At Lepus proprietary Trading, one of the asset classes we trade are the Major Stock Indices.
A Stock index is a selected group of the best performing stocks from a relevant region/sector i.e. UK100 is a group of the top 100 stocks on the London Stock exchange.
A country’s index can be used to gauge the current performance of its economy. The relevant stock exchange will constantly revise these groups, only keeping the best of the best in terms of performance and growth.
This is done for a couple of reasons & has a number of resultants:
Governments/Stock Exchanges want to paint a picture of prosperity at all times to the public to drive investment.
When people/institutions are considering an investment in a certain country, they will want to ensure that its overall economy is performing well and has a positive outlook going forward.
Clearing out the under performing assets from an index group will promote growth in an economy as the Index will always be painting the best picture possible of a country’s current economic state at that time.
As a result, major indices have an upward bias. This is something I always take into considering when looking for a trade. Trading against the trend for the Dow Jones Industrial Average over the last 100 years would not have been a good idea.
How macroeconomic factors effect a stock Index
Politics, technological development and crowd psychology could be considered as a macro-factors that effect a stock index;
Decision regarding interest rates (increase or decrease) - There is a negative relationship between returns and interest rates. It means that if interest rate decreases, it has a positive impact on stock returns, and vice versa.
Money supply (aggregate M0) – Significant negative correlation
Inflation – the rise in the price of goods and services reduces the purchasing power each unit of currency can buy. Rising inflation has an negative effect on equities as input prices are higher, consumers can purchase fewer goods, revenues and profits decline, and the economy slows for a time until a steady state is reached.
Local currency exchange rate – An undervalued local currency will be attractive to foreign investment as institutions will look for avenues to invest their money within an economy.
How specific macro indicators effect capital markets
GDP is an indicator of total output of the economy in particular period. Changes in GDP derive from changes in total production, investment expenditures, public expenditures and net export. If an economy is in a good state, companies look for additional financing to boost their investing activity. One of the sources of capital is stock exchange. It means that positive signals from GDP should have positive impact on shares’ returns.
REMEMBER - GDP is a lagging indicator! News release will already be priced in at the time of announcement.
If a company invests in human capital, it means that its condition is sound. If a company anticipates increased demand on its products, it hires more personal, which results in a reduction of unemployment.
CPI & PPI
Increase in total production should be a positive indicator of economy’s performance. However, very high level of production could be interpreted as a turning point and result in decline of share prices.
Why trade we index as opposed to single equities
When trading indices, the factors we take into account are macroeconomic, as discussed above. When trading specific equities, the fundamental analysis (FA) they must carry out on company is different to FA for indices.
When attempting to decipher the intrinsic value of a company, as a retail investor you do not have access to the wealth of information that the large institutions have, straight away putting you a step behind the pace.
All the information we use to garner an opinion on an index is information that is released by the government and will be transparent.
With single equities – if you are reading the yearly report of a failing company, they will try to paper up the cracks as much as possible as they do not want to deter investment. This may cause misjudgement in some cases.
We also reduce our specific risk by trading indices as opposed to single equities. Single stocks are susceptible to unexpected earnings reports, resulting in a big gap up or down. If price gaps over your stop loss, you are left in a very vulnerable position and will have to take a larger loss than your original considered risk.
While gaps are common while trading indices, they are generally small and not a large point of pain for us.
Next week, I’ll do a market outlook on the major indices and will put up a few entry ideas I am looking at.