Globalization

“Give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime.”  – Chinese Proverb

In the past few decades, globalization has been a hot discussion topic.  The term itself means so many things to so many different people.  Many advocate that globalization is a good thing while others fiercely oppose it.  But just what is globalization?  In short, globalization refers to the integration of national markets through trade and investment.  Moreover, it involves the movement of goods, services, labor, technology, and capital (i.e., money) across international borders.  Globalization also encompasses broader political, environmental, and sociocultural issues. Over the years, globalization has been fueled by advances in transportation, telecommunications, and finance.  Globalization promotes market efficiencies through open trade policies by allowing countries to specialize and focus on what they do best, and more cheaply.  The result is that it empowers consumers (governments, businesses, and individuals) to purchase the best the world has to offer while giving producers the best tools available to make and promote their products.

Not all economies choose to engage in open-market trade policies, but it has been shown that those who do, including poorer developing nations, have flourished economically.  This is especially true over the long term.  Just embark on a time capsule and travel back in time to the year 1900.  At the beginning of the twentieth century, Argentina and the United States of America were economically very similar.  But at the time, the United States chose to adopt an economic policy that favored trade with other nations, while Argentina did not.  Fast-forward to today.  Who is economically superior now?  No contest!  The moral of the story here is that market integration between nations really forces each to innovate, adapt, and contribute to the world, whatever it is that they are best at.  It helps characterize what each economy is about.

Today, thanks in large part to globalization, investment opportunities are not limited to the national boundaries of the country in which you live.  As we will see throughout this book, it is wise to diversify one’s investments.  Geographic diversification of your investment portfolio is a must because the economies of all countries go through ups and downs.  When there is a downturn in a country’s economy, its stock markets usually tend to do poorly, as companies try to cope with all sorts of economic challenges, cut their costs, and do everything possible to stay competitive.  To mitigate these effects, all investors should secure a portion of their investments in foreign securities.  For the most part, foreign securities consist of foreign stocks, bonds, and currencies.  Both Canadians and Americans live in fairly stable economies; therefore, the stock markets in these countries also tend to be stable.  The problem may be that, in general, the performance of these markets tends to parallel economic growth.  In the past decade, economic (and stock market) growth in Canada and the U.S. has hovered just a little over 3.3% while the markets of emerging economies such as China lie in the 9% to 10% range.  Hence the rate of return on foreign investment can be significantly better than that for domestic investments.  However, whenever you see higher rates of returns, they are often accompanied by higher levels of risk.  In other words, even though investors can obtain higher rates of returns by investing in foreign markets, they can also suffer greater losses when those economies stumble.  In general, emerging markets tend to be less stable and are more sensitive to economic downturns.  This occurs because many of these countries are in a “transition phase”, where they are building and upgrading all the necessary infrastructures to feed their growing business and consumer needs.  Furthermore, businesses need to constantly reinvent themselves to be more competitive against older and more established players in the global marketplace. This is something that can be very difficult to accomplish on a consistent or sustained basis.  Corporations, especially multinational corporations, from developed countries such as Canada, the United States, the United Kingdom, Japan, and Germany have been around for many decades (some even for centuries) and have adjusted to many challenges over the years, making them extremely competitive, innovative, and robust.  Time and time again they are able to perform well and provide good returns for their investors.  This kind of “market adaptability” doesn’t come as naturally to newer corporations in emerging markets.  But do keep in mind that many of them are, nonetheless, very competitive, innovative, and worthy of consideration for investment. 

Economic Indicators

The main objective of this chapter is to provide you with some tools so that you can be in a better position to assess the potential worthiness of investing in foreign markets.  The remaining sections of this chapter will provide you with valuable insights as to where opportunities lie and the means you can use to evaluate them.  For now, we need to look at some important economic indicators as they are the starting point in the evaluation of foreign markets.  Although there are many factors that shape and define a given country’s economy, the following ones are often the key determinants:

1. Gross Domestic Product (GDP)
2. GDP Per Capita
3. Interest Rates
4. Balance of Trade
5. Investment Rates
6. Foreign Direct Investment (FDI)
7. Research & Development (R&D)

Gross Domestic Product (GDP)

GDP refers to the value of all goods and services produced within a country’s borders during a specific period of time such as one year.  In brief, GDP measures the overall size of the economy.  The country that has the highest GDP in the world is the United States.  According to The World Factbook (prepared by the Central Intelligence Agency),the estimated GDP for the U.S. in 2006 was about 12.98 trillion U.S. dollars.  China is the nearest rival with a GDP of 10 trillion followed by Japan at 4.22 trillion. 

GDP Growth is another common way to measure the pace at which a given economy is growing.  As mentioned earlier, a country’s stock markets often grow at a rate that is similar to its economy.  Later in this chapter we will make specific comparisons between growth rates of particular countries along with the rates at which their overall markets are growing.  But for now, let’s look at a sampling of growing and established economies as seen in the table below.

