SHAHEED ZLFIQAR ALI BHUTTO INSTITUTE OF SCIENCE AND TECHNOLOGY

What is stock exchange and how it works

Syed Muhammad Abbas
12/29/2011

This document include a detail about the stock exchange its functions and operations, including the major stock exchange of the world and Pakistan

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Contents
Abstract Outline Purposes, Roles, Functions and Benefits of Stock Exchanges History Behind the Stock Exchanges The Karachi Stock Exchange Stock Indexes How A Company can be Listed in Stock Exchange How an Individual can Start Doing Investments in Stock Exchanges The Way to Make Profit in Stock Trading References 2 2 3 5 6 7 11 13 15 20

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Syed Muhammad Abbas Jafri Reg# 103915 What is stock exchange and how it works
Abstract
Stock exchange is an entity that provides services for stock brokers and traders to trade stocks and other securities. It provides companies with the facility to raise capital for expansion through selling shares to the investing public. Markets are electronically networked, which gives them advantages of increased speed and reduced cost of transactions. Supply and demand in stock markets is driven by various things that, as in all free markets, affect the price of stocks. To buy stocks, always need to do business with a brokerage firm

Outline
Every company needs the funds. Companies only have two ways to find funds. It can either borrow money (known as debt financing) or sell stock (known as equity financing). In order to raise funds through equity financing, a company must need to be listed in the Stock Exchange. Every company listed in the stock exchange gets the certain benefits. We will explain in the project how a company can be listed in the stock exchange in order to raise money and enjoy benefits. Interest of common investor is to get profit share as per their stake in a particular company. When you want to buy groceries, you go to the grocery store. Similarly when you want to buy stocks, you need to do business with a brokerage firm. Stock investor must have to do proper financial analysis on the basis of previous financial, current quarter results of that company. We will explain in the project how a person can do trading in a stock exchange and what analysis should be done by trader before doing the investment? We will take Karachi Stock Exchange as an example

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Purposes, Roles, Functions and benefits of Stock Exchanges

Raising capital for businesses
The Stock Exchange provides companies with the facility to raise capital for expansion through selling shares to the investing public. The Stock Exchange provides companies with the facility to raise capital for expansionthrough selling shares to the investing public. It induces people to save and invest insecurities. There is regular publicity of its operations, which encourages savings andinvestments. People know that when they need money, they can easily sell their securitieson stock exchange. Therefore, they are more willing to invest their savings in securities.Thus a stock exchange serves as an instrument for raising capital.

Mobilizing savings for investment

When people draw their savings and invest in shares, it leads to a more rational allocation of resources because funds, which could have been consumed, or kept in idle, are mobilized and redirected to promote business activity with benefits for several economic sectors such as agriculture, commerce and industry, resulting in a stronger economic growth and higher productivity levels and firms.

Facilitating company growth

Companies view acquisitions as an opportunity to expand product lines, increase distribution channels, hedge against volatility, increase its market share, or acquire other necessary business assets. A takeover bid or a merger agreement through the stock market is one of the simplest and most common ways for a company to grow by acquisition.

Redistribution of wealth
Stocks exchanges do not exist to redistribute wealth. However, both casual and professional stock investors, through dividends and stock price increases that may result in capital gains, will share in the wealth of profitable businesses

Corporate governance
By having a wide and varied scope of owners, companies generally tend to improve on theirmanagement standards and efficiency in order to satisfy the demands of these shareholdersand the more stringent rules for public corporations imposed by public stock exchanges andthe government. Consequently, it is alleged that public companies (companies that areowned by shareholders who are members of the general public and trade shares on publicexchanges) tend to have better management records than privately-held companies (thosecompanies where shares are not publicly traded, often owned by the company

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foundersand/or their families and heirs, or otherwise by a small group of investors). However, somewelldocumented cases are known where it is alleged that there has been considerableslippage in corporate governance on the part of some public companies. The dot-combubbles in the early 2000s, and the subprime mortgage crisis in 2007-08, are classical. Examples of corporate mismanagement are as follows. Companies like Pets.com (2000), Enroncorporation (2001), One.Tel (2001), Sunbeam (2001), Webvan (2001), Adelphia (2002),MCI WorldCom (2002), Parmlat (2003), American International Group (2008), LehmanBrothers (2008), and Satyam Computer Services (2009) were among the most widelyscrutinized by the media.

