Investment Education

CPI – Consumer Price Index. A gauge of price movements in cost-of-living items such as food, rent, DVD’s etc., maintained by the Bureau of Labor. The CPI is the best known and most widely followed inflation indicator, though perhaps not the most accurate. It’s broken out two ways, “core” and “non-core” Core CPI excludes the costs of food and energy, on the grounds that these components are more volatile due to vagaries of weather, acts of God etc. that don’t necessarily reflect pricing pressure from real trends in supply and demand. That reasoning works much of the time, but at other times food or energy go on extended runs that do represent shifts in supply and demand. Non-core is also known as the “headline” number.

GDP – Gross Domestic Product. GDP is one way to measure a country’s output, essentially consisting of consumption (sales), investment and government spending. Exports are added to the total, while imports are subtracted (i.e., the number is “domestic”). Within the U.S., GDP is always used as an annual rate, often by annualizing the quarterly rate. Many other countries, however, publish quarterly rates rather than annualized ones.

The GDP figure commonly used is “real” GDP, or the dollar value of the GDP accounts adjusted for price inflation: “Current” GDP divided by the “Price Deflator” equals “Real” GDP. The price deflator is at times quite different from other measures of inflation. All of the measures are calculated by the Bureau of Economic Analysis (BEA), itself a branch of the Department of Commerce.

ECB – European Central Bank. The central monetary authority for the Euro zone, which includes most of Western Europe but notably, not Switzerland (Swiss franc) or the United Kingdom (the good old pound). It sets the base interest rates, among other things. Think of them as Europe’s Fed.

EFSF – The European Financial Stability Facility. The EFSF is essentially a bailout facility for distressed countries and might be thought of as a mini-IMF for Europe. Should a country apply for emergency funding, the EFSF will negotiate some sort of program in exchange, much as the IMF has often done in the past.

The EFSF funds itself by selling bonds guaranteed by the members of the eurozone. It also has lines of credit from the EFSM and the IMF. There is currently a funding ceiling, but it could presumably be changed.

ESM – European Stability Mechanism – is a proposed permanent replacement facility for the EFSF. If approved, it would have capital of up to 700 billion euros available to lend to member states that apply for money. As with the IMF or EFSF, countries would need to negotiate an agreement with the ESM in exchange for funds. The ESM is somewhat circular in nature, in that Italy and Spain, the two largest potential borrowers, are also committed to provide 210 euros in capital. In other words, they would be borrowing the same money that they lent.

ETF – Exchange Traded Fund. If you crossed a classic mutual fund with a stock their offspring might be an ETF. ETFs can grow in asset size, as can a regular mutual fund, but like a stock trade constantly on the market. ETFs began as ways to track the peformance of the major indices, such as “Spyders” (SPY) for the S&P 500, or “Diamonds” (DIA) for the Dow Jones. Although index mutual funds served the same purpose, they can be transacted only once a day, at the market close, and most fund sponsors have tight restrictions on entry and exit.

ETFs have come to be popular vehicles for betting on and against market segments. They can be sold short, or designed to move in opposite directions from indices, even offer double the movement in either direction. Trading ETFs also means paying commissions and can encourage excessive trading. They tend to have more tracking error than index funds. The success of ETFs has resulted in a huge surge being brought to market, but it is unclear if all of them will survive.

Expiration Friday or Week – Options contracts always expire on the third Friday of a month (technically on Saturday, but there is no trading then). Only the options dated for that month expire on the Friday. There is often considerable movement in prices around the expiration dates. As expiration approaches, holders of options have a strong interest in seeing the underlying price move in a direction that enhances the value of the options, while the options sellers have a strong interest in seeing the underlying price render the option worthless.

