Tag: Educational

Understanding Stock Options: A Comprehensive Guide for Investors

Posted on by phoffman@channelchek.com

Stock Options Trading Explained

Stock options, sometimes referred to as derivatives, are a tool for managing risk when combined with a related equity holding, or as a means to amplify return on moves made by a stock or index. There are also related income strategies investors should know about. Newer investors often learn they could have benefited from options after it’s too late. Below we talk about stock options, what they are and how they are used to fill some investor knowledge gaps they may not even be aware they have. This discussion includes understanding what options are, why they are used, the different types of options available, and how you can use them to hedge against the market moving in the wrong direction. You’ll also discover how options can be used to amplify portfolio results.

What are Options?

Options are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price and date(s). The underlying asset can be anything from stocks, bonds, commodities, or even currencies, for the purpose of this article, we focus on stocks and stock indices.  

There are two types of stock options: call options and put options. A call option gives the buyer the right, but not the obligation, to buy the underlying stock at a specified price and date. A put option gives the buyer the right, but not the obligation, to sell the underlying stock at a specified price and date.

When an investor buys an option, they are said to be “long” the option. When they sell an option, they are said to be “short” the option. Being long a call option is similar to being long the stock, as the investor profits if the stock rises. Being long a put option is similar to being short the stock, as the investor profits if the stock price falls.

Why Are Options Used?

Options are used for various reasons, such as speculation, hedging, and income generation. Speculators implement strategies to bet on the direction of the options underlying stock. For example, an investor that expects a stock price may rise will buy a call option. It they believe it will fall, they could get short exposure by going long a put option.

Options can also serve investors to hedge (protect) their holdings and offset potential losses in the underlying position. For example, if an investor owns XYZ Stock, they can buy a put option to protect against a potential drop in XYZ Stock. If the stock price falls, the put option will increase in value; depending on the shares controlled by the option, it can offset the decline in the stock.

Income generation using stock options is growing in usage. The scenario where this works is when an investor sells a call option against a stock they own, as part of the sale, they collect a premium for the option. If the stock price remains below the strike price of the call option, the investor keeps the premium and the stock. If the stock price rises above the strike price, the investor must sell the stock at the strike price, but still keeps the premium. This works best in a flat or declining market.

Using Options as a Hedge Against Losses

Options can be used as a hedge against the market moving against a stock position. For example, if an investor owns 100 shares of ABC Stock, currently trading at $50 per share. And the investor is concerned that the stock price may fall, but does not want to sell the stock and miss out on potential gains if the stock price rises, or in some cases, create a tax situation.

To hedge against a potential drop in ABC’s stock price, the investor may decide to buy a put option with a strike price of $45, expiring in three months, for a premium (cost) of $2 per share. If the stock price falls below $45, the put option will increase in value, offsetting the losses in the stock. If the stock price remains above $45, the put option will expire worthless, and the investor keeps the stock and the premium.

Time Decay, Intrinsic Value, and Extrinsic Value

So far, the use of options described here have been fairly straightforward. But there are considerations that might help keep this portfolio tool in the toolbox until it is most needed. The considerations are time decay, intrinsic value, and extrinsic value. Here is what is important to understand about these realities.  

Time Decay:

Time decay, also known as theta, refers to the decrease in the value of an option as it approaches its expiration date. Options have a limited lifespan, and as time passes, the likelihood of the option ending up in the money decreases. Therefore, the time value of an option decreases as it approaches its expiration date, resulting in a decrease in the option premium.

Intrinsic Value:

Intrinsic value is the amount by which an option is in the money. In other words, it is the difference between the current market price of the stock and the strike price of the option. For example, if a call option has a strike price of $50 and the underlying stock is currently trading at $60, the intrinsic value of the option is $10 ($60 – $50).

Intrinsic value only applies to in-the-money options, as options that are out-of-the-money or at-the-money have no intrinsic value. The intrinsic value of an option is important because it represents the profit that an option holder would realize if they exercised the option immediately.

Extrinsic Value:

Extrinsic value, also known as time value, is the portion of an option’s premium that is not attributed to its intrinsic value. Extrinsic value is the amount that investors are willing to pay for the time left until expiration and the possibility of the underlying asset moving in their favor.

Extrinsic value is affected by several factors, including the time left until expiration, and the volatility of the underlying stock. As the expiration date approaches, the extrinsic value of an option decreases, and the option premium decreases as well.

Options Premium:

The options premium is the price that the buyer pays to purchase an option. The options premium is determined by various factors, including the current market price of the underlying asset, the strike price, the expiration date, and the level of volatility in the stocks price.

The options premium is made up of intrinsic value and extrinsic value. The intrinsic value represents the portion of the premium that is directly attributable to the difference between the current market price of the underlying asset and the strike price of the option. The extrinsic value represents the portion of the premium that is not attributable to the intrinsic value and is based on the time left until expiration, the level of volatility in the market, and other factors.

Understanding time decay, intrinsic value, and extrinsic value is crucial when it comes to trading stock options. Time decay affects the value of an option as it approaches its expiration date, while intrinsic value and extrinsic value make up the options premium. By understanding these concepts, investors can better understand their costs and make more enlightened decisions.

Take Away

Stock investors transact in stock options for various reasons. These include portfolio protection, income generation for an existing portfolio, and speculating on the direction of an asset. There are considerations associated with holding options beyond any commission or bid/offer spread. These are intrinsic premium costs for in-the-money trades, extrinsic as they relate to value and decay on the position as it approaches its expiration date.

Adding risk management using options to your investment tools to call upon when appropriate can reduce stress; speculating with the help of derivatives can be very rewarding but may have the impact of increasing portfolio swings in value along the way.

Paul Hoffman

Managing Editor, Channelchek

Fairness Opinions, Understanding a Transaction’s Full Value

Posted on by phoffman@channelchek.com
Image Credit: Jernej Furman (Flickr)

Why Companies Get a Fairness Opinion Before Entering a Financial Transaction

How important is a fairness opinion (FO) when a company is evaluating a merger, acquisition, spin-off, buyback, carve-out, or other corporate change of ownership? Part of the due diligence of a large financial transaction is to engage for a fee, an experienced expert to create a fairness opinion that, among other things, advises on the valuation of the proposed transaction. And possibly recommends adjusting some terms to align the transaction with what the expert sees as fair. 

Understanding Fairness Opinions

When companies are considering impactful transactions, they may be required to get an objective opinion on whether the terms of the deal are fair. If it isn’t required, it is still a good idea to help reduce risks inherent in large transactions.

A fairness opinion is a professional assessment of the fairness of a proposed transaction. An independent third-party advisor, such as an investment bank, usually provides it. The goal of a fairness opinion is to provide an impartial evaluation of whether the transaction is fair to all parties involved based on various financial and strategic factors. The analysis involves evaluations of the impact of synergies, overall asset value, current market worth, dilutive effects, structure, and other attributes that a non-experienced executive may easily overlook.

Who Provides Fairness Opinions

Investment banks are the most common providers of fairness opinions. Choosing an institution that has extensive industry-specific experience and knowledge in valuing a transaction or strategic opportunity could save the client many times the cost of the service.