Creating investment opportunities for small investors

As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and small stock investors because a person buys the number of shares they can afford. Therefore the Stock Exchange provides the opportunity for small investors to own shares of the same companies as large investors

Barometer of the economy

At the stock exchange, share prices rise and fall depending, largely, on market forces. Share prices tend to rise or remain stable when companies and the economy in general show signs of stability and growth. An economic recession, depression, or financial crisis could eventually lead to a stock market crash. Therefore the movement of share prices and in general of the stock indexes can be an indicator of the general trend in the economy.

Regulation of companies
The stock exchange exercises a wholesome influence on the management of companies. Acompany that wants to be listed on stock exchange must bind itself to the rules andregulations prescribed by the stock exchange.

Employment Opportunities
Stock exchange provides employment opportunities to the jobbers and other members whoperform their activities in the stock exchange. So it is an important source of employmentnot only for investors but also for the members and their employees.

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History behind the Stock Exchanges

In 1789, Congress met on Wall Street to authorize the issue of $80 million in government bonds in order to finance the cost of the war. Shortly thereafter, stocks were created to establish the Bank of the United States and to offer shares to the public. As more bank stocks and government bonds emerged, the need for an organized market to trade these instruments developed. Stocksrepresented an ownership in something and the opportunity to make money as businesses grew. Wall Street businessmen met regularly to auction stocks and bonds, and agents left securitieswith auctioneers who received a commission for each stock and bond that they sold. With an increased interest and the need for an improved system, 24 brokers met under a buttonwoodtree on May 17, 1792 and signed what they considered to be an all-inclusive document. This document enabled them to trade securities among themselves, to maintain fixed commissions on these trades, and to avoid dealing in other auctions. We consider this event to be the actual founding of the New York Stock Exchange (NYSE). In March 1817, the members adopted a formal constitution of trading rules and regulations. Exchange members could trade securities and sit at the auction for a cost of only $400 (the beginning of what is now called owning a seat on theexchange). Ironically, members never sat down while trading securities; instead, they always stood when auctioning their shares of stock. This practice continues today on majored changes. As trading activities increased and more members purchased a seat to trade securities, thisexchange moved to larger quarters several times. Finally, in 1863, the exchange settled into its present facilities at 11 Wall Street in New York City. The actual building occupied by the New York Stock Exchange at 16 Broad Street was not finished architecturally until 1903. During the late 1800s, the discovery of gold and the development of railroads created a large interest in owning mining and railroad stocks. People considered many of the smaller company issues to be too speculative for trading, so some non-members of the exchange took up the slack and actually traded these shares on the streets of New York City. They were called curbstone brokers and used hand signals to convey price and volume information to brokers who leaned out of second- and third-story office windows. They wore brightly colored clothes so that clerks could easily spot them in the crowd and would instantly know that certain stocks were being traded at specific landmarks or lamp posts. These street brokers later united and settled in a large building on Wall Street to form what is now known as the American Stock Exchange (AMEX). As the communications media advanced in the early 1900s, people all across America began to read newspaper stories about what was taking place in New York City. They were finally discovering what Wall Street was all about. They learned that it was a marketplace wheremerchants, agents, and customers

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actually gathered together each day to buy and sell stocksand bonds. As the popularity of making money by trading these instruments grew, other companies sprang up in order to participate in this type of activity. Many of them could notafford to own a seat on the exchange and therefore began to make a market in securities ofsmaller companies outside the original trading process. Brokerage companies that did not own a seat on a major exchange were called non-member firms. Their orders for exchange-listed stocks were processed through another member firm or were executed in the third market. This third market is referred to as the Over-the-Counter Market (OTC), where brokerage firms act as market makers for various company stocks. This term was originally referred to more than 100 years ago when securities were actually sold over the counter in stores and banks. Securities exchanges today are designed to facilitate and organize the buying and selling of stocks and other securities instantaneously. Two major types of exchanges include the registered exchanges and the OTC market. Registered exchanges include the NYSE and the AMEX, which are linked electronically in order to facilitate trading activity. Securities that are not traded on one of these two exchanges are traded on the OTC market. Dealers in these stocks must communicate with each other by using a sophisticated buyand-sell process. This system is known as NASDAQ, where thousands of brokers and dealers communicate electronically to buy and sell shares of specific companies. This system acts as the marketplace and central clearinghouse for trading many smaller company shares