2. GDP Per Capita

GDP Per Capita represents each citizen’s share of the overall GDP.  To calculate GDP per capita, simply divide GDP by the estimated population.  GDP per capita is significant from an investment perspective because it represents, in a generalized fashion, the average earnings of a typical citizen in a given country.  The higher the GDP per capita, the more spending power or disposable income consumers will hold in their wallets.  Of course you need to keep in mind things such as personal expenses, the cost of living, and the level of taxation on income and goods and services.  Nevertheless, GDP per capita is a very good indicator of the purchasing power of consumers in a given market.  Therefore, if you make investments in companies that offer goods or services to individuals, you need to look at how much disposable income the average consumer has to spend.  An exciting trend that is emerging right now is the rapid increase in disposable income of consumers in the Chinese and Indian markets.  Add to this the fact that these two countries alone account for over 2.45 billion people or roughly 37% of the world’s population.  No wonder so many companies are scrambling to enter these burgeoning markets.

Every once in a while you hear on the business news: “Today, the Fed [or the Bank of Canada] raised its target interest rate by one quarter of a percentage point.”  Most often, such announcements are accompanied by a lot of movement and activity in the markets.  Stock markets are especially sensitive to changes in interest rates and even to rumors about upcoming changes in rates.  Now, just what does all this chaos and turmoil mean?  Let’s take a moment to understand what is really going on and see what the fuss is all about.  Before I explain what is meant by interest rates, we need to take a step back and look at the bigger picture.  Governments from industrialized countries such as Canada and the United States have established monetary policies over the past few decades.  Such policies are in place for a broad range of macroeconomic reasons, most of which are very complex and beyond the scope of this book.  All you need to know for now is that one of the main goals of any monetary policy is to maintain a good standard of living for citizens through low and stable levels of inflation.  A government can help control the level of inflation through its Central Bank.  Most countries have a Central Bank.  In Canada it is the Bank of Canada and in the United States it is the Federal Reserve Bank,more commonly known as The Fed. 

Central banks attempt to keep the rate of inflation low, usually in the 1% to 3% range, by making adjustments to the interest rate.  In this particular case the interest rate is referred to as the overnight rate.  The overnight rate is the interest rate that other banks pay the central bank to borrow money directly from it.  Yes, even banks borrow money!  So the overnight rate influences other interest rates, such as those for mortgages or consumer and business loans offered by banks and other lending institutions.  Central banks usually adjust the overnight rate by a quarter of a percentage point (i.e., 0.25%) or sometimes by a half percentage point (i.e., 0.50%) and, on occasion, they leave it unchanged.  Central banks can raise or lower the rate.  Both initiatives usually set in motion a chain reaction of consequences that influence the following:

• The level of spending by consumers and businesses
• Financial markets
• The rate of inflation
• The exchange rate of the dollar

Are you still with me?  This is heavy stuff, no doubt.  But don’t worry because with time this will all become second nature to you.  Now we need to look at what happens when interest rates rise.  For the most part, it has the opposite effect of a decrease in the interest rates.  When interest rates rise, there is a decrease in demand for loans as they become more expensive.  Fewer loans mean a decrease in spending, as individuals and businesses will hold off on their expansion plans for a while.  So, there will be a lower level of production in the economy.  Unemployment may rise, as businesses are laying-off employees due to lower production levels.  The upside is that it will lead to lower prices (due to lower demand) and, consequently, lower inflation.  In addition, the dollar will likely increase in value.  The effect on the bond market will be negative as, when interest rates increase, the value of existing bonds fall because new bond issues will pay a higher yield.  In other words, investors will want to purchase bonds offering higher returns than those currently available on the market.  This gets confusing, because even though the larger bond market will be negatively affected, new bond issues will actually perform well since some parties are still willing to pay higher interest on the loans (i.e., bonds). 

That just about covers it for interest rates.  I have included a table below to summarize the effects of increases or decreases in interest rates.

4. Balance of Trade

The Balance of Trade represents the economic value of all the products and services a country exports, minus what it imports.  When a country exports more than it imports, it has a trade surplus and the trade balance is said to be positive.  A positive balance of trade is a good thing because it helps economic growth.  As goods and services are exported (i.e., sold) to other countries, money flows into the country as payment.  This money is then further invested into the local economy by governments, business, and individuals who use it to buy more goods, services, and investments.  When a country imports more than it exports, it has a trade deficit and its trade balance becomes negative.  A negative trade balance is bad for economic growth, as more money is leaving the country to pay foreign suppliers for goods and services.  Since 1975 Canada has enjoyed a favorable (i.e., positive) balance of trade.  It is worth noting that 80% of Canada’s exports are destined for the U.S. market.  So, in large part, Canada’s economy is strongly dependent on and sensitive to the U.S. economy.  Moreover, if there is an economic downturn in the United States, Canada will suffer as American governments, businesses, and individuals will purchase fewer goods from the great white north.  For the past several years the United States has been subject to a negative trade balance as it imports almost twice as many goods and services than it exports.

5. Investment Rates

Investment rates are an important indicator of future economic growth.  They represent the share of the total GDP that is devoted to investment in fixed assets.  Fixed assets consist of factories, machinery, equipment, dwellings and other buildings, roads, bridges, inventories of raw materials, computer software, and expenditures on mineral exploration, as well as some other assets.  Essentially, what all these assets have in common is that they will be used to contribute to the production of future goods and services.  In short, investment rates state how much a country is investing from its current wealth in infrastructures for future economic expansion. 