For example, Noble Capital Markets, an investment banking firm with 39 years of experience serving clients in a variety of industries, provides as one of its opinion services, FOs to companies considering a transaction. Francisco Penafiel, Managing Director and part of Noble’s investment banking & valuation practice, explained why getting an opinion from a reputable investment bank can avoid expensive problems.  Mr. Penafiel said, “FO’s should be provided by independent third parties, but it’s highly recommended for companies to have the assistance of advisors with a sound reputation, credibility, and significant industry experience.”

Why should the advisor have an intimate understanding of the industry? Penafiel explained, “it’s also important for the advisors to have knowledge of the regulatory compliance factors that affect the process as well as to be fully independent to avoid any conflict of interests.” He believes most often, investment banking firms, with platforms that include many years of experience, are best suited to run analysis that is deep and thorough, and are necessary when rendering these opinions

“Noble has helped clients over the years with their valuations needs, we’re now witnessing an increased demand for FOs because of the benefits they bring to the companies involved in a transaction. It also goes a long way to demonstrate that management and boards fulfilled their fiduciary duties, reducing risks of litigation,” said Penafiel.

The SEC has shown that they approve of and, in some cases, could require an FO. Recent regulations applying to de-SPAC transactions make fairness opinions the standard as de-SPAC transactions have an inherent conflict of interest between a SPAC’s sponsor and the stockholders. The third-party FO provider allows for impartiality and transparency to benefit all parties, especially investors.

Steps in Creating an FO

To provide a fairness opinion, an investment bank will typically conduct a thorough analysis of the deal’s financial and strategic aspects. This analysis may involve evaluating the company’s financial statements, projecting future earnings, analyzing the transaction structure, and reviewing comparable transactions in the industry. The investment bank will also consider the prevailing market conditions, economic climate and the impact on interest rates and the effects of any regulatory or legal issues on the transaction.

After completing its analysis, the investment bank will issue a formal report summarizing its findings and conclusions. The report will typically contain a detailed explanation of the fairness opinion, including the methodology used, the assumptions made, and the supporting evidence. It will also provide a valuation of the company, which may be used as a reference point for negotiating the deal’s terms.

It’s worth noting that a fairness opinion is not a guarantee that the proposed transaction is fair. Rather, it’s a professional opinion based on the information available at the time of the analysis. The ultimate decision about whether to proceed with the transaction lies with the parties involved, who must consider various factors beyond the scope of the fairness opinion.

Take Away

 Obtaining a fairness opinion is a critical step for companies considering major transactions. It provides an objective evaluation of the transaction’s fairness, which can help the parties involved make informed decisions. Investment banks are well-positioned to provide fairness opinions, given their extensive experience and expertise in financial analysis and valuation. By engaging an investment bank to provide a fairness opinion, companies can gain a valuable perspective on the proposed transaction, which can help them negotiate more effectively and ultimately achieve a better outcome.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://noblecapitalmarkets.com/opinion-practice

https://core.ac.uk/download/pdf/160249385.pdf

https://www.investopedia.com/terms/f/fairness-opinion.asp

http://edgar.secdatabase.com/1680/121390023011399/fs42023ex23-4_heritage.htm

US Treasury Bonds: A Safe Haven Investment in Times of Economic Uncertainty

Posted on by phoffman@channelchek.com
Image Credit: US Dept. of Treasury

Are Treasuries the Safe Bet Investors Think They Are?

Are US Treasury bonds worth owning? US Treasury debt is considered one of the safest investments in the world. The securities are issued by the US government and are backed by the full faith and credit of the US Treasury – guaranteed at the same level as the dollar bills in your wallet. These bonds are a popular investment choice for individuals, institutions, and governments in times of economic uncertainty. But, as with other investments, they are market priced by the combined wisdom of the marketplace. So the return, or what is sometimes referred to as “the risk-free rate,” may not measure up to the potential that stock market investors expect.

Why Allocate to Treasuries

US Treasury bonds are considered a safe haven investment because they are perceived to have a low risk of default. This is because the US government has never defaulted on its debt, and it has the ability to raise taxes and print money to meet its obligations. In addition, the US dollar remains the world’s reserve currency, this makes US Treasury bonds highly liquid and easily tradable.

Image: Fmr. Fed Chairman Greenspan, Meet the Press interview, August 2011

During periods of low economic clarity, investors that are not required to invest in low-risk investments will weigh US Treasury returns against expected returns in other markets. As interest rates approach or exceed expected inflation US Treasuries become more attractive to investors, both individual and institutional. This is because they provide a reliable source of income (semiannual interest payments) at times of market volatility, and at maturity, owners know exactly what they will receive (face value plus the last interest payment). For example, during the global financial crisis of 2008-2009, investors flocked to the safety of US Treasury bills, notes, and bonds as a safe haven. This drove down yields and pushed up bond prices.

There are three main Treasury Securities, TIPS are not included below, they are T-Notes and have unique risks, so, therefore, deserve a separate presentation.

Treasury Bills:

Maturity: Typically less than one year (usually 4, 8, 13, 26, or 52 weeks)

Yield: Discounted yield, historically lower than T-notes and T-bonds

Size: Available in denominations of $1,000 or more

Treasury Notes:

Maturity: 2 to 10 years

Yield: Par plus interest historically higher than T-bills and lower than T-bonds

Size: Avaialable in denominations of $1,000 or more

Treasury Bonds:

Maturity: 10 to 30 years

Yield: Normally higher than T-bills and T-notes

Size: Avaialable in denominations of $1,000 or more

Overall, the main difference between these securities is their maturity. T-bills have the shortest maturity and are discounted at purchase to provide the yield, while T-bonds have the longest. T-notes fall in between. Additionally, their yields are calculated on an actual number of days held over the actual number of days in the year. The US Treasury yield curve, above which other bonds are priced, depends on market conditions and economic expectations.  

Can Not Avoid Risk

Despite their reputation for safety, US Treasury bonds are not without risk. In December of 2021, the 10 year US Treasury note had a market yield of 1.70%. Just ten months later the same bond sold at a yield of 4.21%. This represents an actual loss over the ten month period for those selling the bond then. For those holding until maturity, when they will receive full face value, investors would have to hold more than eight years during which they will be earning a measly 1.7%. This is interest rate risk, the time period used to explain was a recent extreme example of how Treasuries still have very real risk. This is why a good bank investment portfolio manager will do stress tests and scenario analysis of the banks portfolio using extreme conditions.

Another risk is credit rating. In 2011, for example, the credit rating agency Standard & Poor’s downgraded the US government’s credit from AAA to AA+. This was the first time and continues to be the only time the US government has been downgraded. The downgrade was based on concerns about the government’s ability to address its long-term fiscal challenges, including high levels of debt and political gridlock.

Similar conditions may be playing out now as the debt ceiling has been raised quite a bit since 2009, and large buyers such as China are seeking alternative investments for their reserve balances.

