Stock Market Report. January 26, 2005

Transcription

1 January 26, 25 Stock Market Report Market Analysis for Period Ending Friday, January 21, 25 This document presents technical and fundamental analysis commonly used by investment professionals to interpret direction and valuation of equity markets, as well as tools commonly used by economists to determine the health of financial markets and their impact on the domestic United States economy. The purpose is to provide a synopsis of equity markets from as many disciplines as possible, but is in no way an endorsement of any one mode of study or source of advice on which one should base investment decisions. Definitions of terms and explanations of indicator interpretation follow the charts in the Endnotes section. Technical Trends Figure 1 presents price trends and daily volumes for the New York Stock Exchange and Nasdaq Composite Indices. The New York Stock Exchange Composite Index (NYSE Index) closed Friday, January 21 at The index has fallen 3.5 since the beginning of the year, and it has risen 55.9 since hitting its low on March 12, 23. The National Association of Securities Dealers Composite Index (Nasdaq Index) closed at The index has fallen 6.4 year-to-date and is up 56. since March 11, 23 (figure 1). Figures 2, 3, and 4 present some technical indicators commonly cited by stock market analysts. The relative strength index for the NYSE Composite has settled in the middle of neutral territory (figure 2, upper panel). The number of stocks making new 52-week highs declined sharply in January while the number of new lows remained close to zero (figure 3, upper panel). The middle panel shows that momentum (overbought/oversold oscillator) moved down to oversold territory in January but has lately climbed into overbought territory again. The Market Breadth indicator has been lagging, implying a narrow rally (figure 3, bottom panel). For the Nasdaq Index, the relative strength index has remained in neutral territory (figure 2). The number of new highs dropped while the number of new lows increased slightly in January (figure 4, upper panel). The momentum indicator stayed in oversold territory during the month while Nasdaq composite prices were declining (figure 4, middle panel). The Market Breadth indicator has remained flat, suggesting a narrow rally (lowest panel, figure 4).

2 Volatility Indicators of market volatility are shown in figure 5. The Chicago Board of Options Exchange (CBOE) provides daily measures of volatility for the S&P 1 (VIX) and for the Nasdaq 1 (VXN). Both volatility indicators rose slightly in January. Put/Call ratios appear in figure 6. Monthly data are shown from January 1997 through August 24. The CBOE individual equity put/call ratio has remained in neutral territory. The S&P 1 put/call ratio has moved to territory normally identified as bullish. Sector Performance Figure 7 compares the performance of the various economic sectors within the S&P 5 as well as other international and style indices. Returns on eight of the ten S&P 5 economic sectors have been negative since the start of the year. The energy sector, which had the largest average returns over the past five years, has increased.89 year-to-date. Information Technology and Telecommunications, the worst performers between 1999 and 24, have seen the largest decline so far (figure 7, top panel). The Wilshire 5 and the German DAX had positive average returns of about 1 over the last five years. Japan s Nikkei 225 and the U.K. s FTSE both experienced negative annual returns on average. All four geographic indices have recorded a decrease year-todate. The Wilshire 5 is down 3.9, Germany s DAX fell 1, Nikkei 225 dropped by 2.2, and U.K.'s FTSE 1 declined.2 (figure 7, middle panel). The Russell 2 Small-Cap index and the Russell Value index had positive average returns between 1999 and 24, while the Russell Large-Cap and the Russell 1 Growth experienced losses on average. All four Russell Style Index recorded a decrease year-todate. The Russell 2 Small-Cap Index fell by 6.2. The Russell 1 Value index is down 3.2, the Russell Large-Cap Index 3.7, and the Russell 1 Growth 4.3 (figure 7, bottom panel). Valuation Figure 8 displays historical and current price-earnings ratios for the S&P 5 economic sector groups described above in the top panel, and analyzes earnings growth in 5-year, 3-year, and 1-year increments for each sector in the bottom two panels. Figure 9 graphs the current and previous earnings forecasts for several calendar years in the top panel, and lists the current and previous growth of earnings forecasts for each S&P 5 sector in the two tables. Figure 1 shows three measures of historical and future valuation: historical PE ratios in the top panel, forward and