The Karachi Stock Exchange

Past The Karachi Stock Exchange (KSE) is Pakistans first and one of the oldest stock exchanges in emerging markets. KSE was established in 18 September 1947 just two months after Pakistan became an independent state. KSE was incorporated on 10th March 1949. It is considered as a premier stock exchange in Pakistan. It was started with a paid-up capital of PKR 37 million. Trading was done through open-out-cry system. The other exchanges in Pakistan, the Lahore Stock Exchange (LSE) and the Islamabad Stock Exchange (ISE), were established in 1974 and 1997 respectively Present The Karachi Stock Exchange is owned by 200 members and brokers. There are more than 1800 terminals available at the broker counters. There are 651 companies are listed in the KSE. Trading is being done through electronic trading system. Market capitalization is 26.48 billion US$. The listed capital is 9.65 billion US$. KSE 100 index showed a result of 40.19% in 2007. At the moment they have the following customers. 1. Issuers Listed Companies

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2. 3. Brokers and Members

Investors

Future Karachi Stock Exchange will be de mutualized (Publically listed company with strategic investors). Investors participation will be on broader base. Float of existing listed companies will be increased in order to make it as a regional hub for the source of capital. They are planning for the cross border listing of companies and trading of indices. KSE is planning for the following new products. 1. 2. 3. 4. Index Trading Options Swaps New Indices (e.g., Sector Index)

Stock Indexes

In todays sophisticated markets, major indexes are used to gauge the performance of variousindustries. They are now being followed more closely by investors to help make decisions onwhether to buy or sell securities. When talking about movements in the market, we need to compare them with economic indicators such as industrial production, consumer spending, changes in the money supply, and the level of corporate profits. Rates of return in various sectors of the market can be a valuable benchmark for judging the performance of actual stock portfolios.

In order to diversify money rationally among stocks, indexes are used to study the pricerelationship of individual stocks compared to movements in the market as a whole. Thisprocess is known as asset allocation and helps investors lower the overall risk in theirportfolios. The best summary measure of market behavior is indexes. We will discuss theprinciples underlying them and the uses for which each is best suited. There are two important issues to keep in mind when using an index:

1. Knowing the stocks that are included in each one. 2. Determining the relative importance or weight of each reported stock in its index.

These two points include the problems of a) sampling

b) Weighting. Sampling: - An index can be based on a sampling of stocks or on all of the stocks. For example, the Dow Jones Industrial Average (DJIA) represents only 30 stocks, which constitutes sampling of those stocks in

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the entire NYSE composite index. Although it is widely recognized as reflecting the general market environment, the DJIA does not represent a wide variety of stocks that might be moving in opposite directions. The adequacy of indexes based on samples is caused by two elements: (1) the fact that stocks of relatively few companies constitute a large proportion of the value of the stocks of all companies, and (2) the tendency of all stocks to move together. Therefore, the substantial concentration of value in relatively few companies contributes to the power of small samples such as the DJIA.

In other words, if we try to measure the performance of a particular portfolio against such anindex, the degree of conformity will obviously be distorted. This statement is also trueregarding some mutual funds that are focused on specializing in only one industry forexample, the Fidelity Biotechnology Fund should not be expected to represent stocks ingeneral, nor should we expect it to reflect the performance of the broader-based DJIA.Investors can also fall into the trap of thinking their portfolios are under-performing or over performingthe market by comparing their holdings of individual stocks to the wrong index. Unfortunately, the market receives much media attention when it is going through periods of extreme volatility. Busy investors who do not have time to sit and watch their stockseach day will receive a synopsis on the evening news. A negative report on the performance of the DJIA, NASDAQ, or KSE will imply that their stocks may be following these indexes in the same direction. However, this situation might not necessarily be true, and this example shows theimportance of tracking the performance of each individual holding. Weighting: - The price of each stock represented in an index must be combined in order to determine the value of the entire index. For that purpose, the index must be computed eachtime in order to determine the relative importance of each reported stock. Thus, higher-pricedstocks of larger companies will carry a much greater weighting than lower-priced stocks of smallercompanies. The two most common ways of weighting stocks are in accordance with market value or byassigning equal weights to equal relative price changes. The former method is appropriate forindicating changes in the aggregate market value of stocks represented by an index, while thelatter is more appropriate for indicating movements in the prices of typical or average stocks. For example, changes in general market value are more important for studies of relationships between stock prices and other factors in the national economy. You must realize that valueweighted indexes attach relatively great importance to largecompanies and that the stocks of those companies might behave differently from the stocks ofsmaller companies. The main difference is shown through greater volatility in the fortunes andstock prices of small companies, and the greater tendency for the price of stocks of largecompanies to be moved by the general tides in the economy as a whole.