Inflation is another risk that is quite real. As in the earlier example of the USTN 10-year yielding 1.7% in December 2021, during the following year, CPI rose 6.5%. this is another recent example of how investing in a low-rate environments can erode the purchasing power of the interest income and principal payments from US Treasury bonds. If the rate of inflation exceeds the yield on the bonds, investors can actually experience a negative real return.

If the government is seen as possibly not being able to pay interest on maturing securities, as is the case during debt ceiling standoffs, US Treasuries coming due may experience illiquidity problems as bids for maturing debt that may not get paid on time will be weak.

Although US Treasury bonds are highly liquid and easily tradable, there may be periods when the market for the bonds becomes illiquid. This can make it difficult for investors to sell their bonds at a fair price, especially during times of market stress or uncertainty.

How to Invest in Treasuries

Investors can buy US Treasury bonds directly from the US government (treasurydirect.gov) or through a broker. The bonds are issued and market priced at auctions on a regular schedule. Individual investors typically will bid to own securities at the average auction price. Savvy institutions and individuals may contact their broker and bid at the auction and hope to win an allotment.

Investors can also invest in US Treasury bonds through mutual funds or exchange-traded funds (ETFs). These funds don’t offer the benefit of holding to maturity or some of the tax planning strategies that can benefit those holding a security and not a fund.

Take Away

US Treasury bonds are considered a safe haven investment in times of economic uncertainty. They are backed by the full faith and credit of the US government and are considered one of the safest investments in the world. While they are not without risk, they remain a popular choice for investors seeking a reliable source of income and capital preservation. The US government’s credit rating was downgraded once, but investors continue to have confidence in US Treasury bonds due to the idea that they may not be safe, but they are likely the safest place to store savings.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.realclearpolitics.com/video/2011/08/07/greenspan_us_can_pay_any_debt_it_has_because_we_can_always_print_money.html

https://www.bls.gov/opub/ted/2023/consumer-price-index-2022-in-review.htm

US Debt Ceiling Explained

Posted on by phoffman@channelchek.com
Source: The White House

What Happens if the US Hits the Debt Ceiling?

The US debt limit is the total amount of money the United States government is authorized to borrow to meet its existing obligations. These include interest on debt, Social Security, military costs, government payroll, utilities, tax refunds, and all costs associated with running the country.

The debt limit is not designed to authorize new spending commitments. Its purpose is to provide adequate financing for existing obligations that Congress, through the years, has approved. While taxes provide revenue to the US Treasury Department, taxation has not been adequate since the mid-1990s to satisfy US spending. This borrowing cap, the so-called debt ceiling, is the maximum congressional representatives have deemed prudent each year, and has always been raised to avert lost faith in the US and its currency.

Failing to increase the debt limit would have catastrophic economic consequences. It would cause the government to default on its legal obligations – which has never happened before. Default would bring about another financial crisis and threaten the financial well-being of American citizens. Since a default would be much more costly than Congress meeting to approve a bump up in the borrowing limit, which the President could then sign, it is likely that any stand-offf will be resolved on time.

Congress has always acted when called upon to raise the debt limit. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt.

How Does this Apply Today?

According to the Congressional Budget Office, tax receipts through April have been less than the CBO anticipated in February. The Budget Office now estimates that there is a significantly elevated risk that the US Treasury will run out of funds in early June 2023. The US Treasury Secretary has even warned that after June 1, the US will have trouble meeting its obligations. The implications could include a credit rating downgrade in US debt which could translate to higher interest rates. If US Treasury obligations, the so-called “risk free” investments, does not pay bondholders on time (interest), then the entire underpinning of an economy that relies on the faith in its economic system, could quickly unravel.

What Took Us Here?

On January 19, 2023, the statutory limit on the amount of debt that the Department of the Treasury could issue was reached. At that time, the Treasury announced a “debt issuance suspension period” during which, under the law, can take “extraordinary measures” to borrow additional funds without breaching the debt ceiling.

The Treasury Dept. and the CBO projected that the measures would likely be exhausted between July and September 2023. They warned that the projections were uncertain, especially since tax receipts in April were a wildcard.

It’s now known that receipts from income tax payments processed in April were less than anticipated. Making matters more difficult, the Internal Revenue Service (IRS) is quickly processing tax return payments.

If the debt limit is not raised or suspended before the extraordinary measures are exhausted, the government will ultimately be unable to pay its obligations fully. As a result, the government will have to delay making payments for some activities, default on its debt obligations, or both.

What Now?

The House of Representatives passed a package to raise the debt ceiling by $1.5 trillion in late April. The bill, includes spending cuts, additional work requirements in safety net programs, and other measures that are unpopular with Democrats. To pass, the Senate, which has a Democratic majority, would have to pass it. Democratic Senator Chuck Schumer described the chances as “dead on arrival.”

House Speaker McCarthy has accepted an invitation from President Biden to meet on May 9 to discuss debt ceiling limits. The position the White House is maintaining is that it will not negotiate over the debt ceiling. The President’s party is looking for a much higher debt ceiling that allows for greater borrowing powers.

In the past, debt ceiling negotiations have often gone into the night on the last day and have suddenly been resolved in the nick of time. Treasury Secretary Yellen made mention of this and warned that past debt limit impasses have shown that waiting until the last minute can cause serious harm, including damage to business and consumer confidence as well as increased short-term borrowing costs for taxpayers. She added that it also makes the US vulnerable in terms of national security.

Expect volatility in all markets as open discussions and likely disappointments will heat up beginning at the May 9th meeting between McCarthy and Biden.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://fiscaldata.treasury.gov/americas-finance-guide/

https://www.cbo.gov/taxonomy/term/2/latest

https://www.cbo.gov/publication/58906

Are You an Accredited Investor? Here’s What You Need to Know

Posted on by phoffman@channelchek.com

Demystifying What it Means to be an Accredited Investor

Have you looked into determing if you qualify as an accredited investor? Individuals and entities that are deemed “accredited” may be permitted to participate in certain types of investment offerings that would not otherwise be available to those that don’t meet the criteria. It allows access to a broader range of offerings, many of which are considered to allow for greater potential returns in exchange for higher potential downside.

What is an Accredited Investor?

An accredited investor includes those that meet certain financial criteria set by the Securities and Exchange Commission (SEC) in order to participate in certain types of private securities offerings. Accredited investors are deemed to have the financial sophistication and ability to bear the risks associated with these investments.

The SEC defines an accredited investor as someone who has a net worth of at least $1 million (excluding the value of their primary residence) or who has earned at least $200,000 in annual income ($300,000 for married couples) for the last two years and has a reasonable expectation of earning the same income in the current year. Entities such as trusts, partnerships, corporations, and certain types of retirement accounts can also be accredited investors if they meet certain financial criteria.

Why Learn if You’re Accredited

So why is it worth knowing if you qualify as an accredited investor? For one, it opens up a wider range of investment opportunities to allocate your capital to. This can include private securities offerings, private equity funds, venture capital funds, and direct investment in hedge funds. These types of investments are considered riskier than publicly offered registered securities but may offer higher potential returns.