6. Foreign Direct Investment (FDI)

Foreign Direct Investment (FDI) refers to the amount of money a country and its businesses either invest abroad or are recipients of.  Monies invested abroad are known as FDI outflows, while monies received from foreign investors are considered FDI inflows.  The purpose of FDI is to create long-lasting relationships between nations while promoting increases in trade.  Increase in trade activity is known to improve the economic situation of countries as new investments are often used to create new infrastructures, technologies, and promote new goods and services to different markets.  Often, businesses will establish operations abroad for a number of reasons.  A common reason is to gain more access to foreign business and consumer markets.  Many industrialized nations such as the United States, the United Kingdom, France, and Canada have very strong FDI outflows.  They seek new opportunities for growth and expansion abroad, as profit potentials are higher there than they are domestically (due to saturated domestic markets).  In recent years, emerging economies such as China, Brazil, India, and the Russian Federation have been recipients of huge amounts of FDI inflows. 

7. Research & Development (R&D)

The level of expenditures on Research and Development (R&D), especially in Science and Technology, by governments and private-sector participants is a key indicator of a country’s innovativeness.  A higher level of R&D generally leads to additional economic growth through the commercialization of new product and service inventions.  Often, R&D efforts are rewarded by exclusive rights to manufacture and exploit such products by means of patents.  A patent gives exclusive rights, usually for a period of twenty years, to produce and commercialize an invention.  In other words, no one else may copy, produce, or sell a product that is filed under a registered patent unless a licensing agreement exits.  Of course, the inventor must pay patent filing fees to countries’ Patent or Intellectual Property Office where it wants to sell its product.  But the main benefit is that the patent holder essentially holds a monopoly on the new product (or process).  Pharmaceutical companies, for example, develop and exploit a large number of patents – usually new drugs – destined for foreign markets.  Another example of a very successful patent is one that is currently being exploited by the Canadian company called Research in Motion (RIM).  RIM has a patent that helps operate its Blackberry – a portable wireless device similar to a cell phone – that lets users check their e-mail and surf the Web away from the office. 

Now back to our discussion about R&D.  A good way to determine the amount a country spends on research and development is to compare R&D expenditures as a percentage of its GDP.  The Organization for Economic Co-operation and Development (OECD) compiles such data (as well as data for many economic and social indicators).

Each year the Organization for Economic Co-operation and Development (OECD) publishes its own Factbook which contains many statistics on economic and social trends for member countries.  Be sure to consult this source of data as it will provide you with additional insight as to where countries stand against each other.  A link to this resource is provided in the link box that follows.

For specific economic data and information regarding Canada and the United States, be sure to consult the resources found in the link box that follows. 

Sectors & Industries

In any given domestic or foreign market, there exists a wealth of industries to choose from when deciding which sector or area you wish to invest your money in.  Before we get into listing them (or at least the main ones) let’s make a distinction between the terms sector and industry.  A sector is broader than an industry.  You may find many industries within a given sector but the opposite is not true.  For example, in the Healthcare sector you find the biotechnology, pharmaceutical, as well as other, industries.  In the Financials sector there are the banking, insurance, and financial services industries.  In the investment world, industries are grouped into sectors in order to keep track of how well (or poorly) they are performing against one another.  Industry and sector-specific performance is tracked using market indices, a topic which is covered in the following section.  Investment portals and other investment-related websites list varying, but often similar, sector categories.  For the most part, the following list enumerates the sectors which are typically tracked and covered:

• Consumer Staples
• Consumer Discretionary
• Energy
• Financials
• Healthcare
• Industrials
• Materials
• Metals & Mining
• Services
• Information Technology
• Transportation

An excellent online resource that provides a wealth of information about nearly all industries is Reuters.com. In this online investment portal we can find, among many other goodies, Industry Overviews, Key Developments, Company Lists and Rankings, and Research Reports about particular industries.  I invite you to pay a visit to the site via the link provided below so you may explore which industries are located in which sectors as well as find related industry information.

Later, specifically in Chapter 6 – Anatomy of a Stock, we will come back to the Reuters portal as it contains some outstanding learning tools and insightful information about the performance of publicly-traded companies.  But for now, let’s dig a little deeper and see just how industries are tracked, which ones are performing well, and where we can access such market data.

Market Indices

For investors, market indices represent one of the best known tools to evaluate and follow all kinds of investments from stocks to bonds, and from currencies to commodities.  There are literally thousands of indices that track the performance of any type of investment.  But just what is a Market Index?  A Market Index attempts to represent the overall performance of a certain group or type of investment.  For example, you may have heard of the Dow Jones Industrial Average or the S&P 500 indexes.  The Dow Jones Industrial Average (or Dow) index tracks the daily stock performance of thirty large American corporations listed on the New York Stock Exchange (NYSE).  These companies are varied in terms of what goods and services they provide.  Disney, Coca Cola, and Wal-Mart are but a few companies that make up the Dow.  The S&P 500 tacks the performance of five hundred large corporations listed on the American Stock Exchange (AMEX) and the NASDAQ exchange.  In general, what these indices attempt to represent is the overall performance (i.e., price movements) of all stocks listed on these exchanges.  Since there are thousands of stocks listed on most stock exchanges it is difficult to for one to assess how good (or bad) they are all performing on a given day.  So, tracking only selected stocks on an exchange can provide us with the general trend of whether more stocks are (or were) being bought or sold.  A general increase in the purchasing of stocks leads to a positive return (i.e., market increase) of the index.  Conversely, a large sell-off of stocks in a given market leads to a negative quote for the index.  Every night on the evening news you will hear broadcasters mention that a certain index either gained or lost so many points (sometimes expressed as a percentage).  As an example, they may say: “Today, the Dow lost 230 points, down 2.1 percent.”