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Major Indexes
Indexes that are most widely followed and used today include the following:

DJIA Comprised of 30 larger companies stocks that represent all major areas of the economy. The average is price-weighted and is managed by editors of the Wall Street Journal, who occasionally drop or add stocks to keep the index current. The average is calculated after the close of the market each trading day and is adjusted for stock splits, substitutions, and spin-offs. This index is still the most popular benchmark and has proven reliable in reflecting general market conditions as a whole.

NASDAQ Composite Index (NASDAQ) Measures the performance of stocks traded on the OTC market and is weighted for market value. Newer or smaller companies, or those larger companies that do not want to be listed on a larger exchange, are represented in this index. In recent years, this index has been weighted more heavily toward technology companies.

Standard & Poors 500 (S&P 500) Index Comprised of 500 of the largest corporations traded on the New York Stock Exchange (NYSE). These stocks are tracked together, and a summary measure is reported on a daily basis. This index is a popular benchmark for gauging the performance of individual stocks.

Russell Indexes

Measures the performances of stocks based on market capitalization (for example, Russell 3000 includes stocks that represent 98 percent of the total equity in market capitalization). Russell 1000 includes stocks of companies that have larger capitalization, and Russell 2000 comprises companies that have smaller capitalization.

Wilshire 5000 Index Includes any stock traded in the United States for whichinformation is readily available. There is a separate index for the 750 largest stocks, one for the next 1,750 companies, and one for the remaining smaller

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companies. This index has been gaining more attention from federal policy makers and market strategists who try to determine the next direction that the market will take. The Wilshire combines stocks as represented by the old and new economies so that people can see market activity in its entirety.

Industry Indexes This industry index is designed to measure the performance of stocks related to a specific industry (for example, automobile, airline, financial, health care, technology; and so on)

Europe, Australia, and Far East (EAFE) Index It measures the total return of a sample of common stocks of companies in 20 European and Pacific Basin countries. This index helps gauge the performance of foreign markets as a whole.

KSE 100 Index The most popular index tracking the overall prices on the market is the KSE-100 index. Karachi Stock Exchange 100 Index (KSE-100 Index) is a stock index acting as benchmark to compare prices on the Karachi Stock Exchange (KSE) over a period of time. This index is a market capitalization weighted index of 100 stocks consisting of top market capitalization companies from each of the 34 sectors. The remaining 66 firms are selected on the basis of market capitalization without considering sector. The securities traded in the market include ordinary shares, preference shares, redeemable certificates and term-finance certificates (corporate bonds). The ordinary share is the most traded security. Since 2003, futures trading in some active stocks also started. The exchange Stock Market in Pakistan: An Overview4plans to start options in the near future and according to their estimate by 2012, 50% of the trading will be in the derivatives. KSE-30 Index The Karachi Stock Exchange has launched the KSE-30 Index with base value of 10,000points, formally implemented from Friday, September 1, 2006. The main feature of this index that makes it different from other indices are KSE-30 index is based only on the free-float of shares, rather than on the basis of paid-up capital. The other index in Karachi Stock Exchange represents total return of the market. That is, when a company announces a dividend, the other indices at KSE are not reduced/adjusted for that amount of dividend (whether cash or bonus).Whereas, KSE-30 Index is adjusted for dividends and right shares. At the end of 13 July, 2007, KSE-30 Index has reached its highest ever level of 17,162.45.

