October 27th, 2011
By Guest Author Larry D. Spears, Contributing Writer, Money Morning
The language of investing used to be fairly simple. A limited vocabulary of investing terms gave you enough understanding to successfully navigate the markets. Those days are gone. Things like 24-hour media coverage and analysis, computer-driven trading systems that affect prices within minutes of breaking news, complicated macroeconomic issues, and sophisticated investment products have created an increasingly complex market environment.
This means investors must understand a variety of sometimes strange or seemingly unrelated terms if they hope to prosper - or, at the least, hold their own - in these treacherous economic times. Failing to become familiar with these investing terms could damage to your portfolio.
Investing Terms You Must Know
The following 11 investing terms have become commonplace in today's market and economy. Study these and you'll have a much better chance of not just surviving, but profiting:
- Volatility - This word lately has been almost synonymous with weekly - or daily - market movement. It's used to describe prices and market index levels that can rise or fall, often sharply, in very little time and seemingly with even less provocation. However, volatility is more than just price movement.
Volatility measures the range of potential returns for a specific security or market index over a given period of time. It reflects the degree of risk surrounding how much a stock's price could move. Highly volatile stocks can change value significantly in either direction in very little time, while one with low volatility probably won't fluctuate much in the short term, instead changing gradually (i.e., trending) over time. Past price patterns are used to calculate the likely amount returns will rise or fall - their expected "variance" from the norm.
- Double-dip recession - In the normal business cycle, a recession is marked by falling gross domestic product (GDP), rising unemployment, decreased consumer spending and declining investment, and lasts six months or more. It's followed by a reversal of those conditions and a return to economic growth. The growth, or recovery, period typically extends for several quarters or even years.
But when recovery is weak - like we're seeing now - there's a higher chance that after a limited period of expansion the economy will again turn down. In other words, a dip, followed by a small bounce, followed by another dip - a "double dip."
- Stimulus - The government hates recessions - mostly because of what they do to politicians' re-election chances. So when one occurs, our leaders try to jumpstart the economy and restore growth through moves collectively referred to as a "stimulus package." Such measures include easing monetary policies and lowering interest rates to encourage lending, and increasing government spending and cutting taxes.
The U.S. government has employed many of these moves over the past few years, like the $787 billion American Recovery and Reinvestment Act of 2009 and U.S. President Barack Obama's recently proposed $447 billion jobs plan.
- "Operation Twist" - This is the most recent stimulus maneuver launched by the U.S. Federal Reserve Bank and its chairman Ben Bernanke. It got its name from a 1960s initiative that was designed to "twist" the interest-rate yield curve by flattening it out. The newest version involves the Fed buying $400 billion worth of bonds with six-year to 30-year maturities while selling an equal amount of shorter-term debt with three-year maturities.
Bernanke said rolling maturing Treasuries into longer-term debt securities would lower the Fed funds rate by 50 basis points and drop long-term rates by 20 basis points. Interest rates were already so low that reducing them further to boost the economy was essentially impossible, so the Fed needed an alternative - but market consensus is that the move will do more long-term economic harm than good.
- Debt Ceiling - This is an arbitrary limit, set by Congress, on the amount of debt the U.S. government is allowed to have outstanding at any given time - but it has also become a bone of political contention at the center of heated Congressional debates.
The debt ceiling originally served as a means of supporting the value of U.S. Treasury debt securities - i.e., T-bonds, T-notes and T-bills - to make them more attractive to both domestic and foreign investors. The government should not spend more than where the debt ceiling is pegged, but since it was originally set it's been repeatedly increased, most recently in August.
In a last-minute compromise to prevent a government default, Congress approved a short-term debt-ceiling increase of $400 billion (from $14.3 trillion to $14.7 trillion), pending longer-term negotiations on debt-reduction measures. Congress hoped the move would prevent a credit-rating downgrade by rating service Standard and Poor's, but U.S. debt was still lowered to AA+ from AAA.
- Real Unemployment - Real unemployment is more than just on the number of individuals actively looking for work. It also includes the number of part-time workers who want full-time jobs but can't find them, the number of underemployed workers looking for jobs comparable with their skills and experience, and the number of individuals who have given up the job search.
As the name implies, "real unemployment" is often higher than a country's reported unemployment rate. The U.S. official unemployment rate determined by the U.S. Department of Labor is currently 9.1%, but it masks the economy's true weakness because the real unemployment rate is estimated to be at least 16.7%.
- Sovereign Debt - This is a country's obligations, as represented by bonds issued in a foreign currency, taken on in order to finance that country's economic growth. As a rule, the more stable the issuing government, the lower the risk of investing in such debt, with developed nations usually safer than those with still-developing economies.
However, as we've learned from Europe's ongoing debt crisis, that's not always the case. Poor economic policies and overspending can threaten the solvency of even long-standing nations and governments, like Greece.
- Credit-Default Swaps (CDS) - Money Morning Global Investing Strategist Martin Hutchinson once called these instruments one of Wall Street's worst inventions ever due to their major role in 2008's economic meltdown.
Here's how they work: Credit-default swaps are designed to transfer the risk of debt instruments from one party to another. Investors buy CDS as a type of insurance to protect them if the issuer of a debt security fails to make promised payments, and defaults. Sellers of CDS collect a premium for ensuring the debt obligation will be fulfilled.
Complicated credit-default swaps related to pools of mortgage debt contributed to the housing market collapse in 2008. Now more investors are buying CDS against Greece and other Eurozone countries, betting that they will fail to meet payments and default on their debt.
- Solvency vs. Liquidity - Solvency is the ability of a company, government or other entity to meet its debt payments and other long-term expenses, thereby enabling it to prosper and grow - or, in hard economic times, to survive. The term is often confused with liquidity, which merely refers to the ease with which a company's stock or an entity's debt can be traded or its assets converted to cash. Both are measures of an investment's safety, with the degree of risk rising as solvency and liquidity fall.
With many companies recovering from the financial crisis but facing weak growth prospects, beware of those with low solvency. A number of businesses are on the verge of bankruptcy and you should avoid their stocks.
- Real Interest Rates - The actual cost of borrowing money - and the actual return to lenders - when adjusted for inflation. Defined as the stated (or nominal) interest rate minus the rate of inflation (either actual or expected), the real interest rate is used to measure the change in consumer purchasing power relative to the value of the dollar (or other currency).
- Trailing Stop - This is an essential risk-management tool especially in uncertain markets like we have today. Money Morning Chief Investment Strategist Keith Fitz-Gerald recommends they always be used.
A trailing stop is a protective trading order designed to both limit risk and lock in profits on positions, most generally used in the stock market. The order features a "stop" price - either below the current market price for long positions or above it for short positions - used close the position should the market price hit that level.
The stop can be set either a fixed-dollar amount or a fixed percentage below (or above for shorts) the current market price. It is then adjusted upward as the price of the long security rises, or downward as the price of a short security falls, reducing your possible loss or locking in a greater portion of your profits. Trailing stops should never be lowered on long positions and never be raised on short positions.