3 trailing PE ratios using analysts' estimates of operating earnings in the middle panel, and strategists two-year forecasts of earnings growth in the lower panel. The rebound in earnings has caused price-earnings ratios to stabilize at values consistent with past observations for most S&P 5 economic sectors. The PE for the energy sector, despite recent price gains, has been cut from 39.5 to 13.95, due to strengthened earnings. The telecommunication sector has the highest PE ratio of (figure 8, top panel). Over the last five years, earnings per share for the S&P 5 has increased an average of 6.3 per year, and operating earnings per share has increased 5.1 per year. Earnings for energy have been the strongest, while telecom saw the largest average annual decline in earnings. During 23, the energy sector saw the biggest increase in both earnings and operating earnings per share, while health care had the biggest decline. As-reported earnings for the consumer cyclical sector increased 64.5 in 23, but operating earnings declined 2.8 for the year. Overall, earnings per share increased 24. in 23, and operating earnings per share increased 1.7 (figure 8, middle and lower panels). The analysts surveyed by Thomson Financial/First Call predict a 15.1 increase in earnings for the S&P 5 in the fourth quarter of 24, and a 19.4 increase for calendar year 24. The largest gains are expected to come from the materials and energy sectors, while the telecom sector is expected to show a collective loss. In the first quarter of 25, earnings are projected to rise by 7.7, with the materials and energy sectors being again the biggest contributors (figure 9). The macro projections from strategists for the growth of earnings for the Standard and Poor s 5 index over the next two years have been revised upward to a positive 1.6 in the fourth quarter of 24. The S&P 5 trailing price-earnings ratio decreased to 18.4 in the first quarter of 25 from 18.9 in the fourth quarter of 24. The 25 first quarter forecast for the S&P 5 forward price-to-operating-earnings ratio, using bottom-up forecasts from analysts, is 16.6, down from 17 in the fourth quarter (figure 1). Breadth of the S&P 5 During 23, prices rose from a year ago for 91.8 of stocks in the S&P 5, and in the third quarter of 24 that trend continued, as 78. of S&P 5 stocks were above their third quarter 23 levels (figure 11, middle panel). The price increases were consistent for both 23 and the third quarter of this year, as the median price change for eight of ten deciles of companies rose (figure 11, top). The median

4 price earnings ratio for nine of the ten deciles remained flat during calendar year 23 and three quarters of 24. The median price earnings ratio for the top decile decreased slightly in 23 and during the first two quarters of 24, increasing again in the third quarter (figure 11, bottom). Comparative Returns The earnings-price ratio decreased to 5.1 in the fourth quarter of 24 from 5.2 in the third quarter. The dividend-price ratio, an indication of the yield investors receive through dividends by holding stocks, decreased to 1.67 in the fourth quarter from 1.74 in the third quarter of 24, remaining substantially below the bond rate (figure 12). As dividends have increased more rapidly than earnings, the operating profit payout rate for nonfinancial corporations has risen, from 41.4 in the second quarter of 24 to 42.9 in the third quarter of 24 (figure 13, lower panel). Moody's downgraded a high number and upgraded a small number of Investment Grade Securities in December. A greater number of Speculative Grade Securities were upgraded than downgraded (figure 15, top and middle panels). The default rate on junk bonds increased in December to 2.3 (figure 15, lower panel). The Stock Market Report is now available to the general public. The current issue, as well as previous editions, can be found at our public website, Please contact Maria Giduskova for questions and comments at Maria.Giduskova@bos.frb.org, or by phone at (617)

5 Figure 1 Daily Trends of Major U.S. Stock Exchanges New York Stock Exchange index price millions of shares NYSE Composite Price Index 2-day moving average day moving average 1 65 daily volume /1/23 1/16/23 1/2/24 3/19/24 6/4/24 8/2/24 11/4/24 1/21/25 Nasdaq Stock Market index price 23 millions of shares 4 22 Nasdaq Composite Price Index day moving average 1 2-day moving average daily volume /1/23 1/16/23 1/2/24 3/19/24 6/4/24 8/2/24 11/4/24 1/21/25 Source: Bloomberg, L.P.