Another benefit of being an accredited investor is that it allows you to invest in crowdfunding opportunities that are only available to accredited investors. Crowdfunding is the practice of funding a project or venture by raising small amounts of money from a large number of people, typically via the internet. While crowdfunding is open to anyone, there are certain types of crowdfunding that are only available to accredited investors. These offerings, called Regulation D (Reg D) offerings, allow companies to raise capital without having to register with the SEC.

Reg D offerings can take several forms, including Rule 506(b) and Rule 506(c) offerings. Rule 506(b) offerings allow up to 35 non-accredited investors to participate in the offering, while Rule 506(c) offerings are only available to accredited investors. Companies raising capital through a Rule 506(c) offering are required to verify the accredited investor status of participants through documentation such as tax returns or financial statements.

Important to Think About

It seems obvious, but worth noting that just because you are an accredited investor does not necessarily mean that investment opportunities that become available to you will work out well. It’s crucial to do your due diligence and thoroughly research any investment opportunity before committing funds. While those that meet the definition of accredited and may have attained a higher degree of financial sophistication increase their opportunities, investing always involves a varying degree of risk.

Is it worth becoming an accredited investor to open the door to exploring private securities offerings? While this decision ultimately depends on your individual financial goals and circumstances, it’s worth considering the potential downsides of becoming an accredited investor solely for this reason.

For one, becoming an accredited investor often requires a significant amount of wealth, which may not be feasible for everyone. Additionally, investing in private securities offerings often requires a higher degree of financial sophistication and access to professional investment advice. It’s important to consider whether or not you have the resources to properly evaluate investment opportunities and make informed decisions.

Furthermore, private securities offerings are often less liquid or illiquid, meaning that it can be challenging to sell your investment if you need to access your funds quickly. This lack of liquidity can be a significant disadvantage for investors who may need to access their funds in the short term.

Take Away

Being an accredited investor allows individuals and entities to participate in certain types of private securities offerings that are typically not available to non-accredited investors. This can provide access to higher potential returns but also comes with a higher degree of risk. It’s important to thoroughly research any investment opportunity before committing your funds and to consider the potential downsides of becoming an accredited investor solely for the purpose of investing in private securities offerings.

Did you Know?

From time to time, Noble Capital Markets, Inc. may post Investment opportunities (“Offerings”) on its site that may only be purchased by accredited investors, as defined by Rule 501 of Regulation D under the Securities Act of 1933 (“Regulation D”). To learn more about your qualifications and potentially these offerings, click here to explore further.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.sec.gov/education/capitalraising/building-blocks/accredited-investor

https://www.finra.org/rules-guidance/guidance/faqs/private-placement-frequently-asked-questions-faq

https://www.channelchek.com/terms/accredited-investors

Hedge Funds 101: What They Are and How They Work in Investing

Posted on by phoffman@channelchek.com

Developing a Deeper Understanding of Hedge Fund Investments

Hedge funds have become a buzzword in the world of investing, it’s one of those investment instruments that people think they can explain until they’re asked to – not everyone understands what they are or how they work. In simple terms, a hedge fund is a private investment vehicle that is managed by a professional investment manager or team. The primary goal of the fund is to generate above market returns for its investors by using various investment strategies that are often more complex and riskier than traditional investment vehicles like managed mutual funds or index funds. The following should help fill many of the gaps in investors understanding of these funds, including their legal structure, investment strategies, and how they differ from other types of investment vehicles.

Structure of a Hedge Fund

Hedge funds are formed as limited partnerships. This makes investors in the fund limited partners. The investment manager is the general partner of the fund and is responsible for making investment decisions on behalf of the limited partners. The general partner is also responsible for raising capital for the fund, safekeeping, and negotiating fees with investors.

Hedge funds are typically only available to accredited investors, which requires that they meet SEC wealth, income, or financial sophistication thresholds. This is because hedge funds are considered to be high-risk investments and are not subject to the same regulations as other types of investment vehicles. Accredited investors are assumed to have the financial sophistication and resources to handle the risks associated with hedge fund investments.

Investment Strategies

Hedge funds use a wide variety of investment strategies to generate returns for their investors. These strategies can range from relatively simple, such as long/short equity, to highly complex, such as quantitative trading or event-driven investing. Some of the most common investment strategies used by hedge funds include:

Long/Short Equity – This strategy involves buying stocks that are expected to increase in value (long) and shorting stocks that are expected to decrease in value (short).

Event-Driven – This strategy involves investing in stocks that are likely to be impacted by specific events, such as mergers, acquisitions, or bankruptcies.

Quantitative Trading – This strategy involves using mathematical models to identify trading opportunities based on patterns in historical data.

Distressed Investing – This strategy involves investing in companies that are in financial distress or undergoing restructuring.

Global Macro – This strategy involves investing in currencies, commodities, and other assets based on macroeconomic trends.

Valuing a Stock

One of the key skills required to be a successful hedge fund manager is the ability to value a stock or other opportunity. This involves analyzing a company’s financial statements, industry trends, and other relevant factors to determine the intrinsic value of the company’s worth. If the stock is undervalued, the hedge fund may decide to invest in it in the hopes that its value will increase over time. Conversely, if the stock is overvalued, the hedge fund may decide to create a short position in it in the hopes that its value will decrease.

Compared to Other Investment Vehicles

Hedge funds differ from other types of investment vehicles in several ways. First, hedge funds are not subject to the same regulations as other types of investment vehicles, which means that they have more flexibility to use complex investment strategies and take on higher levels of risk. Second, as mentioned above, hedge funds are typically only available to accredited investors, whereas more traditional types of investments like mutual funds or index funds are available to the general public.  Finally, hedge funds typically charge higher fees than other types of investment vehicles, which can include both management fees and performance fees.

Take Away

Hedge funds are complex investment vehicles that can use a variety of riskier methods in an attempt to generate high returns for their investors by using a wide variety of investment strategies. These strategies can range from relatively simple to highly complex and are often more risky than other types of investments. Hedge funds are structured as limited partnerships and are typically only available to accredited investors. They differ from other types of investment vehicles in their lack of regulatory oversight, and known to charge higher fees.

Paul Hoffman

Managing Editor, Channelchek

Sources:

https://www.sec.gov/education/capitalraising/building-blocks/accredited-investor

Bed Bath and Beyond, Why Companies Delist, and Investor Impact  

Posted on by phoffman@channelchek.com

Do Investors Take a Bath When Stocks Delist?

One popular meme stock, Bed Bath & Beyond (BBBY) is being delisted from the Nasdaq exchange, according to a company announcement. There are a number of reasons a public company can delist from an exchange. In BBBY’s case it is related to their recent bankruptcy filing, according to management. Below are examples of the many reasons a company would delist, what happened in BBBY’s case, and what delisting means for investors.

Many Reasons to Delist

Delisting from the stock exchange refers to the removal of a company’s shares from public trading on a particular exchange. It occurs by management choice or at the exchange’s request. The process can happen for various reasons, such as regulatory violations, bankruptcy, or a company’s decision to go private. Delisting can have significant consequences for the corporation and its investors, including decreased liquidity and visibility in the market.

