they believed the future earnings of the company were going to increase or the future price of the stock was going to be driven higher by the market for some other reason.

Conversely, when we see investors who are only willing to pay a lower price for a stock, we know they are not willing to accept a lower yield on the current earnings of the company represented by that stock. In most cases, investors would only do this if they believed the future earnings of the company were going to decrease or the future price of the stock was going to be driven lower by the market for some other reason.

Putting it All Together to Assess the Current P/E Level

Now that you have all of your data — the 10-Year Treasury has a yield of 3.74 percent and the S&P 500 has a yield of 4.33 percent — you can assess whether the current P/E level for the S&P 500 is too high, too low or just about right.

In this case, the current P/E level shows us investors are gaining more confidence in stocks. Whether they believe corporate earnings are going to improve or that more money is going to be coming into the stock market and driving up prices, investors are showing they are willing to accept a lower yield and a lower risk premium — the difference between the yield they could get by investing in bonds compared to the yield they can get investing in stocks, which is 0.59 percent (4.33 – 3.74 = 0.59) in this case — right now.

All in all, it looks like the current P/E level of the S&P 500 is in a comfortable range relative to the yield on the 10-Year Treasury.

 

Image courtesy Jeff Keen.