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How a company can be listed in stock exchange

Any organization can be listed in the stock exchange through Initial Public Offerings (IPOs). IPOs are depending on the type of market at any given point in time, companies might be willing to offer shares to the public especially if there is a receptive environment. When a new business enterprise wants to raise capital for expansion and long term growth, it will contact an investment banker. This persons function is to help guide the company when dealing with investors on capital market for the first time, and to explore alternate sources of financing when a company wants to raise money. For example, before a company issues stock for the first time, the investment banker will examine several factors such as general economic conditions, the market environment, and the companys financial condition. Most importantly, potential investors want to know the companys history of profitability and the outlook for future success of its products before purchasing any new stock. These and other factors help establish an offering price for the new shares. This price is determined in advance and is considered reasonable for attracting new buyers. If conditions look favorable for the marketing of new stock, the investment banker will negotiate an agreement to underwrite the issue by buying all of the shares and then reselling them at apre-determined price. For larger issues of stock, inviting other dealers to join in the underwriting process spreads the risk. This concept is known as a syndicate group, where all firms together will contract to sell the new shares to investors at a set price. Before a new issue of stock can be sold, however, each potential buyer must receive a prospectus. This legal document is required by the Securities and Exchange Commission (SEC) and contains essential facts regarding the financial condition and recent operations of the company.

Listing Requirements
Listing requirements are the set of conditions imposed by a given stock exchange upon companies that want to be listedon that exchange. Such conditions sometimes includeminimum number of shares outstanding, minimum marketcapitalization, and minimum annual income.

Requirements by stock exchange

Companies have to meet the requirements of the exchange in order to have their stocks and shares listed and traded there, but requirements vary by stock exchange: Bombay Stock Exchange

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Bombay Stock Exchange (BSE) has requirements for a minimum market capitalization of Rs.250 Million and minimum public floatequivalent to Rs.100 Million.

London Stock Exchange The main market of the London Stock Exchange has requirements for a minimum market capitalization 700,000), three years of audited financial statements, minimum public float (25 per cent)and sufficient working capital for at least 12 months fromthe date of listing.

NASDAQ Stock Exchange To be listed on the NASDAQa company must have issued at least 1.25 million sharesof stock worth at least $70 million and must have earnedmore than $11 million over the last three years. New York Stock Exchange To be listed on the NewYork Stock Exchange (NYSE) a company must haveissued at least a million shares of stock worth $100million and must have earned more than $10 million overthe last three years.

Karachi Stock Exchange Minimum paid up capital of Rs. 200 million for a companyseeking listing. In order to succeed public offer of equity, it has to be subscribe byat least 500 applications.Provisions of Listing Regulation 6-A relating to minimumfresh public offering through prospectus as well as the minimumpublic offering requirements by way of offer for sale as laid down under the Companies (Issue of Capital) Rule, 1996.The offering document has to be cleared by KSE before it issubmitted to the Securities & Exchange Commission of Pakistan (SECP) for approval. The company seeking listing is required to fulfill therelevant requirement of the Exchange under the ListingRegulations and the disclosures as required under the SecondSchedule of the Companies Ordinance 1984 & Companies (Issue of Capital) Rules. Please check www.kse.com.pk for the details. Simple Admission and Listing Fee Initial Listing Fee:1/10 of 1% of the paid-up capital (subject to a maximum of Rs. 1.5 million. Annual Listing Fee (companies having paid-up capital of): Upto Rs.50 million and above.Rs.15, 000 Up toRs.200 mill.................Rs.30, 000 Above Rs.200mill............Rs.60, 000

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In addition, Service Charges of Rs. 25,000 are also applicable

How an individual can start doing investments in stock exchanges

Investordeal with brokers or registered representatives who act on their behalf as agents. These peoplemust know the rules and regulations of securities trading and must be professionally licensed. They are also known as stock brokers. These professionals are compensated by commission, charged each time a stock is bought or sold. The intermediary functions between the buyers and sellers of security in the KSE areperformed by brokerage firms called members of the stock exchange. At the close of2011 (as of 26th December), there are 200 members. Pakistans capital market witnessed very high trading volume growthresulting in excessive handling of physical certificates. To manage this large volume, the Central Depository Company of Pakistan (CDC) was established in September1997. The CDC registers and maintains the transfer of securities in the form of an electronic book-entry. It transfers the ownership of securities without any physicalStock Market in Pakistan: An Overviewmovement. The investors have the option to purchase the shares certificate in paperform or as an electronic book-entry. Presently, 97 percent of settlements are routedthrough CDC. The regulated trading in the KSE is carried out through computerized. Karachi Automated Trading System (KATS). The trading can be divided into foursegments each of which has its own settlement procedure. Most common is the T+2settlement procedure in which transactions are settled through the Clearing House which nets out the purchases and sales of the financial obligations of each member for the notified clearing period and issues instructions for deliveries of netted outstanding amount.