A common reason for delisting is regulatory violations. For example, if a company fails to comply with the reporting requirements of the Securities and Exchange Commission (SEC), it may face delisting from the stock exchange. This was the case with Chinese tech giant Alibaba, which was delisted from the Hong Kong Stock Exchange in 2020 because of regulatory violations.

Sometimes, companies have a reason to take themselves private and delist as part of that process. Going private means that a corporation’s shares are no longer traded on public stock exchanges. In 2013, computer maker Dell was taken private in a deal worth $24.9 billion. The company’s delisted its shares from the NASDAQ exchange. Twitter was recently purchased and taken private.

As is the case with Bed Bath and Beyond, bankruptcy often causes shares not to meet the exchange’s criteria, forcing a delisting. Another retailing example is Toys R Us in 2018. It filed for bankruptcy and was subsequently delisted from the New York Stock Exchange (NYSE).

Delisting can have significant implications for a company and its shareholders. One of the main consequences is a decrease in liquidity. When a company is delisted, its shares are no longer traded on public stock exchanges, which means that investors may have a harder time finding buyers or sellers for their shares.

Additionally, delisting can impact a company’s visibility in the market. Without a public listing, a company may find it more difficult to attract investors and raise capital. This can be particularly challenging for small and mid-sized companies that rely on the stock market to raise funds.

Bed Bath and Beyond’s Delisting

Trading in BBBY common stock will cease at the opening of the trading day on May 3 – according to a filing with the Securities and Exchange Commission (SEC).

In its bankruptcy announcement, the company said trading of shares would halt on the Nasdaq exchange. Nasdaq and the NYSE have standards companies need to meet for their stocks to be listed and stay listed. This includes minimum levels of liquidity, market value, or price level.

Back in January, Nasdaq warned the company its shares would be delisted after it failed to report quarterly results in a timely manner. The company eventually filed the report and returned to compliance. This time Bed Bath and Beyond said it doesn’t intend to appeal.

Shareholders will still own the stock and fractional shares of the company after May 3. However, without the help of a major exchange, trading between stockholders and speculators is usually much more difficult. Some bankrupt companies’ stocks continues to trade in over-the-counter markets (OTC). They typically have the letter “Q” at the end of their stock symbol. It isn’t yet clear if BBBY will trade as BBBYQ.

After a company files for Chapter 11, unsecured creditors—including suppliers and leaseholders—line up in an attempt to get repaid. How much creditors get paid back depends on how much money Bed Bath and Beyond can raise from the sale of either parts of its business or the chain itself.

Take Away

Delisting from major stock exchanges can happen for various reasons and can have significant consequences for investors. While regulatory violations and bankruptcy can lead to forced delisting, companies may choose to delist voluntarily to go private or for other strategic reasons. Regardless of the reason, delisting can impact a company’s liquidity and visibility in the market, making it important for investors to carefully consider the implications before investing in delisted companies or those facing delisting.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.sec.gov/edgar/browse/?CIK=0000886158

https://www.investopedia.com/ask/answers/10/stock-holder-lose-equity-chapter-11.asp

https://bedbathandbeyond.gcs-web.com/news-releases/news-release-details/bed-bath-beyond-inc-receives-nasdaq-delisting-notice

https://bedbathandbeyond.gcs-web.com/news-releases/news-release-details/bed-bath-beyond-inc-files-voluntary-chapter-11-petitions

If Bad Expectations are Fully Priced Into Stocks, Which Ones Could Outperform This Year 

Posted on by phoffman@channelchek.com
Image Credit:Maarten Takens (Flickr)

Highly Regarded Analyst Tells Investors How to Position for the Upturn   

Are recession worries fully baked into stock prices? At least one Wall Street analyst has publicly made her case this may be accurate. And she offers tips on what sectors may have more upside and on those that have factors working against them. While a recession still may occur before year-end, forward-looking stock investors may have fully priced that risk in – forward-looking investors may also be the reason the overall market is up on the year despite greater expectations of a recession. They are looking past any slowdown.

Stock market participants, many still down on last year’s price moves, have been extremely cautious in front of a Fed that is playing catch up in a fight against inflation. The rapid Fed Funds rate increases that began in March 2022, coupled with quantitative tightening, sank stocks, bonds, and even cryptocurrency holdings. While the economy did shrink for two consecutive quarters last year, there are many that expect a mild recession will begin at some point this year.

Those that do expect a bumpy economic ride and a rough landing point to high-interest rates, a weakening dollar, tech industry layoffs, and a Federal Reserve that is resolved to get inflation down as soon as possible.

Savita Subramanian, equity and quant strategist at Bank of America Securities, proposed to investors in a research note published on April 24, that these fears and recession worries have been in place for a while and may be largely baked into the market. She says, barring a sudden shock to the economy, it makes sense for investors to reintroduce riskier assets into their portfolios.

Her guidance on finding value is well thought out. Subramanian, proposes investors own stocks over bonds and cyclical stocks over defensive names. The reason given is that hedge funds and long-only funds are near maximum exposure in defensive industries such as health care, utilities, and consumer staples. The suggestion here is that the probabilities would lean toward a better risk-reward payoff for cyclical names.

Ms. Subramanian does not say an economic slowdown won’t occur; instead, her thinking seems to be that after raising the Federal Funds rate from near-zero to a range of 4.75% to 5%, there is more control should a downturn need to be dealt with by easing. When rates are at or near zero percent, there is less the Fed can do to stimulate growth. So far, we’ve made it through the first quarter, and now April with only a few disruptions in the banking sector.

“Even if a recession is imminent, the Fed has latitude to soften the impact after pushing rates up by 5%. And after the fastest hiking cycle ever, the only thing to ‘break’ so far is SVB,” Subramanian wrote.

In an article published in Barron’s this week the investment news publication wrote, “Some corners of Wall Street are feeling confident that there will be no recession and that the very things that make a recession appear likely–the inverted yield curve, inflation, and the recent banking crisis–actually guarantee that one won’t happen.”

This could be good news for investors that have been nervous about having money in a market that has been given much to be concerned about, and ver little to be jubilant about.

On Thursday, GDP (Gross Domestic Product) for the first quarter will be released. No one expects this to indicate a recession began then. Forecasters expect that the economy will show 2% growth, following growth of 3.2% and 2.6% in the third and fourth quarters of 2022. This is one of the cases where if the number surprises much higher, the market may expect the Fed to make bigger rate moves. If it surprises on the low side, markets may see it as a sign of an approaching recession.

Take Away

A highly regarded analyst joins others with thoughts that the market could be priced for a recession; this could be good for stocks. If true, investors may want to start looking past a recession. Those she is most positive on are riskier names. While funds and other investors are near maxed out in lower-risk holdings, there is far less upside for them. The bigger upswings can occur in the industries, market-cap sectors, and companies that have been given less attention due to recession fears.