6 Figure 2 Moving Averages and Relative Strength New York Stock Exchange index price day moving average Relative Strength Index NYSE Composite Price Index Overbought 18-day moving average 2 2 Oversold 8/2/24 8/25/24 9/2/24 1/13/24 11/5/24 12/1/24 12/27/24 1/2/25 Nasdaq Stock Market index price day moving average Nasdaq Composite Price Index day moving average 2 17 Relative Strength Index Oversold 8/2/24 8/25/24 9/2/24 1/13/24 11/5/24 12/1/24 12/27/24 1/2/25 Source: Bloomberg, L.P. Overbought

7 Figure 3 Index Breadth and Momentum Indicators - New York Stock Exchange New Highs and New Lows 4 index price NYSE Composite price New Highs number of stocks New Lows 6 8/2/24 8/3/24 9/28/24 1/26/24 11/23/24 12/22/24 1/21/25 1 Momentum Oscillator Overbought Oversold -1 8/2/24 8/3/24 9/28/24 1/26/24 11/23/24 12/22/24 1/21/25 Market Breadth 6 index price Cumulative Advances - Declines NYSE Price Index number of stocks /2/24 8/3/24 9/28/24 1/26/24 11/23/24 12/22/24 1/21/25 Source: Bloomberg, L.P.

8 Figure 4 Index Breadth and Momentum Indicators - Nasdaq Stock Market New Highs and New Lows 4 index price 22 number of stocks NASDAQ Composite Price Index NASDAQ New Highs NASDAQ New Lows 17 8/2/24 8/3/24 9/28/24 1/26/24 11/23/24 12/22/24 1/21/ Momentum Oscillator Overbought Oversold -75 8/2/24 8/3/24 9/28/24 1/26/24 11/23/24 12/22/24 1/21/25 Market Breadth 6 index price Cumulative Advances - Declines number of stocks NASDAQ Composite Price Index /2/24 8/3/24 9/28/24 1/26/24 11/23/24 12/22/24 1/21/25 Source: Bloomberg, L.P.

9 Figure 5 Volatility 7 S&P1 and CBOE's OEX Volatility Index 8 index price VIX S&P1 Price Index /2/24 2/2/24 4/7/24 5/25/24 7/14/24 8/3/24 1/15/24 12/2/24 1/2/ Nasdaq 1 and CBOE's NDX Volatility Index 9 index price Nasdaq 1 Price Index VXN /2/24 2/2/24 4/7/24 5/25/24 7/14/24 8/3/24 1/15/24 12/2/24 1/2/25 2 S&P5 Index Return and Implied Volatility year average Returns Implied Volatility /2/24 2/2/24 4/7/24 5/25/24 7/14/24 8/3/24 1/15/24 12/2/24 1/2/25 Source: Bloomberg, L.P.

10 Figure 6 Put / Call Ratio CBOE Index and Individual Equity Put/Call Ratios 1 index price Excessive Put Buying = High Put/Call Ratio = Overly Pessimistic = Bullish Sign S&P 5 Price Index Ratio for Individual Equity Options Excessive Call Buying = Low Put/Call Ratio = Overly Optimistic = Bearish Sign 7.2 Jan:1997 Aug:1998 Mar:2 Oct:21 May:23 Dec:24 ratio Nasdaq 1 Price Index and Put/Call Ratio index price Index Price Ratio Jan:1997 Aug:1998 Mar:2 Oct:21 May:23 Dec:24 S&P 1 Price Index and Put/Call Ratios index price Ratio Jan:1997 Aug:1998 Mar:2 Oct:21 May:23 Dec:24 Source: Haver Analytics Index Price ratio ratio