Trading procedure on Stock Exchange

Following procedure will be followed with some differences in stock exchanges but we are taking Karachi Stock Exchange as an example. The following steps have to be taken. Selection of Broker A broker is a member of stock exchange and securities can only be purchased and soldthrough him. After selecting the broker the investor has to convince the broker to buy or sellsecurities on his behalf. For this purpose, the investor may have to make an advance or givereferences of a bank or some other persons.

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Placing the order There are three parties involved in the dealing of shares: The Stock Broker The Client The Jobber

The stock broker simply acts as agent and contacts the particular jobber in the stockexchange on behalf of the client. He does not disclose to the jobber whether he is a buyer orseller of shares. He therefore, asks him to quote two prices: The upper prices at which he is ready to sell the shares. The lower prices at which he is ready to buy the shares.

For Example, Mr. Ali wants to sell one thousand shares of a Company. He contacts a brokerdealing on the stock exchange. The broker asks a jobber to give quotations. He does notdisclose the jobber whether he wants buy or sell the shares of a company. The jobber givestwo prices, one at which he is willing to sell and the other at which he is ready to buy. Forinstance, the two quoted prices are Rs.21.90 and Rs.22.00 in a thousand. This means brokeris willing to purchase at Rs.21.90 and sell at Rs.22.00 per share. If the broker is notsatisfied, he can go to another jobber or ask the first one to make it closer (i.e. to reduce themargin between buying and selling). If the broker is satisfied with the new quotation, hethen contacts with his client informs him the bid of the share. If the client agrees to the bidprice, then bargain is struck Preparing the contract note: The stock broker prepares a contact note, one copy of which is given to the client; secondone to the jobber and the third remains with the broker. The contact note generally containsthe following information: Name and the address of the stockbroker. The name and address of the jobber. The type and price of the share. The commission of the broker.

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The date of transaction

Settlement: In case of ready delivery contract, the buyer pays the money and the seller deliversthe securities one same day. In the case of forward delivery contracts settlements are done in a week or once in amonth. On the settlement day, the difference in the purchase and the sell price may be paid withoutany delivery of securities. The parties may also postpone the deal to the next settlement datethrough mutual consent. This is known as carryover or budla.

The way to make profit in stock trading

The best way to profit in the stock market is to identify its absolutetops and bottoms and then have the courage to trade them.Part one is yield curve analysis and is the backbone. Millions of investors use the yieldcurve to forecast the stock market, and it is one of the most powerful andmost widely used indicators in existence.Part two, technical analysis, measures the levels of investors fearand greed. It simplifies technical analysis down to afew benchmarks for assessing the crowds emotions. We can then profitfrom the effects of mob psychology.Part Three, cultural indicators, analyzes the economy and the stockmarket for people who think with their right brain to avoid math at all costs.The world is full of intuitive investors who know how to read their environment, and economists often include anecdotal evidence in their thinking.We probably draw from all three forms ofinsight when we make major investment decisions.The first three parts develop the purchase and sale decisions. Part Four applies the stock market timing decisions to specific investments.Your financial security requires that you learn how to profit from timing. It is critical that you make the volatility in themarket work for you. If you lost money when the bubble burst in 2005, you need to get that money back. The only way to recoup your loss is totime the next big market moves correctly. If you have dreams for the futurethat require a large portfolio, you need to profit from buying and sellingat the right time. The next markets moves may be extraordinary andcould affect the global economy.You need the ability to build your own fortune and create your owndestiny.

