Understanding Today’s Relevant Financial Terms
We recognize a majority of investors are overwhelmed by the onslaught of information provided by the financial media. In most cases, it is unnecessary for the everyday investor to understand the intricacies of Wall Street.
However, with the state of the economy often leading the nightly news, it is important for investors to have a clear understanding of the topics being discussed. The following is a glossary of timely financial terms.
Recession
Discussion on whether the United States is in a recession has been a fiercely debated topic. With the unease inspired by such talk, it is important to understand the basic definition of a recession and what that means as an investor.
A recession is defined as: A period of general economic decline; specifically, a decline in GDP (gross domestic product) for two or more consecutive quarters.
By that definition, the United States would NOT be considered in a recession. Figures from the Bureau of Economic Analysis, show the 2007 third quarter growth at 4.9%, the fourth quarter at 0.6%, with the first quarter of 2008 also coming in at 0.6%.
Recession or not, the economy is far from the force it was from 2003 to the third quarter of 2007. What does this mean to an investor? Don’t Panic!
Periods of economic downturn are a natural occurrence. While these periods can be uncomfortable and frightening in the short-term, understand they are a necessary evil for a healthy market in the long-run. Why is this?
In periods of rapid growth, certain sectors become the front runners. Often times, investors mistakenly believe that because an investment has fared well in the recent past, it will continue to do so in the near future. An ever increasing amount of new money flows into the sector, ultimately driving up prices to levels that are not supportable. Invariably, an event comes along that bursts this bubble, resulting in large losses for those late to the party.
This natural market cycle is all the more reason to remain diversified and keep a long-term focus. With inevitable short-term market fluctuations, turning a blind-eye is your best (read: most profitable) plan of attack. Waiting it out and allowing your money to enjoy the benefits of compounding interest far outweighs the alternative of trying to time the market. A study by Fidelity Investments highlights the importance of staying invested in the market: From 1992 – 2007, missing the 10 best days of the market would have reduced an investor’s portfolio by nearly half!
Inflation
Inflation occurs when the prices of goods and services rise, leading to a decline in overall purchasing power. As inflation rises, every dollar you own will buy a smaller percentage of a good or service.
It is common for countries such as the United States to sustain an annual inflation rate of 2-3%. In a healthy economy, this makes sense: As wages increase, so do the prices of goods and services available. However, when an economy is struggling, much like we are experiencing today, inflation presents a big problem.
For example, the following are statistics from the Bureau of Labor Statistics showing the inflation rate in specific areas of our economy.
Category Unadjusted 12-month Rate
Energy 17.0%
Transportation 8.2%
Food 4.5%
It is no surprise that Energy (oil, gasoline, etc…) has by far the largest inflation rate. Everyone experiences the effects of this when they fill up their gas tank. Such a drastic price increase will ultimately be cutting into budgets as wage increases are certainly not keeping pace.
Markets and Market Volatility
With the recent turmoil in the stock market, investors should understand and expect ups and downs in the market. It is one thing to hear the Dow lost 100 points; it is another to comprehend the significance, or lack thereof, of such a move. To better explain the stock markets and the corresponding values, understanding the most widely discussed index is necessary.
Dow Jones Industrial Average (Dow)
The Dow is an index that tracks the price-weighted average of 30 significant stocks traded on the New York Stock Exchange. The individual stocks are generally large, blue-chip companies such as Exxon, GE and Microsoft. The Dow is the single most watched index in the world. Generally, if you asked how the market is doing on a particular day, the response is based on the current Dow numbers.
The past year has been turbulent to say the least. On April 1st 2007, the Dow was in the midst of a record ascent. While there was still the occasional day where the Dow lost value, overall, the market experienced a steady, upward trend over the previous 12 months.
Market fluctuations during this period were minimal, with the largest one-day increase being 153.25 points (April 19th – 20th) and the largest one-day decrease (May 9th – 10th) of -147.74. The relative stability of this period was certainly “the calm before the storm” for investors.
As the summer of 2007 came to an end, investor skepticism was on the rise. The housing market was beginning to slump, oil prices continued to rise and banking institutions were showing signs of stress. As the weather turned cold, so too did the mood of investors as news of the mortgage-backed securities crisis grew and financial institutions worldwide began writing off billions of dollars of assets. This troubling economic news could not be ignored and the market responded with extreme volatility.
As you can see from this 2-year chart of the Dow, the subtle fluctuations seen during the market’s steady climb (August ’06 – June ’07), gave way to steep peaks and valleys, characteristics of a market in flux.
The days of 10 – 50 point daily losses were replaced by days enduring 200 – 300 point declines. Despite all of this, the Dow remarkably managed to close at an all-time high on October 9th 2007, at 14,164.53. The celebration was short lived, as just over three months later investors would watch the Dow decline 2,193.34 points to under 12,000 in January, a decline of over 15%!
The markets will continue to fluctuate and experience painful and frightening periods. We are confident the best strategy is to remain steadfast in your approach and to not fall victim of trying to time the market. The consequences of doing so can be costly. This point is well emphasized in a past article titled, Understanding Market Volatility, written by President of World Trend, Tory Meiborg.
Bull Market vs. Bear Market
When analyzing the current state of the stock market or the prospects of an individual position, two general terms are frequently used: Bull and Bear. In order to understand such analysis, it is vital to know the difference between the two adjectives.
When markets are doing well, or an individual security is being viewed optimistically, they will often be described as being “Bullish”. When markets start to decline in value or an individual security loses its prestige, they are classified as “Bearish”. Why?
The use of the terms “bull” and “bear” stem from the way these animals attack their adversaries. A bull charges his opponent and thrusts him upward with his horns. Hence, when a market is rising you hear the term “bull market”. Alternatively, a bear attacks his foe with a downward swing of her powerful arms. Therefore, as markets decline in value, the term “bear market” is often used to describe the downward trend.
Despite recent volatility, it is difficult to say whether we are in a “bear” market, which is typically when markets drop 20% from their peak. Recessionary fears and rising inflation aid in creating a pessimistic economic environment, the consequence being an overall market decline. Since mid July 2007 (the end of a prolonged bull market), the Dow has declined -8.42% through the end of April. At the lowest point of the decline, the Dow was down an astounding -16.14%.
I hope this article provides additional insight to any terms or phrases commonly used when discussing finance. I realize these are just a few of the many financial terms out there. If you would like definitions of additional financial words or phrases, please visit our online financial dictionary. Additionally, we are always available to answer questions you may have regarding the market place and how it relates to your personal portfolio.