11 Figure 7 S&P 5 Economic Sectors - Index Returns 5-Year Annualized Performance of S&P 5 Economic Sectors Energy Financials Utilities Materials Health Care Industrials Consumer Staples Consumer Cyclicals Info Technology Telecommunications Year-to-Date Performance (as of 1/21) of S&P 5 Economic Sectors Year Annualized Performance of Selected Geographical Indexes Wilshire 5, U.S. DAX, Germany FTSE 1, U.K. Nikkei 225, Japan Year-to-Date Performance (as of 1/21) of Selected Geographical Indexes Year Annualized Performance of Selected Russell Style Indexes Small-Cap 1 Value 1 Large-Cap 1 Growth Year-to-Date Performance (as of 1/21) of Selected Russell Style Indexes Source: Bloomberg, L.P.

12 Figure 8 S&P 5 Economic Sectors - Earnings Growth PE Ratios for S&P 5 Economic Sectors Q4 98 Q4 Q4 2 Q4 4 1/21/ S&P 5 Energy Materials Industrials Cons Cyclicals Cons Staples Health Care Financials InfoTech Telecom Utilities Earnings Growth for S&P 5 Economic Sectors (annualized change) S&P Energy (316.8) Materials Industrials Cons Cyclical 5-YEAR 3-YEAR 1-YEAR Cons Staples Health Care Financials InfoTech Telecom Utilities 2 Operating Earnings Growth for S&P 5 Economic Sectors (annualized change) 12 4 (88.8) S&P Energy Materials Industrials Cons Cyclical 5-YEAR 3-YEAR 1-YEAR Cons Staples Health Care Financials InfoTech Telecom Utilities Source: Standard & Poor's Compustat, Bloomberg, L.P.

13 3 2 Figure 9 S&P 5 Economic Sectors - Earnings Forecast S&P 5 Operating Earnings (Year-over year change) Calendar Year 2 Calendar Year 23 1 Calendar Year 1999 Calendar Year 21 Calendar Year 22 Calendar Year 24 Calendar Year /26/98 12/25/98 6/25/99 12/31/99 6/3/ 12/29/ 6/29/1 12/28/1 6/28/2 12/31/2 6/27/3 12/26/3 6/25/4 12/31/4 Growth of Earnings - Quarterly Pattern (4-quarter change) Sector Current 4Q4 Dec-4 4Q4 Nov-4 4Q4 Oct-4 4Q4 Current 5Q1 Nov- 4 5Q1 Oct-4 5Q1 Current 5Q2 Dec-4 5Q2 Nov-4 5Q2 Current 5Q3 Oct-4 5Q3 Consumer 7% 8% 1% 15% 4% 18% 19% 9% 8% 14% 2% 17% Cyclicals Consumer 8% 8% 8% 1% 8% 8% 9% 8% 9% 9% 1% 12% Staples Energy 72% 66% 58% 39% 17% 18% -2% -4% -2% -1% -5% -15% Financials 9% 1% 11% 13% % % 1% 7% 7% 8% 2% 18% Health 9% 9% 8% 13% 4% 8% 1% 8% 9% 9% 9% 14% Care Industrials 13% 14% 14% 14% 15% 15% 13% 15% 15% 15% 2% 17% Materials 7% 75% 75% 74% 41% 38% 36% 22% 19% 14% 19% 12% Technology 15% 13% 15% 16% 14% 13% 15% 11% 1% 11% 1% 17% Telecom % 1% 3% -7% 8% 3% -3% 8% 6% 3% 2% 6% Utilities 3% 6% 7% 3% 8% 8% 1% 11% 14% 8% 19% 12% Total 15.1% 15.% 15.7% 15.5% 7.7% 9.3% 7.9% 8.1% 8.4% 8.8% 13.1% 12.3% Growth of Earnings - Calendar Year (4-quarter change) Sector Current 4CY Dec-4 4CY Sep-4 4CY Jul-4 4CY Apr-4 4CY Jan-4 4CY Current 5CY Dec-4 5CY Oct-4 5CY Consumer Cyclicals 24% 24% 27% 27% 19% 18% 14% 15% 14% Consumer Staples 1% 1% 11% 11% 9% 1% 1% 1% 11% Energy 51% 47% 35% 21% -1% -15% -4% -4% -6% Financials 12% 11% 14% 14% 13% 11% 11% 11% 12% Health Care 1% 11% 13% 13% 13% 15% 9% 11% 12% Industrials 19% 2% 2% 19% 15% 15% 18% 17% 17% Materials 73% 84% 81% 72% 57% 49% 24% 22% 22% Technology 43% 4% 4% 43% 37% 37% 13% 13% 13% Telecom -9% -9% -14% -15% -9% -2% 5% 3% 1% Utilities % % 2% 4% 2% 4% 13% 12% 12% Total 19.4% 19.1% 19.1% 18.2% 14.2% 12.7% 1.5% 1.7% 1.6% Source: Thomson Financial/First Call