Indices track performance not just on a daily basis, but also on a weekly, monthly, quarterly, and annual basis.  It is worthwhile to compile information about the performance of investments such as stocks through indices over time since it permits us to see whether or not the markets are progressing.  When markets progress it is usually a strong indicator that the economy is growing.  Conversely, when indices are consistently down it may indicate a slowdown in economic activity.  There are many, and often complex, factors that influence the performance of stocks on markets.  Some of those factors were described in the Economic Indicators section above.  News happenings can also strongly influence the performance of stocks on a given day.  We will talk more about that later.  For now, as a savvy investor, you should always keep an eye on the markets through the lens of market indices.  Be sure not to obsess over the daily ups and downs of market indices.  Rather, look at the general trend or direction the market seems to be heading.  Do try to observe which specific factors, economic or otherwise, influence the performance of the markets.  Over time, you will develop your own expertise about the intricate workings of the markets.

As mentioned previously, there are thousands of different indices that track the performance of many different types of investments.  Some follow a specific sector or industry.  Others follow the course of a particular commodity such as gold.  Many track the performance of a particular country or region’s markets.  I will conclude this discussion by providing you with links to some useful financial websites that provide data about all these indices.  So feel free to explore which investments and markets are doing well and which are not.  And be sure to look at the performance of indices over longer periods of time.

The Markets

Although there are a great number of markets in which an eclectic mix of goods and services are traded, I will only focus on four: the Stock Market, the Bond Market, the Foreign Exchange (currency) Market and the Commodities Market.  As an investor, you are likely to have investment exposure, either directly or indirectly, to each of these markets at one point or another.  So it is important that you understand how they work.  It is impossible for me to describe to you all the intricate workings of these machines we call markets.  But I will cover the basics and provide you with some good Web resources where you can educate yourself further on the subject.

1. The Stock Market

“Time is your friend; impulse is your enemy.” – John Bogle, American investor

“If you have trouble imaging a 20% loss in the stock market, you shouldn’t be in stocks.” – John Bogle, American investor

A stock market is, by definition, a market in which stocks of various companies are traded.  So what is a stock?  A stock is simply a piece of ownership in a company.  Companies issue stock (individual shares) to raise money in order to expand their business.  Anyone who is interested in investing in the company with the intention of making a profit may do so by buying its shares of stock.  Some companies sell shares to the public directly.  But for the most part, shares are bought and sold on a stock exchange.  I will talk more about stocks in Chapter 3 – Investment Types and Chapter 6 – Anatomy of a Stock.  For now, I just want you to get a sense of what goes on in the overall stock market as opposed to what happens to a single stock.  Notice that I mentioned that stocks are bought and sold on a stock exchange.  We need to make a distinction between a stock market and a stock exchange.  A stock exchange is a place where buyers and sellers meet to exchange stocks.  In other words, people buy and sell stocks of companies listed on a certain exchange.  The stock market generally refers to the ensemble of stock exchanges in which company stocks are traded.  In the United States the three major stock exchanges are the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the NASDAQ. Please note that the NYSE and AMEX are now consolidated into one big entity called NYSE Euronext.

In Canada, the principal stock exchange is the Toronto Stock Exchange (TSX). The other popular exchanges include the Montreal Stock Exchange and the TSX Venture Exchange. These have been consolidated into a major entity called the TMX Group.

On any given day, thousands, if not millions, of shares are traded between buyers and sellers on any given stock exchange.  A trade involves a buyer who wants to purchase a stock and a seller who wants to sell of the stock.  A trade is an agreement between both parties to swap the stock at an agreed-upon price.  It’s like an auction.  The seller will sell the stock to the highest bidder and the buyer will buy the stock from the seller who offers it at the lowest possible price.  Not all stock exchanges work in the exact same way.  But for the most part, only members who have “seats” on an exchange may place trades.  Memberships can be quite costly, as a single seat on an exchange can cost upwards of one million dollars.  Consequently, it is usually brokerage firms, banks, and other financial institutions such as investment houses that hold seats on stock exchanges.  They place trades for themselves as well as their clients such as individual investors.  Of course they charge their clients commissions to place trades.  Individual investors like you and me can buy and sell shares through the intermediary of a stockbroker or the services of an online broker.  In Chapter 7 – Do it Yourself! Online Investing I will talk more about online brokers.  Although stocks can be traded at any time, most of them are traded on stock exchanges during regular trading hours, Monday to Friday from 9:30 a.m. to 4:00 p.m. Eastern Standard Time.  On big exchanges such as the NYSE the volume of trading is huge.  It is typical to see over a billion shares (from listed companies) valued at over $40 billion change hands each day.  Institutional investors such as banks, investment houses, pension funds, and insurance companies place the majority of trades (upwards of 80% of all trading volume) on any given day.  The remaining portion is settled by smaller individual investors.  Now, there is a very important point I want to emphasize here; and I want to make sure that you remember this.  Since it is the big players (as mentioned above) who place the lion’s share of trades it is also they who have the most influence on stock prices.  These players buy and sell HUGE amounts of company stocks at a time.  Consequently, they are the ones who really influence the value (price) of a stock by the simple act of buying (which drives the price up) or selling (which drives the price down).  So, if you ever wondered what makes stock prices move up or down, it is due in large part to the actions of these big traders. 