Paul Hoffman

Managing Editor, Channelchek

Blockchain Decentralized Organizations are Quietly Growing Behind the Scenes

Posted on by phoffman@channelchek.com
Image Credit: BYBIT (Flickr)

The Evolution of Blockchain Includes the Less Heralded DAO

Less talked about creations that can only exist with blockchain technology are Decentralized Autonomous Organizations (DAO).  This is an organization that operates autonomously on a blockchain network, using smart contracts to execute its functions. While a famous Ether hack gave DAO’s a figurative black-eye a few years back, the defi organizations exists and new purposes, and with that new challenges as well.

What is a DAO?

A Decentralized Autonomous Organization (DAO) is a type of organization that is run by smart contracts on a blockchain network rather than a centralized authority. In a DAO, the rules and regulations are encoded in computer code, which is executed automatically by the blockchain network. This means that decisions are made through a decentralized voting process rather than being controlled by a central authority.

DAOs are not controlled by any single entity or individual but rather by a distributed network of users. The DAO will self-execute on rules and directives encoded in the blockchain. All of these decisions and transactions made within a DAO are recorded on a public blockchain, this is designed to make them transparent and auditable.

DAOs can be used for a wide range of applications, including governance, finance, and decentralized applications (DApps). They offer a way for communities to come together and govern themselves in a decentralized and transparent way, without the need for a centralized authority.

The Purpose of a DAO

The purpose of a DAO is to provide a trusted method of organizing and managing a group of people, without the need for a centralized authority. DAOs are designed to be self-governing, transparent, and autonomous. They enable members to collaborate on a common goal, make decisions through a democratic process, and manage resources in a decentralized way. DAOs are often used for fundraising, investing, and community-driven projects.

Examples of DAOs

One of the most well-known examples of a DAO is The DAO, which was launched in 2016. The DAO was a decentralized investment fund that raised $150 million in Ether (the cryptocurrency of the Ethereum network). Unfortunately, The DAO was hacked shortly after its launch, leading to the loss of millions of dollars. This event highlighted the potential risks associated with DAOs and the need for proper security measures.

A more successful example of a DAO is MakerDAO, which is a decentralized lending platform that uses a stablecoin called DAI. MakerDAO enables users to borrow and lend cryptocurrency without the need for a centralized authority. It operates autonomously through a set of smart contracts that are stored on the Ethereum blockchain network.

Who Uses DAOs?

DAOs are typically used by communities, organizations, and individuals such as Decentralized Finance (DeFi). The Defi projects use DAOs to govern the platform and make decisions about its future path and development.

Some gaming communities have used DAOs to manage in-game assets and govern the community. Social media outlets have chosen decentralization and implement a DAO  social media platforms use govern the platform and make decisions about content moderation and platform development.

Are DAOs Legal and Safe?

Regarding the safety and legality of DAOs, they can be safe and legal if designed and implemented correctly. However, like any technology, there are risks associated with DAOs, including the potential for hacking and exploitation of smart contracts.

The legality of DAOs depends on the jurisdiction and the specific nature of the DAO. In some countries, there may be regulatory frameworks that apply to DAOs, while in others they may not be explicitly recognized. In general, the local law applies to the DAO. Those that engage in illegal activities or violate securities laws can be subject to legal action. Regulations specifically applicable to this new technological format are subject to revision.

Take Away

Blockchain technology has grown and evolved since the creation of the first DAO, simply called, The DAO, in 2016. The development of new blockchain platforms and smart contract languages has made it easier to create and operate DAOs, and there are now many different types of DAOs being developed for various use cases. The security of blockchain technology has also improved and expanded adoption and adaptation to different groups will rely on the trust of the technology to shield itself from outside harm.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://blockworks.co/news/reevaluating-crypto-journalism-funding

https://www.investopedia.com/tech/what-dao/

https://www.bloomberg.com/news/articles/2020-09-16/a-trip-down-the-crypto-rabbit-hole-in-search-of-the-dao-hacker#xj4y7vzkg

Record Decline in Money Supply, What this Means for the Economy

Posted on by phoffman@channelchek.com
Image Credit: FrankieLeon (Flickr)

Money Supply Numbers Show the Fed is Making Headway

Money Supply, as reported by the Federal Reserve, fell by the largest amount ever recorded. This significant year-on-year drop shows the Fed’s tight monetary policy at work. However, despite the dramatic decline of cash available to consumers, the pace of increase that led up to the twelve-month period was even more dramatic. This indicates the Fed is not even close to finished draining liquidity from the economy, which serves to push up the cost of money (interest rates).

What is M2, how does it impact spending, and how much lower can the money supply go to reach “normal”? Let’s explore.

The M2 Report

Data for January, released on February 28th, showed a negative growth rate of 1.7% versus a year ago. This is both the biggest yearly decline and also the first time ever it has contracted in consecutive months. The monthly rate of change has been falling consistently since mid-2021. As indicated on the chart below, it follows a historic peak of 27% growth in February 2021.

Money Supply is a measure of household liquidity, it includes household cash on hand, savings and checking deposits, and money market mutual funds. The level had been growing slowly, keeping pace with low inflation until 2020. In response to pandemic-related economic risks, the economy was then flooded with cash by the Fed. Like any other oversupply, this oversupply causes money’s value to decline – a recipe for inflation.

Source: St. Louis Federal Reserve

The Fed’s Actions

For almost a year, the Fed has been draining liquidity from the US economy. This includes the well-publicized retargeting of overnight bank lending rates which are accomplished by contracting the aggregate amount of cash banks hold in reserves. Draining liquidity also includes quantitative tightening by the Fed, not repurchasing maturing securities.

The Fed’s tightening is having an impact on savings and cash available to households. Although the consumer is still spending, the decline in savings makes the spending pace unsustainable. Unrelated to M2, but as important, is that consumer borrowing is up, and this, too, can not stay on an upward trajectory forever. The Fed’s actions have a lag time, but it is becoming obvious that there will come a point when consumers will need to change their spending habits downward. This is how inflation is expected to be reeled in, but it isn’t certain whether it is being reeled in at a pace where the Fed can succeed at reaching the 2% inflation rate goal – particularly in light of the last inflation number actually being higher than the previous month.

Where We Are Now

Although M2 growth rates declined at a pace shattering all records, levels are still abnormally high. To put numbers on it, Money Supply remains 39% higher than it was before the Covid-19 pandemic, just three years ago. In other words, the amount of liquidity in the economy is still significant, and too much money chasing too few goods and services lead to rising prices.

The current M2 of $21.27 trillion is nearly $6 trillion higher than the pre-pandemic level. At this point, money in the economy has surpassed real gross domestic product levels, a momentous shift that first happened in 2020 when the Fed flooded the economy with cash as the pandemic hit.

All of this indicates the Fed is actually being patient despite the dramatic tightening over the past year. It also makes it clear that they are not done mopping up the Covid-19 monetary mess. And investors shouldn’t be surprised to see their resolve continue until balances are more in-line with moderate inflation rates.

Take Away

The still elevated M2, despite its record yearly decline, is feeding inflation. The Fed is making headway removing fuel to the inflation fire.