14 Figure 1 PE Ratios and the Growth of Earnings Price-Earnings Ratios S&P 5 S&P Smallcap 6 Wilshire 5 1 Russell :Q1 1973:Q2 1978:Q3 1983:Q4 1989:Q1 1994:Q2 1999:Q3 24:Q4 S&P5 Price-Operating Earnings Ratio qtr Trailing Earnings qtr Forward Earnings 1968:Q1 1973:Q2 1978:Q3 1983:Q4 1989:Q1 1994:Q2 1999:Q3 24:Q4 S&P5 Price-Earnings Ratio and the Growth of Earnings Price-Earnings Ratio 2 yr Growth of Earnings :Q1 1973:Q2 1978:Q3 1983:Q4 1989:Q1 1994:Q2 1999:Q3 24:Q4 Source: Thomson Financial/First Call, Global Exchange (formerly DRI), Bloomberg L.P., Frank Russell Company, Haver Analytics

15 Figure 11 Breadth of the S&P 5 One-Year Price Changes for Companies (median age change for each decile, ranked by performance) Proportion of the S&P 5 Stocks Whose Price Increased Over One Year Price-Operating Earnings Ratios for Companies (median ratio for each decile, ranked by PE ratio) Q1 Q2 Q3 24 Q1 Q2 Q Source: Standard & Poor's Compustat 24 Q1 Q2 Q3 PE=14.4

16 Figure 12 Comparative Returns Dividend-Price Ratio 12 for the S&P 5 and the Real Corporate Bond Rate 13 DP Ratio Yield on A-Corporate Bonds Less Inflation Expectations 1982:Q1 1985:Q2 1988:Q3 1991:Q4 1995:Q1 1998:Q2 21:Q3 24:Q Earnings-Price Ratio 12 for the S&P 5 and the Real Corporate Bond Rate EP Ratio Yield on A-Corporate Bonds Less Inflation Expectations 1982:Q1 1985:Q2 1988:Q3 1991:Q4 1995:Q1 1998:Q2 21:Q3 24:Q Growth of Real Earnings for S&P 5 (average rate of growth for 2 years forward) :Q1 1985:Q2 1988:Q3 1991:Q4 1995:Q1 1998:Q2 21:Q3 24:Q4 Source: Haver Analytics, FAME

17 Figure 13 Dividend Yields 12 Dividend Yields for S&P 5 and Components 1 Utilities 8 6 Financials 4 Composite 2 Industrials Transports 196:Q1 1965:Q3 1971:Q1 1976:Q3 1982:Q1 1987:Q3 1993:Q1 1998:Q3 24:Q1 Nonfinancial Corporate Dividend Expenditures and Personal Dividend Income Personal Dividend Income ( of disposable income, right scale) Nonfinancial Corporate Dividends ( of profits, left scale) :Q1 1965:Q3 1971:Q1 1976:Q3 1982:Q1 1987:Q3 1993:Q1 1998:Q3 24:Q1 Source: Haver Analytics