Many other factors make a particular company’s stock price go up or down. Such factors include, but are not limited to, company performance and earnings, company news, and economic indicators (as discussed earlier).  In Chapter 6 – Anatomy of a Stock I will talk more about factors which are essential in evaluating a company and its stock. 

Stock exchanges are present not just in North America but in many countries of the world.  In fact, there are over 145 stock exchanges worldwide.  While it may not be easy for an individual investor like you or me to place trades on a foreign stock exchange some brokers will have seats on exchanges in other countries giving you access to foreign investment opportunities.  And actually there is another way in which you can invest in foreign companies while not being required to place trades on foreign exchanges; please consult the American Depository Receipt (ADR) section of Chapter 3 – Investment Types for more information on the subject.

2. The Bond Market

The bond market is much less structured than the stock market.  There really aren’t many common exchanges for bonds, as many different parties can issue them.  The bond market is not as heavily regulated as the stock market.  When we refer to the bond market we are really talking about people and entities involved in the buying and selling of bonds.  A bond is simply a loan from a lender, like you and me, to another party – the borrower.  The majority of borrowers include governments (federal, state or provincial, and municipal) and businesses.  When governments or companies issue bonds to investors, they are really borrowing a certain amount of money for a predetermined amount of time, after which they will repay the loan back to the issuer in its entirety, along with bond interest payments every six months.  Governments issue (sell) bonds to fund infrastructure projects such as building new roads or to help fund a budget deficit.  Companies issue bonds to fund their business projects.  It is much easier for companies to issue bonds to investors as opposed to issuing shares of stock.  Issuing corporate stock on a stock exchange can be a complex, lengthy, and expensive proposition, but bonds are much easier to issue.  Bonds in general are much less volatile than stocks.  Therefore they are much safer.  However, they may carry some risks and usually do not yield such a strong return on investment as stocks do.  Government bonds (from stable economies) are extremely safe investments.  Corporate (company) bonds are slightly riskier.  A company can go bankrupt, leaving both bondholders and stockholders broke.  However, the main advantage of owning corporate bonds as opposed to company stock is that bondholders are usually paid before stockholders when the company goes out of business, as their remaining assets are being liquidated to pay off creditors and investors.

The big players in the bond market include mutual and pension fund companies as well as banks.  They hold a large share of existing bonds as do baby-boomers who will be retiring in the next few decades.  Individuals can buy bonds directly from the issuer but most buy them through Fixed-Income Mutual Funds.  A Fixed-Income Mutual Fund is simply a basket of different bonds.  In Chapter 3 – Investment Types I will talk more about bond funds as well as individual bonds, how they work, and how they are valued. 

Factors that affect the movement of bond prices include:

• The level of interest rates
• Credit rating of the issuer
• Other characteristics of the bond itself such as the term (in years), the yield (how much it pays), etc.

As mentioned previously, interest rates greatly affect the bond market.  When interest rates rise, the overall demand for loans decreases as it becomes more expensive to borrow.  Consequently, with low demand for loans, bond prices fall.  Higher interest rates usually mean that the economy is strong.  But the bond markets don’t like that.  The better the economy is doing, the more there is a downward pressure on bond prices.  Credit Rating simply indicates the level of trustworthiness and solvency of the bond-issuer to repay the loan.  In other words, we are looking at the credit quality of the borrower.  In the bond market there are three major agencies that rate the ability of borrowers to repay debt.  They are Moody’s, Standard & Poors, and Fitch in the United States and the Dominion Bond Rating Service in Canada.  These agencies assign credit ratings on borrowers based on their ability to repay debts over time.  Links to the websites of these agencies can be found under the Bond Ratings section of Chapter 4.

Other factors that affect the movement of bond prices are more specific to the type of bond in question.  For this, I will refer you to the following chapter.

So that is the bond market in a nutshell.  Although it may not seem like much, the bond market is actually bigger than the stock market.  The size of the worldwide bond market is estimated to be around 45 trillion U.S. dollars.  This can be partly attributable to all the baby boomers who hold bonds in their retirement portfolios.

3. The Foreign Exchange (Currency) Market

With the equivalent of 1 to 5 trillion U.S dollars in daily trading, the Foreign Exchange or Currency market is by far the biggest market in the world.  The foreign exchange market is sometimes referred to as Forex or FX. The foreign exchange market includes anyone who wishes to buy or sell currencies issued by any one country.  For example, if you wish to travel to Japan you will have to purchase Japanese yen using your own currency.  Once you have obtained Japanese notes or bills, you will be set to purchase goods and services upon your arrival in the land of the rising sun.  When you come back from your trip you may wish to sell your remaining yen in exchange for your original currency.  For a fee, your local bank will provide you with the means to exchange one currency for another.  Thus, anyone who owns money denominated in one currency and wishes to convert that money to a second currency is said to participate in the foreign exchange market.  Individuals who exchange for a foreign currency or traveler’s cheques only represent a tiny portion of all FX traders.  Many medium and large-size businesses purchase foreign currencies in order to pay their foreign suppliers.  This makes sense because suppliers usually like to be paid in their own currency.  Just think of all the global trade that is occurring between countries.  For nearly all international business transactions, currency exchange is essential as there is no single global currency (with the possible exception of gold).  Things would be much easier if we did have a common global currency as all parties would simply pay each other directly without the need for a third party such as a bank to perform the currency conversion and provide foreign notes while charging a fee to do so.  Most countries that are part of the European Union do, however, have a common currency – the euro.  Just think how much this has simplified things for individuals and businesses in these European countries.  There has been some discussion of adopting a common currency in North America but we are far from seeing such an arrangement.  Meanwhile, it’s business as usual.