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You need to know whetherthe economy is expanding or contracting and when the stock market isgetting ready for a major change in direction. It would also be valuable toknow when to buy or sell real estate, start a new company, or stay in a securejob. All of your major life decisions are easier and more productive ifyou know where we are in the economic and investment cycles. In particular,you need to know when to buy or sell the stock market. The investment map that we will develop in this article works so wellbecause it is rooted in fundamental economics. These fundamentalswill be our first screen for identifying the major tops and bottoms inthe stock market.We need to start with two major facets of economics: the supply-demandtrade-off, and interest rates. These two subjects come together inthat snapshot of securities prices called the yield curve.This curve tells us what investors think, and it will demystify the investmentworld for us. Fundamental economics, or the study of supply and demand, worksbecause people bid prices up or down according to the supply of goodsand services. The inverse relationship between price and supply driveseverything from the price of apples to the price of stocks and is particularlyimportant in the bond market. Investors buy stocks that they think will have increasing earnings.When investors expect a recession in the near future, they expect earningsto decline and they sell stocks. Conversely, they buy stocks whenthey expect a strong economy. Interest rates determine how much a business can borrow. When rates arelow, it can borrow a lot of money and expand its operations. However,when rates are high, it must cut back on production. The economy declines into a recession. Recessionsdepress the earnings that motivate investors, so they sell stocks whenthey see an economic slowdown coming. The shape of the yield curve is the key to our road map becauseit tells us what investors think will happen to both the economy andthe stock market.As you know, the yield curve is a graph of each security,from 30day bills to 30-year bonds, and the return for each investment (see Figure 1). You may expect to get an annual rate of 3 percent, for example,if you lend the government your money for 30 days and 6 percent ifyou lend the money for 30 years. Beyond the intuitive fairness of thisarrangement, there are sound economic principles at work.

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The investment map that we will develop is based on the fundamental economics of supply and demand. Prices allocate scarce supplies of everything from apples to U.S. Treasury bonds. Higher prices mean lower returns, or yields, on all our purchases whether they are houses, apples, or bonds. The yields of all Treasury securities from short-term bills to long-term bonds are reflected on the graph called the yield curve. Investors know that the shape of this curve forecasts the direction of both the economy and the stock market in most industrialized nations. A normal, upward-sloping curve suggests a strong economy and stock market, while a negative, downward- sloping curve indicates a coming recession and a bear market. The shape of the yield curve, or yield curve analysis, and its ability to forecast the stock market is one of the trade secrets that professional money managers discuss around the water cooler.

Summary of Yield Curve Analysis

Buy stocks when: The federal funds rate is declining. And the money market yield curve is positive. And bond quality spreads are shrinking. And the 10-year note, three-month bill spread is positive.

Sell stocks when: The federal funds rate is rising. And the 10-year, three-month spread is negative. And bond quality spreads are expanding. Or the yield on the 10-year note is greater than 10 percent.

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Technical analysis looks at stock prices and volume. Some practitioners refer to this powerful theory as price-based analysis in order to differentiate it from fundamental economics. Technicians use security prices rather than fundamental economic analysis to make their investment decisions. Part Two will give us the tools to measure fear and greed in the marketplaceso that we could trade against the crowd. We are more able tobuy stocks cheaply when everyone else is panic-stricken and wantsto sell them to us at any price. However, we like to have a lot of peopleclamoring for our merchandise when we sell, so we are happy to give theoptimists a chance to mount a bidding war for our portfolio. It is not ourfault that they are making exactly the wrong decision each time. They cannot help being victims of the effects of crowd psychology. They do notknow that the intelligence sinks to the lowest level representedin a crowd. We just measure the crowds emotions and then tradein the other direction.We measured the investing masses fear and greed with tools fromtechnical analysis. One of our tools, the number of advancing stocks in theDow Jones Industrial Average, became and indicator for us and provideda trade date for the model portfolio. The rest of the tools appear to be a littleless reliable in identifying absolute tops and bottoms of the market, sowe use them to support our trades. The volatility index, the put/call ratio,moving averages, and the amount of leverage in the market validate ourdecisions as they strengthen our resolve to defy the crowd.Technical analysis is a dispassionate observer of behavior. Technicalindicators have credibility because they use prices rather than opinionsabout a companys future earnings or what the Central Bank may do.Most investors blend fundamental and technical analysis in an effort touse the best of both worlds.We think that the best from the world of fundamental analysis is the predictiveability of the yield curve, and I find the number of advancingstocks in the Dow (Dow is explained below) to be the most reliable technical indicator.Investing in defiance of the crowd is very difficult, however, and weneed all the indicators we can get to confirm a proposed change in ourportfolio. The volatility index, the put/call ratio, moving averages, and theamount of leverage in the market serve this purpose well.