Fed Funds Rate – Banks that are subject to supervision by the Fed have to keep special types of money – “Fed Funds” – on deposit at their regional Federal Reserve bank. The amount is a percentage of the bank’s assets, which of course fluctuate day to day. To ensure that they have enough on deposit, banks can borrow money overnight from the Fed and pay the “discount” interest rate, or from other banks and pay the Fed funds rate, which is usually kept lower (although it used to be that the reverse was true, which is how the “discount” rate got its name). The actual rate is agreed between the banks, the Fed targets the rate but does not set it. Banks like to keep their Fed funds holdings at a minimum because they don’t earn interest.

Federal Reserve Bank (or more simply, the Fed) – the Federal Reserve Bank is the central monetary authority for the United States. It regulates nationally chartered banks and bank holding companies, and has considerable influence over the price and availability of money and credit. The Fed is run by a Board of Governors based in Washington, D.C. and has twelve regional member banks. The Board is appointed by the President, subject to confirmation by the Senate, to fourteen-year terms.

FOMC – Federal Open Market Committee. These are the people who decide the monetary policy of the Federal Reserve Bank. The FOMC has eight regularly scheduled meetings a year, but may meet at other times as well. It’s made up of the Board of Governors of the Federal Reserve – the board of directors, in effect – and some of the regional Bank presidents, who take turns being able to vote. The FOMC has a toolkit for influencing the price and availability of money and credit, the biggest one being the federal funds rate. The fed funds rate is the rate that you hear about when the press is talking about the Fed raising or lowering rates. FOMC meetings are the undisputed champions of market interest.

Futures – Futures are contracts that specify a fixed amount and settlement date. Financial futures settle in cash and are based on such things as market indices or interest rates. Commodity contracts call for physical delivery of the commodity, though in practice the contracts are usually offset before the settlement date and no delivery takes place. Futures contracts offer a way to hedge against price changes, speculate on them, or both. Futures contracts are traded and regulated on futures exchanges.

High Frequency Trading (HFT) – is essentially a way of trying to profit from the electronic order flow that makes up “real” buyers and sellers by piggybacking on orders. HFT uses various algorithms and high-speed computational power to try to detect the direction of buying and selling, then uses multiple buy and sell orders in an attempt to arbitrage price differences between buyers and sellers (often other HFT firms). The differences are usually fractions of a cent, relying on volume to make money; many orders are cancelled within milliseconds of being placed.

Defenders of HFT, including the exchanges (who profit greatly from the extra transaction volume), claim that participants provide liquidity and price discovery to the marketplace. Detractors look upon the practice as a form of front-running that can exaggerate market movements.

IMF – International Monetary Fund. The IMF is a supra-national organization with 188 member countries, designed to promote international monetary co-operation. While the IMF has many functions and roles, it is most prominently a lender of last resort for distressed countries and a disburser of grants. Lending arrangements can be quite strict, usually demanding considerable budgetary and fiscal rigor. The programs have at times been widely resented by applicants. The U.S. is its largest and most influential member.

ISM – Institute for Supply Manufacturing. Formerly known as the PMI, this association surveys purchasing managers in manufacturing and services on their behavior and expectations. The institute produces two monthly numbers that are closely watched by Wall Street, the manufacturing number and the services (or non-manufacturing) number. Although the services side of the economy is larger, the manufacturing number is older and generally considered a more reliable indicator of where the economy is heading. The data do not represent actual output.

LIBOR – is the London Interbank Offered Rate. In essence, a wholesale interest rate for inter-bank lending and a widely used base rate for pricing corporate credit terms. LIBOR is the standard base rate in most Western countries, but in the U.S. the prime rate is more popular. LIBOR is likely to be replaced or modified after the discovery that some of the member banks contributing rate quotes (LIBOR itself is an average) during the financial crisis had deliberately tried to game the results.

MBS & RMBS – Mortgage-Backed Securities & Residential Mortgage-Backed Securities. These are typically bundles of mortgages that are pooled together and sold as bonds. The collateral is based on the homes and the interest payments are funded by mortgage payments.