Apart from large businesses, the key players in the Forex market include banks (mostly large international banks), central banks or treasury departments, investment banks or firms, hedge or money-market funds, and currency speculators.  Large banks can easily trade the equivalent of billions of dollars per day.  They buy and sell currencies for their customers (mostly businesses) as well as themselves.  Central banks and treasury departments buy and sell either their own currency or foreign currencies for reasons that relate mostly to monetary policy.  In short, they do so to attempt to control the money supply, inflation, and interest rates for economic reasons.  Central banks can influence the value of their own country’s currency (or even a foreign currency) by buying or selling very large chunks of it on the Forex market.  Investment banks or firms use the Forex market to stock up on foreign currencies that can be used to purchase investments such as foreign stocks and bonds for their clients.  Hedge or money-market fund companies buy foreign currencies to purchase foreign notes, bonds, and other money market instruments.  And finally, currency speculators simply buy and sell currencies as an investment in the hope that they correctly predict the movement of one currency against another.  If they guess correctly, they can make huge profits.  Conversely, if they guess wrong they can lose a lot of money.  Speculative currency trading is very risky.

Although many currencies can be traded, the bulk of trading in the Forex market involves only a few currencies.  Respectively, the U.S. dollar ($), the euro (€), the yen (¥), and the British pound (₤) are the most traded currencies.  Please note that although Britain is a country that is part of the European Union it has decided not to adopt the common currency (the euro); therefore it still uses the British Pound.  The U.S. dollar alone is involved in almost half of all daily transactions.  Not surprisingly, the main trading centers are located in London (England), New York (United States), and Tokyo (Japan).  But obviously, as mentioned previously, currency trading takes place between banks and other parties all over the world.

Many factors influence the value of a given currency.  For the most part, the following factors can make a particular currency either rise or fall:

• Changes in the GDP (or level of economic growth)
• Inflation
• Interest rates
• Budget deficits or surpluses
• Trade deficits or surpluses
• Price changes in certain commodities

I will not get into a detailed discussion as to how each of these factors affect the value of a currency because it would just take too long.  I will just give you a few examples so you can get an idea about how currency changes may arise.  An increase in the GDP for a given country usually indicates that its economy is expanding.  When this occurs, foreign investors see an opportunity to make good returns by investing in companies that are located in this country.  In order to purchase company stock they have to first purchase the local currency in order to pay for the shares.  This increases the demand for the local currency; and as demand rises so does its value.  In a similar fashion, a country that has a good trade surplus will often see the value of its currency appreciate.  The change in price or value of a commodity such as oil can also affect the value of a currency.  For example, when the price of oil increases sharply the Canadian dollar also rises while the value of the U.S. dollar declines.  This occurs because Canada is a net exporter of oil while the United States is a net importer of oil.  Moreover, Canada exports more oil to other countries (mostly to the United States) than it imports.  As Canadian oil companies like to be paid in Canadian dollars, demand for the loonie (Canadian dollar) rises and so does its value.  Since 2001, Canada has seen a rise in the value of its currency due to rising levels of GDP, balanced budgets, trade surpluses, low inflation, and high oil prices.  A sharper rise in value of the Canadian dollar can be seen from 2003 onward when the price of oil began to increase significantly.  Meanwhile, the large trade and budget deficits of recent years along with high oil prices have caused a slump in the greenback (U.S. dollar).  The table below shows how much the Canadian dollar has appreciated against the U.S. dollar during the period from December 31st, 2002 to September 30th , 2007.

Table 10 – Appreciation of the Canadian dollar against the U.S. dollar between 2002-2007

One very important thing to understand about currencies and currency trading is that not all currencies are fairly or correctly valued.  The reality is that some currencies are grossly overvalued while others are undervalued.  It is important to know this from an investment perspective since you may invest in foreign securities that will be paid for with a foreign currency.  Furthermore, while you are holding a foreign investment the value of the foreign currency with which you bought it may move against the dollar.  And this may have a direct impact on the value of your investment once you sell it regardless of how well it performed.  Fortunately, there is a way to gauge the extent to which currencies are fairly valued.  We use the notion of Purchasing Power Parity (PPP) to do just that.  PPP states that two currencies are fairly valued when their purchasing power is equal.  For example, suppose you buy a particular TV set in Canada for C$1000 and the exchange rate with the U.S. dollar is 0.90 (i.e., one Canadian dollar buys 0.90 U.S dollar).  The same TV set should cost US$900 (i.e.,: $1000 x 0.90 = $900) in the United States.  But the fact of the matter is that, in most cases, prices will be different for a number of reasons.  The main reason is the strength of a given currency relative to another.  An overvalued currency will have (relatively) more purchasing power, while an undervalued currency will have less purchasing power.  Eventually though, market forces dictate that currencies will become in equilibrium with each other due to the natural market forces of supply and demand.  But how can you tell just how much a given currency is over or undervalued?  A simple yet surprisingly accurate way to do so is to look at prices for a well-known product that is sold throughout the world, namely the McDonald’s Big Mac:

4. The Commodities Market

Commodities markets are markets in which raw materials, primary products, and certain financial products are traded.  Hot commodities that are traded on a daily basis include oil, gold, coffee, and currencies.  Hundreds of commodities are available for trading on the commodities market.  They are usually categorized in the following groups:

• Grains, cereals, & oilseeds (e.g., corn, soybeans, wheat)
• Cattle/livestock (e.g., live cattle, hogs, pork bellies)
• Energy (e.g., natural gas, crude oil, propane)
• Metals (e.g., gold, silver, copper, aluminum)
• Soft commodities (e.g., sugar, coffee, cocoa, orange juice)
• Currencies (e.g., U.S. dollar, Canadian dollar, Japanese yen, British pound)
• Financial & index futures (e.g., ten-year Gov’t Bonds, S&P 500 index, NASDAQ composite index)

Commodities are traded on regulated Commodities Exchanges such as the Chicago Board of Trade or the New York Mercantile Exchange in the United States and the Winnipeg Commodity Exchange in Canada. Most of these exchanges have been consolidated into the CME group and the IntercontinentalExchange (ICE).

On these exchanges, commodities are bought and sold in standardized contracts.  There are several types of contracts that exist.  One of the most common types of contract is a futures contract.  With a futures contract, one party promises to buy or sell a pre-determined amount of a given commodity at a pre-determined price sometime in the future.  The main advantage of these types of contracts is that governments, businesses, or even wealthy individuals for that matter, can buy commodities now for later delivery and payment.  In a sense, they are locking-in a price that is close (or slightly higher/lower) to today’s price.  For example, Southwest Airlinesoften purchases Oil Futures where they lock in a given price for oil that is near today’s price.  The bet is that oil prices will rise in the future.  If it does, then the airline company will be able to get the oil at a discount (i.e., cheaper).  In the year 2005 the airline was getting its oil at a price of $26 per barrel because it had bought a futures contract several years earlier.  The risk, however, is that if the price of oil declines then they will have to pay a premium (i.e., pay more) for the commodity.  Just think of how much this strategy can save the airline in the long run.  That is why many businesses bet, or hedge, against price movements of commodities buy purchasing futures contracts. 

Market Cycles

“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” – Warren Buffet, famous American investor

Market Cycles have existed for as long as stocks have been traded.  There is money to be made in all cycles be they rising or declining.  All economies, markets, companies, sectors, industries, and investment types go through ups and downs, commonly known as cycles.  No one investment is immune to cycles.  This means that in the long run all investments will experience periods in which they will do well (rise) as well as periods in which they do poorly (decline).  As an investor, it is important for you to learn about cycles so that you can not only protect your current investments but also capitalize on additional investment opportunities that may arise. 

1. Forces

Cyclical patterns occur in all asset classes, namely in the stock market, the bond market, the commodities market, and in the money market.  Sometimes certain asset classes move in opposite directions.  For instance, when the stock market is moving up, the bond market usually declines or stays flat.  And the reverse may also be true.  Many factors influence each asset class.  A strong economy, low unemployment, low interest rates, rising corporate profits, and tax cuts are all factors that have a positive influence on the stock market.  Similarly, strong FDI inflows and large trade surpluses may also positively influence the stock market.  Conversely, high inflation, high unemployment, large trade deficits, tax increases, or a recession will negatively impact the stock market.  The larger bond market does well when the economy is lagging, stock markets are falling, and interest rates are declining.  The bond market slips when the economy is booming, the stock market is rising, and interest rates are rising.  Since bond and stock markets move in opposite directions, many financial experts say it is wise to have portions of both asset classes in one’s investment portfolio because when stocks do poorly, bonds will do better and vice-versa.  Even though this may seem like a sound investment principle, it really depends on the individual quality of each of your investments.  In the long run, however, investing in the stock market may actually be more prudent.  In the next two chapters I will provide you with additional insight on the subject matter so you can decide what asset mix is best for you.

It is also worth noting that other factors can cause upturns or downturns in the markets.  For example, natural disasters, political unrest, wars, and terrorism can all negatively impact the stock market. 