18 Figure 14 Economic Measures of Equity Valuation Real Rate of Return on Nonfinancial Corporate Equity (from National Income and Flow of Funds Accounts) Tobin's q :Q1 1958:Q3 1965:Q1 1971:Q3 1978:Q1 1984:Q3 1991:Q1 1997:Q3 24:Q Profits of Nonfinancial Corporations ( of GDP) Earnings Before Interest Payments Profits :Q1 1963:Q4 1969:Q3 1975:Q2 1981:Q1 1986:Q4 1992:Q3 1998:Q2 24:Q1 Source: Haver Analytics, NYSE Fact Book, Flow of Funds Accounts

19 Figure 15 Ratings and Default Rates $ billion Changes in Moody's Ratings of Investment Grade Securities and the S&P 5 PE Ratio SP5 PE Ratio Upgrades Downgrades (145.9) (17.9) 2 Jul-98 Jun-99 May- Apr-1 Mar-2 Feb-3 Jan-4 Dec $ billion Changes in Moody's Ratings of Speculative Grade Securities and the S&P 5 PE Ratio SP5 PE Ratio Downgrades Upgrades Jul-98 Jun-99 May- Apr-1 Mar-2 Feb-3 Jan-4 Dec-4 25 Moody's Junk Bond Default Rate and the S&P 5 PE Ratio SP5 PE Ratio Default Rate Jul-98 Jun-99 May- Apr-1 Mar-2 Feb-3 Jan-4 Dec-4 Source: Credqual database, Board of Governors of the Federal Reserve System

20 Figure 16 Margin Debt and Expected Returns Margin Debt and Stock Volatility VIX Outstanding Margin Debt Relative to Total Market Value of Equities :Q1 1989:Q3 1992:Q1 1994:Q3 1997:Q1 1999:Q3 22:Q1 24:Q ratio Gross New Issuance and the S&P 5 PE Ratio PE Ratio New Equity Security Issuance Relative to Total Market Value :Q1 1989:Q3 1992:Q1 1994:Q3 1997:Q1 1999:Q3 22:Q1 24:Q3 $ billions Gross New Issuance of Securities by Nonfinancial Corporations 1 5 Bonds Equity 1987:Q1 1989:Q3 1992:Q1 1994:Q3 1997:Q1 1999:Q3 22:Q1 24:Q3 Sources: Haver Analytics, FAME

21 Figure 17 Foreign and Domestic Holdings $ billions Outstandings Foreign Holdings of US Securities US Resident Holdings of Foreign Securities :Q1 1988:Q2 1991:Q3 1994:Q4 1998:Q1 21:Q2 24:Q3 11 Foreign Holdings of U.S. Equity Securities Relative to Total Market Value of U.S. Equity index price Foreign Holdings of U.S. Securities S&P :Q1 1988:Q2 1991:Q3 1994:Q4 1998:Q1 21:Q2 24:Q3 15 U.S. Resident Holdings of Foreign Equity Securities Relative to Total Market Value of U.S. Equity index price U.S. Resident Holdings of 14 Foreign Securities 12 5 DJ World Stock Index, 1 Excluding U.S :Q1 1988:Q2 1991:Q3 1994:Q4 1998:Q1 21:Q2 24:Q3 Source: Haver Analytics, FAME, Flow of Funds Accounts of the United States

22 Figure 18 Demographics Capital Gains Relative to Personal Income Total Long-Term Capital Gains Total Capital Gains NYSE's and Nasdaq's share of the Total Market (by market value) Households' Equity Ownership by New Worth Decile ( of net worth) Equity Bond Short-Term NYSE NASDAQ Total Trusts Insurance Other State & Private Pension Distribution of Equity Ownership by Sector 4 2 Households 198:Q1 1983:Q3 1987:Q1 199:Q3 1994:Q1 1997:Q3 21:Q1 24:Q3 Source: Haver Analytics, Survey of Consumer Finance, Flow of Funds Accounts