However, consumers that historically have continued to spend at near unchanged levels, even when their disposable income no longer supports it, do eventually adjust. When this adjustment occurs, economic activity will slow. That’s when the Fed will be on the path to winning its inflation fight. Then perhaps we may actually get a pivot in monetary policy.

Paul Hoffman

Managing Editor, Channelchek

Stock Buybacks in 2023 are $175 Billion Strong and Part of the Stock Market Surge

Posted on by phoffman@channelchek.com
Image Credit: Anders Kristensen (Pexels)

Company Stock Repurchases Have Reached Record Levels

Stock buybacks often boom when borrowing costs are down. However, interest rates are currently as high as they have been in a while, yet buybacks are still surging. The rampant pace also flies in the face of new corporate taxes on the practice.  US companies grabbing their own shares is one part of why the market has started the year very strong. The S&P 500 was up for a third week in a row to end January and kick off February. The pace shows no sign of slowing and may even pick up as earnings season and the related blackout periods are lifted. What’s involved in stock buybacks, and what has been the impact now, so early in 2023.

How is a Stock Buyback Executed?

Last week Meta Platforms (META) followed a few logistics companies, oil businesses, and even aerospace contractors by announcing an increase in management’s authorization to purchase its own shares. There are simple but important rules Meta and the others will have to abide by to conduct these purchases. The rules are to provide orderly markets, they fall under the Securities and Exchange Commission’s “Safe Harbor” for Issuer Repurchase, SEC 10b-18 protections.

The head trader at Noble Capital Markets, David Lean is a veteran equity trader whose desk has been involved in many stock repurchases. He explained the critical areas a broker has to follow. They are, Manner of Purchase, Timing, Price, and Volume.

“The company must purchase shares through a single broker or dealer during a single day,” Mr. Lean said, explaining that one day a company may choose a broker like Noble and provide instructions and criteria, it then is the only broker allowed to trade on behalf of the buyback plans that day. Another day a different single broker or dealer may be selected for the trading day.

As far as timing, the SEC has laid out the following guidelines: A company with an average trading volume less than $1 million per day or a public float value below $150 million is unable to trade within the last 30 minutes of trading. Companies with higher average-trading-volume and public float value can trade up until the last 10 minutes.

David Lean explained the trading price restrictions on behalf of the company, “The company must repurchase at a price that does not exceed the highest independent bid or the last transaction price quoted.” While a stock repurchase does put upward pressure on share prices, the act of repurchasing shares should not be allowed to bid up the price directly.

The rules on volume also help prevent the repurchase from being overly disruptive. “The company cannot purchase more than 25% of the average daily volume as measured over the previous four weeks,” according to Lean. He was also was quick to point out that there is an exclusion whereby “The company may make one ‘block’ purchase per week and not be subject to the 25% volume limitation, provided the ‘block’ purchase is the only Rule 10b-18 purchase made on that day.”

The SEC provides these “Safe Harbor” rules as a guide for all parties involved to understand the boundaries of acceptance in the eyes of the SEC.  

Source: Birinyi Associates

Buybacks 2023

During the first month of 2023, announced corporate buybacks more than tripled to $132 billion from a year ago. Then, February kicked off with META immediately adding another $40 billion to the annual tally. According to data compiled by Birinyi Associates, January broke, by 15%, the previous record for a January set in 2021.

There has been no slowdown. According to Bloomberg, Morgan Stanley’s desk that executes buybacks saw orders increase 5%. This feeds into the market strength that thus far has characterized 2023, along increased buying interest from retail accounts, and quant funds.

This increase in stock buybacks in 2023 coes at the same tome a new tax levy on repurchases comes into play by the Inflation Reduction Act of 2022. According to the IRS the new code imposes a 1% excise tax on the aggregate fair market value of stock repurchased by certain corporations during the taxable year. The 1% levy is not deductible. The new tax indicates that the government doesn’t encourage companies repurchasing their own stock. In fact in the case of Chevron (CVX), they had been criticized by the White House for using their cash in this way rather than to try to increase output.

Take Away

Each company has its own reason to repurchase its own stock. However, in each case it could represent confidence in the future. There are rules put in place by the SEC that help provide orderly trading in the names, but the announcements themselves tend to create upward spikes in the names.

A new tax on the practice that came into effect on January 1 is going to cost the companies buying their shares 1%. This has not prevented the record levels of stock buybacks in January.

Paul Hoffman

Managing Editor, Channelchek

Sources:

https://www.rttnews.com/corpinfo/stockbuybacks.aspx

https://finance.yahoo.com/news/7-big-stock-buybacks-meta-065244274.html

https://www.sec.gov/divisions/marketreg/r10b18faq0504.htm

https://www.irs.gov/newsroom/treasury-irs-issue-guidance-on-corporate-stock-repurchase-excise-tax-in-advance-of-forthcoming-regulations#:~:text=The%20new%20code%20section%20added,taxable%20year%2C%20subject%20to%20adjustments.

A Debt for Equity Swap Plan Drove 700% Gains in These Shares

Posted on by phoffman@channelchek.com
Image Credit: Eden, Janine, and Jim (Flickr)

Corporate Debt for Equity Swap Announcements Can Have an Immediate Impact on Share Price

AMC Theatres (AMC, APE) announced plans to hold a meeting in mid-March on capital restructuring. One of the expected outcomes is a plan to swap equity for some outstanding debt. APE shares jumped after the announcement. Another company this week, Motorsports Games (MSGM), shares skyrocketed triple-digits after its announcement to shore up company finances with a debt-for-equity swap. What is a debt/equity swap, and does it always lead to strengthening share prices?

Debt for Equity Swap Basics

Two methods by which companies finance their operations, growth, or other investment is by issuing stock (equity), or borrowing (debt). Both have advantages and disadvantages. One reason a company may swap equity for debt is to restructure and reduce borrowings with a creditor. Perhaps cash flow is tight and restrictive, yet the entity is still viable. Cutting interest costs frees capital and may even help the lender avoid problems receiving timely payments.

The company may also use the method to strengthen its balance sheet by altering the proportion of debt to equity.

Motorsports Games Swap

In the case of Motorsports Games (MSGM), the company had fallen out of compliance with the rules required to maintain a listing on the Nasdaq exchange. MSGMs change in corporate financing allowed it to move back into full compliance with Nasdaq, while repaying $1 million in debt with 338,983 shares of stock. The move has the added benefit of increasing liquidity and reducing interest expense.

According to a research note by Mike Kupinski, Director of Research at Noble Capital Markets, “Following the swap, the parent company increased its ownership from 700,000 shares to 1,038,983 shares, representing 62.1% of the votes outstanding.” Kupinski said, “The move significantly improves the company’s liquidity and reduces its interest expense. Notably, the move adds confidence that Motorsport Network has confidence in Motorsport Games.”

Read the full research note here.

Source: Koyfin

AMC Theatres Plans

The CEO of AMC, Adam Aron, has proven to be very creative with financing. The company managed to cash in on a windfall after its share price soared during periods when shorts in the company had been severely squeezed by retail traders. This has left the company with enviable options. The company is planning a capital restructuring, including swapping equity for its debt. Details of this won’t be released until next month after AMC Theatres holds a special meeting on March 14 to discuss the deal.