2. Cyclical & Non-Cyclical Industries

Some specific sectors or industries are also known to move in cycles.  For example, the real estate industry usually does quite well during periods of low interest rates and economic prosperity.  Such periods can easily last from a few to several years.  But as soon as interest rates rise to a significant level and the economy begins to slow down, demand for loan mortgages declines sharply.  This affects not only the willingness of people to buy homes but also the construction industry as well, since fewer new homes will be erected.  It usually takes a few years before interest rates come down again.  And once they do, these industries get a shot in the arm and the cycle moves back up.  The travel and tourism industries are also known to be cyclical.  In periods of strong economic health and low unemployment, many airlines, tour operators, and hotel chains perform particularly well, as travelers and tourists have more disposable income to spend.  But in periods of high inflation, high unemployment, and weak economic conditions, these industries usually suffer tremendously.  The moral of the story here is that you do not want to have a significant portion of your investment portfolio tied up in companies that are riding a downward cyclical trend.  Knowing when to sell out may be good, as you can profit from other companies that are riding an upward trend.  Of course it is difficult to predict just when a particular sector, industry, or even individual companies will change directions.  And for this very reason it is good to hold a portion of Non-Cyclical stocks in your investment portfolio.  Non-cyclical stocks include stock of companies that are in sectors or industries that are largely unaffected by market declines, and even during periods of recession.  Think about it: even during a recession people still need to buy food, prescription drugs, and pay their gas or electricity bill.  Hence, holding a portion of your investment portfolio in non-cyclical stocks, sometimes referred to as Defensive Stocks, may enable you to weather more difficult periods.

3. The Bulls and The Bears

“Bulls make money. Bears make money. Pigs get slaughtered.” – Anonymous

In the investment world we often hear about bear markets and bull markets.  A bull market occurs in a steady period when stock prices are on the rise and when there is a lot of money that is being invested in stocks.  A bear market sees low levels of money being invested in the stock market, as stock prices and values are on the decline.  Think about it for a second.  A bull is aggressive; it likes to move out and about.  A bear is more relaxed, moves slowly, and also likes to hibernate for long periods of time.  The stock market is a constant battle between the bulls and the bears.  There are winners and there are losers.  Only the strongest companies survive.  And the same can be said about investors.  During a bull market, everyone is happy, as prices and profits are good.  The problem is, however, that the majority of investors enter a bull market late and are also late to leave a bear market.  Predicting a downturn or bear market can be difficult, but certainly not impossible.  Without being too technical, whenever stocks are overvalued or over-priced, it means that investors are paying more than they should.  Often, they are willing to pay more because of enthusiasm generated by several factors such as a hot economy, strong company sales projections, “buy” recommendations or strong ratings from stockbrokers, analysts, and newscasters.  In Chapter 6 – Anatomy of a Stock I will provide you with some basics about stock valuation so you can determine yourself if a stock is overvalued or over-priced.  Once again, it is not easy to determine just when a downward trend will occur.  Making matters worse, stock markets can “crash” at any moment.  A stock market crash is a sudden drop in stock prices of 20% or more over the course of a day or two.  There have been significant crashes on different stock markets of the world.  The United States experienced two major crashes in the last century.  The most famous one started on October 24th, 1929 and is known as Black Thursday.  In just two days the Dow Jones Industrial Average plunged 50%.  The stock market crash was followed by the Great Depression.  And it took the markets almost twenty-five years to fully recover.  The other crash of significance occurred on October 19th, 1987 and is known as Black Monday.  On that day, the Dow lost 22% of its value.  Although it is nearly impossible to predict when a crash will occur, it is important for you to know how you and your investments will be affected by one.  That is why portfolio diversification is so important.  In Chapter 4 – General Investing Guidelines and Tips I will provide you with more insight on how you can make solid investment decisions that will enable you to better protect your cash in rough times. 

As I mentioned in this section’s opener, there is money to be made in all market cycles – even in a bear market.  Both bull and bear markets are secular.  That means that stock markets still go through (smaller) ups and downs during these periods.  Knowing which stocks to own during a bear market is a necessary skill for the investor.  Next time a bear market occurs, be sure to take some time to observe which stocks from which industries are doing well.  Believe it or not, the absolute best time to buy stocks is during a bear market.  During this period, even stocks from high quality companies can be purchased at a bargain for they are usually under-priced or undervalued.  The best and most experienced investors always buy stocks during these periods.  And they also sell them during bull markets.  Overall, there are more bull markets than there are bear markets.  And bull markets usually last longer.  Mathematically speaking, you will come out on top three out of every four years.  That is why it is good to stay vested in the overall market for the long term.  The trick is knowing what to invest in and when.

4. Corrections and Bubbles

A couple of other phenomena occur in stock markets.  A 10% or smaller drop in the major market indices such as the Dow, the S&P 500, or the S&P TSX Composite usually signifies a market correction.  A correction occurs, well, to “correct” overvalued or over-priced stocks.  The sell-off brings stock prices back to levels that more accurately represent companies’ true worth.  A bubble occurs when optimistic investors bring stock prices way up.  As prices rise the bubble “inflates”.  And at some point it will “burst” just like when you make a bubble while chewing gum.  The burst represents a massive sell-off of stocks that can cause prices for some stocks to decline by as much as 50% or even more.  You have probably heard of the dot-com bust of the late 1990s or the year 2000.  In just a couple of years the NASDAQ stock market increased in value by nearly 75% with the introduction of many exciting Internet (dot-com) and technology companies.  The problem was that there was a lot of hype and speculation that these companies would grow into spectacular successes like eBay or Amazon.com.  Investors weren’t really looking at company fundamentals, earnings, and growth.  Instead, they were thinking about ways to get rich quick!  It is really important that you know what kind of company you are investing in.  As with life, there are very few legitimate get-rich-quick schemes.  The best road to profits is through investor education.  So keep reading.

© Dan Fournier, 2007-2010