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Five Misunderstood Stock Market Terms

Wed, Sep 17 2008, 13:50 GMT

Money and Markets

There's a lot of confusion out there in the markets right now. But I want you to know that my stance hasn't changed one bit — I continue to think dividend superstar stocks are a great way for income investors to lock-in attractive yields right now, and potentially reap even bigger gains down the line.

I also continue to like inverse exchange-traded funds as a way to hedge your dividend positions. They can offset losses from market downdrafts and allow you to continue collecting your dividend checks along the way.

For example, I recommended the DXD double-inverse ETF to my Dividend Superstars subscribers in early August, and that position has been doing exactly what it was designed to do in times like this — rise in value as the market declines.

Now, with all the latest action, I'm sure you've been seeing all kinds of market commentary in your local newspapers and on mainstream TV programs.

So today I'd like to tell you about five stock market terms that are often cited, but rarely explained properly, even by investment experts and the financial press ...

Misunderstood Market Term #1: "Beta"

Beta is a measure of a stock's volatility relative to the broad market. Analysts assume the market (an index) has a beta of 1 and cash has a beta of 0. So, if a particular stock's beta is above 1, the shares are likely to experience swings that are greater than those of the market. Conversely, a stock with a beta under 1 should swing less than its comparable index.

Let me give you an example ...

• If XYZ stock has a beta of 0.5, it should move half as much as the S&P 500. In other words, if the S&P 500 loses 10%, XYZ should fall 5%.
• Ditto for up moves — if the market rises 10%, the stock will gain 5%.
• Meanwhile, under the same market conditions, a stock with a beta of 4 would be expected to go up or down 40%!

For this reason, many investors equate beta with "risk."

The danger of doing so is that beta is simply a reflection of a stock's past moves. It doesn't factor in any recent changes in the company's business model ... shifts in market conditions ... or how long a stock has even been around. As you so often hear, "past performance is no guarantee of future results."

Still, betas are a useful "at a glance" number, particularly for stocks with long histories.

Misunderstood Term #2: "Market Breadth"

Market breadth is a measure of how many companies in a particular index or market have gone up vs. how many have gone down. The majority rule, and breadth is then said to be either positive or negative.

For example, the S&P 500 contains 500 constituents. If 300 of those stocks closed in negative territory on a given day, that market had bad breadth. Conversely, if 400 of the stocks went up, market breadth would be considered very positive.

This measure is viewed as a window into investor sentiment. That's because it's a quick way of knowing just how widespread buying or selling was. It's especially useful when you're looking at a market-weighted index.

Reason: By design, they attribute higher importance to larger stocks. Thus, losses in larger shares can weigh the entire "market" down, even if the majority of stocks rose!

Misunderstood Term #3: "Limit Order"

There are many different ways to place a stock order, and the suggested approach depends on the particular security you're going to purchase along with what the market is doing.

Placing a market order is the same thing as telling your broker "Buy me these shares no matter what the cost, and do it as soon as possible." Market orders have the distinct advantage of getting your order filled quickly. They also tend to be the cheapest type of order you can place since your broker is not being asked to do very much on your behalf.

The downside of market orders is that you have no way of knowing exactly what price you're going to pay. This is generally not a problem when a stock trades millions of shares a day and when its price is expected to remain relatively stable. However, it can be a dangerous method when a stock is thinly traded or moving very rapidly.

Limit orders, on the other hand, give your broker very clear instructions — to buy the specified number of shares at a predetermined price ... or better. The "better" means that the broker can buy the stock at a price that is lower than your specified price or sell it at a price that is higher. Limit orders can be a great way to keep everyone involved in the process honest.

When it comes to larger dividend-paying stocks, you should generally be fine using market orders. However, I often tell my Dividend Superstars subscribers to use limit orders to make sure they get the very best entry prices, especially on more volatile shares.

One other thing I'd like to note on placing limit orders with your broker. You will usually have the option to specify a "day order" or a "good till cancelled" (GTC) order. As the name implies, a day order will expire at the end of that trading day if it is not filled. A GTC order will remain open until either A. it is filled or B. you inform your broker that you no longer wish to place that trade.

Misunderstood Term #4: "Same-Store Sales"

We often hear retailers citing same-store sales. And the entire stock market can move when a bellwether like Wal-Mart releases this monthly number.

Here's the important thing to understand about same-store sales: They measure results from stores that have been open for a year or more.

The idea here is that you want to know how much more product a company is selling from its existing locations, not from new stores that it might have recently added.

Reason: Sales growth from new stores is good, but it also requires a lot of money to be spent — for construction, labor, rent, etc.

Rising sales at the same location show rising demand for a company's goods or services. (And they're generally much better for the bottom line.)

Misunderstood Term #5: Fiscal Year

If only every company would just use a regular old calendar, comparing numbers would be so much easier!

Unfortunately, many companies opt to use their own business calendars — or fiscal years — to report their results. In fact, roughly one quarter of U.S. companies choose to end their years on a month other than December.

Some have good reason to do so. For example, retailers often end their calendars in January. That allows them to record all their holiday sales into their current fiscal year. While it technically doesn't matter what year they record the sales, I suppose they like to go out with a bang.

A lot of technology companies also have wacky fiscal years. In many cases, this is simply related to the date of their initial public offering or because their competitors also use the same fiscal year.

The only reason I suggest paying attention to a company's fiscal year is so you'll know when to expect quarterly earnings releases as well as dividend payment announcements. The two tend to go hand-in-hand!

Published on  Wed, Sep 17 2008, 13:55 GMT