23 Endnotes 1. 5-Day, 2-Day Moving Average: Moving averages represent the average price investors paid for securities over a historical period, and present a smoothed picture of the price trends, eliminating the volatile daily movement. Because these lines offer a historical consensus entry point, chartists look to moving average trend lines of index prices to define levels of support or resistance in the market. When a chart trend is predominantly sideways (Figure 1, top chart), moving averages and the underlying series frequently cross, but during a time of prolonged increase or decrease (bottom chart) the daily prices of a security typically are above or below the trailing average. Moving above or below the 5- day moving average is sometimes associated with rallies or corrections. Similarly, prolonged movements, such as bull and bear markets can be represented by securities remaining above or below their 2-day moving average for prolonged periods of time Day, 18-Day Moving Averages: The 9-day and 18-day moving averages are often used together to provide buy and sell signals. Buy signals are indicated by the 9-day average crossing above the 18-day when both are in an uptrend. The reverse, the 9-day crossing below the 18-day while both moving averages are declining is a sign to sell. However, this simple can often be misleading because of its dependence on trending markets and inability to capture quick market turns. 3. Relative Strength Index: This (RSI) momentum oscillator measures the velocity of directional price movements. When prices move rapidly upward they may indicate an overbought condition, generally assumed to occur above 7. Oversold conditions arise when prices drop quickly producing RSI readings below New Highs, New Lows: A straightforward breadth indicator, this is the 1-day moving average of the number of stocks on a given index or exchange making new 52-week highs or lows each day. This indicator also demonstrates divergence. If an index makes a new low, but the number of stocks in the index making new lows declines, there is positive divergence, and in this case a lack of downside conviction. Conversely, In rising markets if an index makes a new high but the number of individual stocks in that index making new highs does not increase this suggests a false rally. 5. Overbought / Oversold Oscillator: This momentum indicator is calculated by taking the 1-day moving average of the difference between the number of advancing and declining issues for a given index. The goal of the indicator is to show whether an index is gaining or losing momentum, so the size of the moves are more important than the level of the current reading. This is first affected by how the oscillator changes each day, by dropping a value ten days ago, and adding one today. If the advance decline line read minus 3 ten days ago, and minus 1 today, even though the market is down again, the oscillator will rise by 2 because of the net difference of the exchanged days' values. This suggests a

24 trough, however, if today's reading was minus 5 it would demonstrate a gain in downside momentum. The magnitude in moves is useful when compared with divergence to the index price. If the Dow peaks at the same time the oscillator peaks in overbought territory, it suggests a top. If the index then makes a new high but the oscillator fails to make a higher high, divergence is negative and momentum is declining. If the index at this point declines and the oscillator moves into oversold territory it may again be time to buy. If the index rises but does not make new highs, but the oscillator continues to rise above a previous overbought level, upside momentum exists to continue the rally. 6. Cumulative Advance / Decline Line: Referred to as market breadth, the indicator is the cumulative total of advancing minus declining issues each day. When the line makes new highs a rally is considered widespread, but when lagging a rally is seen as narrow. 7. Volatility: With regard to stock prices and stock index levels, volatility is a measure of changes in price expressed in age terms without regard to direction. This means that a rise from 2 to 22 in one index is equal in volatility terms to a rise from 1 to 11 in another index, because both changes are 1. Also, a 1 price rise is equal in volatility terms to a 1 price decline. While volatility simply means movement, there are four ways to describe this movement: 1. Historic volatility is a measure of actual price changes during a specific time period in the past. Mathematically, historic volatility is the annualized standard deviation of daily returns during a specific period. CBOE provides 3 day historical volatility data for obtainable stocks in the Trader's Tools section of this Web site. 2. Future volatility means the annualized standard deviation of daily returns during some future period, typically between now and an option expiration. And it is future volatility that option pricing formulas need as an input in order to calculate the theoretical value of an option. Unfortunately, future volatility is only known when it has become historic volatility. Consequently, the volatility numbers used in option pricing formulas are only estimates of future volatility. This might be a shock to those who place their faith in theoretical values, because it raises a question about those values. Theoretical values are only estimates, and as with any estimate, they must be interpreted carefully. 3. Expected volatility is a trader's forecast of volatility used in an option pricing formula to estimate the theoretical value of an option. Many option traders study market conditions and historical price action to forecast volatility. Since forecasts vary, there is no specific number that everyone can agree on for expected volatility. 4. Implied volatility is the volatility age that explains the current market price of an option; it is the common denominator of option prices. Just as p/e ratios allow comparisons of stock prices over a range of variables such as total