Use of the Dow Charles Dow revolutionized investing in 1896 when he created the DowJones Industrial Average. His benchmark allowed investors to track thewhole market easily rather than having to look at each stock separately.We use his index to isolate 30 of the largest stocks in U.S. businessand then we see how many of them advance each day. On those rare dayswhen all 30 of these very different stocks from diverse industries decline,we know that crowd psychology is at work. We know that people are sopessimistic that they are selling stocks from a broad range of industries,including some that often move in opposition to each other. It is time forus to buy the S&P 500 index when pessimism is so widespread.There was just one instance of all 30 Dow stocks declining at once between2000 and 2004; on July 19, 2002, all 30 declined and the Dow closedat 847. Not even after the terrorist attacks did we see such pessimism. Themarket closed for almost a week in September 2001, and when it reopenedseveral telecom stocks in the Dow moved up in price. (Peopletrapped in the burning World Trade Center towers used their cell phonesto call for help and

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dramatized the benefits of this technology.) It was notuntil July 2002 that investors became so despondent that they failed to seevalue in any of the Dow industrials.

Part 3: Cultural Signals

Part Three added cultural signals to our fundamental and technicalanalysis. These signals were the medias changing standards of femininebeauty, demographics, corporate spending, and war. Our culturehas two effects on our trading; it shapes our economy it also forecaststhe stock market.Part Three is important because, in addition to using free and easilyaccessible information those appeals to no quantitative investors, cultureis tied to our economy and our stock market. It is my opinion that theeconomy determines our culture. I have seen standards of beauty and corporatespending change along with the economic cycle; I have seenchanges in birth rates that parallel the economy and I have seen nationsgo to war during recessions. These are the events that shape our lives andour portfolios.

Changing Standards of Beauty We looked at how our popular culture reflects and forecasts our economy.Standards of female beauty seem to change with the economy because weget bored with current models and move on to new stimulation.The Playboy bust line theory began as a joke but stood up to scrutinyas a coincident indicator of the broadbased Russell 2000 index of stocks.The medias ideal of beauty certainly does change over time; models facesbecome softer and more babyish as our pockets become fuller. In fact, thefashion modeling industry says that it needs new faces every six monthsto provide excitement. Everyone knows that the publics taste in entertainmentchanges; and some of us use that information to confirm ouryield curve and technical analysis.

Demographics May Coincide The economy may coincide with peaks in the rates of birth, death, marriage,divorce, and crime. Perhaps expanding economies fill us with confidenceand enable us to have large families, live longer, stay married, andobey our own laws. Recessions seem to push us toward having fewer children,earlier death, divorce, and crime. In addition to shaping our lives,these landmarks are visible to us all in our assessment of the economic cycle.You do not have to be a mathematician to know where we are in thebusiness and stock market cycle; headlines in the local newspaper canprovide coincidental indicators.

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Corporate Spending Extremes Corporations give us, the consumer, what we want; so this chapter held a mirror up to our own faces. Because firms need some lead time to put newproducts on the shelf and make them known to consumers, corporate behaviorand products change about six months to a year before the stockmarket. Advertising, hiring, and entertaining have approximately sixmonths lead over the stock market, while womens fashions are about ayear early. Calvin Klein has mastered the art of advertising so well that wecould almost time the market around the publics reaction to his mostshocking campaigns.

War Stimulates the Economy We usually think of war as starting with a joint declaration from Congress,but Congress has not declared war since Pearl Harbor. In the absenceof a formal declaration of war, our indicator to buy stocks is thedate on which troops are called up. Gross domestic product, employment,inflation, and the stock market all tend to expand during wartime, so investorswant to be fully invested when we actually deploy our troops; theday that we activate our troops is the best time to buy stocks. In fact, thisis one time that we could disregard yield curve analysis and invest whenthe curve is inverted.

References
B. O'Neill Wyss. Fundamentals of the Stock Market, New York: McGraw-Hill, 2000, Informative Deborah, Weir. Timing The Market, New jersey, Wiley Trading: 2005, Informative Kashif Adeel. KSE Listing Regulations. Finance Doctors. Finance Doctors Publications, http://www.financedoctors.net/Notes/181.pdf. 29/10/2011 Brain, Marshall, and Dave Roos. "How Stocks and the Stock Market Work" 06 July 2011. HowStuffWorks.com. http://money.howstuffworks.com/personal-finance/financial-planning/stocks.htm.30 October 2011 The Listing Regulations of the Karachi Stock Exchange (Guarantee) Limited. Karachi Stock Exchange. September 14, 2011. Karachi Stock Exchange. http://www.kse.com.pk/scripts/communicator.php?f=listedrules.zip&l=tXt: 30 October 2011

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