Momentum Investing – is a style of investing that relies on rapid rates of growth in sales, earnings, or simply the stock price. Momentum stocks are more volatile than other stocks as a rule, and can rise and fall quickly. They are also characterized by unusually high valuation ratios, such as price-to-earnings, price-to-sales or price-to-book. Although growth rates can remain elevated for years, providing strong profits to investors, no company can grow at above-trend rates forever. Hence, the falls from grace can be quite abrupt.

Options – Options confer the right to buy or sell an underlying asset at a specified price. Stock options are usually based upon lots of 100 shares. Most options expire within ninety days of issuance, but longer term options exist on many issues. Options are traded on and regulated by the exchanges. American options allow the holder to exercise the right to buy or sell at any time, although most options are simply bought or sold rather than exercised. Options that are worth more than a small amount on the expiration date are generally subject to automatic exercise, that is, the underlying instrument is bought or sold and payment required.

PCE – Personal Consumption Expenditures. This is a monthly consumer spending and cost of living measure put out by the Commerce Department in its Personal Income and Spending reports. It is said to be closely watched, even preferred, as an inflation indictaor by the Federal Reserve bank. However, the Consumer Price Index (CPI) gets more attention in the press.

PMI – Purchasing Manager’s Index. It’s a survey of purchasing manager activity and attitudes. The national survey is no longer called the PMI and has evolved into the ISM. The regional surveys, such as Chicago, are still called the PMI. The Chicago PMI and the Philadelphia PMI are the most closely watched regional reports. The Empire State (New York) PMI is also popular.

PPI – the Producers’ Price Index is a measure of changes in prices at the wholesale and intermediate production level. In recent years, the PPI has been watched less as an inflation indicator and more as a clue to the CPI, as companies have often been able to offset price increases in various ways. Like the CPI, there is “core” PPI, which excludes food and energy, and “non-core” or “headline” PPI, which is the total number.

Prime Rate – the preferred customer rate that banks in the U.S. use for lending to their most creditworthy customers. It serves as a base rate for many corporate loans. See also LIBOR.

Quadruple Witching - four times a year (March, June, September, and December), index futures, stock futures, stock options and index futures options all expire on the 3rd Friday of the month. There is usually considerable volume around the rebalancing and unwinding of positions, leading at times to much intra-day volatility.

Quantitative Easing – occurs when a central bank increases the money supply with a specified program of money creation. When central banks buy securities, they are effectively creating new money; when they sell them, they are taking money out of the system. The Fed’s quantitative easing programs since 2008 have involved buying Treasury and mortgage-backed securities in targeted amounts. When securities are purchased, it creates cash in the buyer account (usually a dealer or bank); that cash is new to the system.

Short Sales – Short sales involve the sale of borrowed stock. Short sellers hope that the price of a stock will decline, so that they can purchase it in the open market for less than the price received for the original sale. The borrowed position can then closed at a profit. Let’s say I lend you my new television, and while you’re watching it you learn that you can sell it today on Ebay for $100 and buy it this weekend new for $50. If you’re ambitious, you might sell my TV, buy a new one for half the money and return that one to me. Most stocks can be borrowed at any given moment, but new and/or thinly traded issues sometimes cannot be. There are margin and other rules governing short sales. The IRS considers all short sale gains and losses to be short-term. Most investors can’t sell short in an IRA due to prohibitions against borrowing.

Subprime Mortgages – The term subprime is a generic lending term for borrowers who fail to meet minimum criteria in areas such as credit scores, income-to-loan ratios. loan-to-value ratios, documentation, etc.

Uptick Rule – The uptick rule was designed to prevent short sellers from amplifying downward price movements. The rule only allowed short sales to occur if the last price change had been positive. The rule was eliminated in July 2007.

Value Investing – first popularized by Benjamin Graham, value investing is an approach that relies upon investing in companies that are cheaply priced relative to their assets and cash flows (as well as the market). Strict value investors prefer a “margin of safety” in their investment, such as a market capitalization that is less than the market value of the assets.

Value investing has outperformed other styles over the long term, but can underperform during periods of rapid or extended economic growth, at times for years. Value investors can also be prone to “value traps,” financially sound companies with deteriorating or dying product lines.