25 earnings and number of shares outstanding, implied volatility enables comparison of options on different underlying instruments and comparison of the same option at different times. Theoretical value of an option is a statistical concept, and traders should focus on relative value, not absolute value. The terms "overvalued" and "undervalued" describe a relationship between implied volatility and expected volatility. Two traders could differ in their opinion of the relative value of the same option if they have different market forecasts and trading styles. 8. CBOE Volatility Index (VIX): The VIX, introduced by CBOE in 1993, measures the Volatility of the U.S. equity market. It provides investors with up-to-the-minute market estimates of expected volatility by using real-time OEX index option bid/ask quotes. This index is calculated by taking a weighted average of the implied volatilities of eight OEX calls and puts. The chosen options have an average time to maturity of 3 days. Consequently, the VIX is intended to indicate the implied volatility of 3-day index options. It is used by some traders as a general indication of index option implied volatility. (Source: CBOE) 9. CBOE NASDAQ Volatility Index (VXN): Like the VIX, the VXN measures implied volatility, but in this case for NASDAQ 1 (NDX) index options, thereby representing an intraday implied volatility of a hypothetical at-the-money NDX option with thirty calendar days to expiration. Both the VXN and the VIX are used as sentiment indicators for the NASDAQ 1 and for the broader market, respectively. Higher readings and spikes generally occur during times of investor panic and at times coincide with market bottoms. Low readings suggest complacency and often occur around tops in index prices. 1. Put / Call Ratio: These ratios are used as contrary sentiment indicators. Higher ratio values, indicating more put trading, is considered more bullish. The CBOE index ratio tracks trade volume of all exchange traded index options, reflecting sentiment of professional and institutional strategies. The CBOE equity ratio is composed of trade volume for individual equity options and a better indicator of retail investor sentiment. Equity ratio readings 6/1 and 3/1 denote levels of bullishness and bearishness. Similarly, bullish and bearish boundaries for the S&P 1 are 125/1 and 75/ Year Growth of Earnings: Growth of earnings over subsequent 8 quarters. Current observations use forecast of earnings from macro projections. 12. Earnings and Dividend Price Ratios: These ratios represent an investor's yield from earnings and dividend payments. Historically, the EP ratio often has exceeded the real return on bonds, reflecting the greater risk to shareholders for choosing equity investments. Recently, the EP ratio has fallen below the return on bonds as investors demand uncharacteristically large capital gains to compensate for the low earnings yield. Historically, the EP ratio has fallen below the real bond rate only when earnings are expected to rise dramatically.

26 13. Real Bond Rate: Moody's composite yield of A-rated corporate bonds less the expected rate of inflation over the next 1 years as measured by the consumer price index from the Survey of Professional Forecasters, published by the Federal Reserve Bank of Philadelphia. 14. Moody's Ratings: Denotes the change in dollar amount of investment grade (above BA1) or speculative grade (BA1 or below) securities outstanding for a particular company if that company is up/downgraded during a given month. For example, if company XYZ was upgraded, and they had bonds rated AA2 for $1, AA1 for $2, and A3 for $15, this company's contribution to the chart value is $ Investor Expectations: Internally generated composite of the Conference Board's 12-month forward investor expectations for no change, increase, and decrease in the stock market. Composite values of 5 indicate neutral expectations. Values below 5 demonstrate bearish sentiment, though the chart demonstrates that the outlook of investors is typically bullish. 16. Tobin's q: The ratio of the market value of equity plus net interest bearing debt to current value of land, inventories, equipment, and structures.