If past history is any indication, there will be a lot of chatter and trading activity in AMC and APE before and after the meeting.

Take Away

The primary reason for a company to contemplate a debt-to-equity swap is to adjust its financing to improve financial conditions. In some cases, the company finds itself being hurt by the cost of servicing its debt, this offers relief. Avoiding any negative news surrounding missing a payment or even bankruptcy is often an underlying reason.

But there can be as many reasons as there are corporate situations. Motorsports Games seem to have hit a home run for their shareholders and their holding company as its share price is now trading over 700% above where it had been before the announced plans.

The massive increase in share price of MSGM is unusual, gains this large are situation dependent. Maintaining a position on a major exchange certainly fed into the rally in its shares.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.wsj.com/livecoverage/stock-market-news-today-01-30-2023/card/amc-stock-ape-units-converge-yJr98TziAirswGLkHge3

https://www.nasdaq.com/articles/consumer-sector-update-for-01-31-2023:-rent-msgm-spot-vsco

https://www.channelchek.com/research-reports/25575

https://investor.amctheatres.com/newsroom/news-details/2022/AMC-Entertainment-Holdings-Inc.-Announces-110-Million-Equity-Capital-Raise-a-100-Million-Debt

https://www.barchart.com/stocks/quotes/AMC/cash-flow/annual

Do Some Money Measurements Double Count?

Posted on by phoffman@channelchek.com
Image Credit: John (Flickr)

Can Correlations Help Define Money?

According to popular thinking, the government’s definition of money is of a flexible nature. Sometimes it could be M1, and at other times it could be M2 or some other M money supply. M1 includes currency and demand deposits. M2 includes all of M1, plus savings deposits, time deposits, and money market funds. By popular thinking what determines whether M1, M2, or some other M is considered money is whether it has high correlation with key economic data such as the gross domestic product (GDP).

However, since the early 1980s, correlations between various definitions of money and the GDP have broken down. The reason for this breakdown, many economists believe, is that financial deregulation has made the demand for money unstable. Consequently, the usefulness of money as a predictor of economic activity has significantly diminished.

Some economists believe that the relationship between money supply and the GDP could be strengthened by assigning weights to money supply components. The Divisia indicator, named after the French economist François Divisia, adjusts for differences in the degree to which various components of the monetary aggregate serve as money. This, in turn, supposedly offers a more accurate picture of what is happening to money supply.

The primary Divisia monetary indicator for the US is M4. It is a broad aggregate that includes negotiable money market securities, such as commercial paper, negotiable CDs, and T-bills. By assigning suitable weights, which are estimated by means of quantitative methods, it is held that one is likely to improve the correlation between the weighted monetary gauge and economic indicators.

Consequently, one could employ this monetary measure to ascertain the future course of key economic indicators. However, does it make sense?

Defining Money

No definition of money can be established by means of a correlation. A definition is supposed to present the essence of the subject being identified.

To establish the definition of money, we must determine how a money-using economy came about. Money emerged because barter could not support the market economy. A butcher who wanted to exchange his meat for fruit would have difficulty finding a fruit farmer who wanted his meat, while the fruit farmer who wanted to exchange his fruit for shoes might not have been able to find a shoemaker who wanted his fruit.

The distinguishing characteristic of money is that it is the general medium of exchange. It has evolved from the most marketable commodity. According to Murray Rothbard:

Just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. Eventually, one or two commodities are used as general media—in almost all exchanges—and these are called money.

With money, the butcher can exchange his meat for money and then exchange money for fruits. Likewise, the fruit farmer could exchange his fruit for money. With the obtained money, the fruit farmer can now exchange it for shoes. The reason why all these transactions become possible is because money is the most marketable commodity (i.e., the most accepted commodity).

According to Rothbard:

Money is not an abstract unit of account, divorceable from a concrete good; it is not a useless token only good for exchanging; it is not a “claim on society”; it is not a guarantee of a fixed price level. It is simply a commodity.

It follows then that all other goods and services are traded for money. This fundamental characteristic of money is contrasted with other goods. For instance, food supplies the necessary energy to human beings. Capital goods permit the expansion of the infrastructure that, in turn, permits the production of a larger quantity of goods and services. Contrary to the mainstream thinking, the essence of money has nothing to do with financial deregulation as this essence will remain intact in the most deregulated of markets.

Some commentators maintain that money’s main function is to fulfill the role of a means of savings. Others argue that its main role is to be a unit of account and a store of value. While all these roles are important, they are not fundamental. The basic role of money is to be a medium of exchange, with other functions such as unit of account, a store of value, and a means of savings arising from that role.

Through an ongoing selection process over thousands of years, individuals have settled on gold as money. In today’s monetary system, the money supply is no longer gold, but metal coins and paper notes issued by the government and the central bank. Consequently, coins and notes constitute money, known as cash, that is employed in transactions.

Distinction between Claim and Credit Transactions

At any point in time, an individual can keep money in a wallet or somewhere at home or deposit the money with a bank. In depositing money, an individual never relinquishes ownership over the money having an absolute claim over it.

This contrasts with a credit transaction, in which the lender of money relinquishes a claim over one’s money for the duration of the loan. As a result, in a credit transaction, money is transferred from a lender to a borrower. Credit transactions do not alter the amount of money. If Bob lends $1,000 to Joe, the money is transferred from Bob’s demand deposit or from Bob’s wallet to Joe’s possession.

Why Are Various Popular Definitions of Money Misleading?

Consider the money M2 definition, which includes money market securities, mutual funds, and other time deposits. However, investing in a mutual fund is, in fact, an investment in various money market instruments. The quantity of money is not altered because of this investment; only the ownership of money has temporarily changed. Hence, including mutual funds as part of money results in double counting.

The Divisia monetary gauge is of little help in establishing what money is. Because this indicator was designed to strengthen the correlation between monetary aggregates such as M4 and other Ms with an economic activity indicator, the Divisia gauge can better be seen as an exercise in curve fitting.

The Divisia of various Ms, such as the Divisia M4, does not address the double counting of money. The M4 is a broad aggregate and includes a mixture of claim and credit transactions (i.e., a double counting of money). This generates a misleading picture of what money is.

Applying various weights to the components of money cannot make the definition of money valid if it is created from erroneous components. Furthermore, even if the components were valid, one does not improve the money definition by assigning weights to components.

The introduction of electronic money has supposedly introduced another confusion regarding the definition of money. It is believed that electronic money is likely to make the cash redundant. We hold that electronic money is not new money, but rather a new way of employing existing monetary transactions. Regardless of these new ways of employing money, definitions and the role of money do not change.

Conclusion

The attempt to strengthen the correlation between various monetary aggregates and economic activity by using variable weighting of money supply components defeats the definition of money. The essence of money cannot be established by means of a statistical correlation, but rather by understanding what money is about.

About the Author

Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. He received his bachelor’s degree from Hebrew University, his master’s degree from Witwatersrand University, and his PhD from Rands Afrikaanse University.