Stock Market Trading Strategy

Why Stock Trading?

Traditionally, the stock market investor has looked to the market for income, capital gains, or both. The income feature on common stocks is met through dividend payments, which are usually paid quarterly on a per-share basis from the profits of a corporation, or, in some cases, from assets. Common stock dividends are not fixed in amount. The payment is set by the boards of directors, usually each quarter, based on profits and overall dividend policy. It is not uncommon for a company that is suffering a temporary setback with reduced or even no profits to continue paying a dividend out of its retained earnings (past profits).

This policy is designed to retain interest in the stock among its shareholders. If a company with a long record of dividends suddenly omits a dividend payment, it is often regarded as a good reason to sell the stock. This, of course, causes a lack of demand for the stock which is the last thing the directors want. So they usually will pay up, even in unprofitable years. A record of continued and increasing dividend payments over a long period of time is one of the key factors in evaluating a common stock for Investment, because it usually indicates a healthy company.

Holders of preferred stock generally receive dividends at a higher rate (as a percentage of the stock price) than common shareholders. Dividends on preferred shares must be paid before dividends on common shares. Preferred stockholders are also given preferential access to the firm's assets in the event of liquidation. Preferred dividends are fixed in amount, meaning the yield varies as the market price changes. As a result, these stocks trade similarly to debt securities and their prices are impacted more by changes in interest rates than by company profits.

Certain companies, called growth stock companies, have sales and profits that have risen consistently over the previous years and have good prospects for future growth. They will generally have low dividend yields because they use the retained earnings from profits to keep financing their continued growth.

Capital gains
Capital gains result from the increase in the price of an asset such as common stock. For example, if you buy 100 shares at $20 per share and over five years the price moves up to $40 per share, should you choose to sell, the difference would be a capital gain.

In previous years capital gains were taxed at a lower rate than ordinary income. But since tax reform, gains and ordinary income carry equal tax status. There remains an advantage, however, in that capital gains aren't taxed until you receive them. If you don't sell your stock, the $20-per-share gain you have built up won't be taxed until you sell.

Total return
A good case can still be made for common stocks as a long-term investment. This is based on the philosophy of total return — a combination of income and capital appreciation. Consider the logic of the following:

Suppose that a common stock trades at an average yield of about 6 percent — in other words, the return on investment is about 6 percent. To yield 6 percent and pay a dividend of $1 a share, the stock should be trading for about $16.67 a share. A few years later, when it is paying $1.46 a share, the 6 percent yield translates to a stock price of about $24.33. The dividend has thus gone up 46 percent and the stock price has gone up 46 percent.

Say you bought 1,000 shares at $16.67 a few years ago. You started off receiving $1,000 a year in dividends. Now, several years later, the dividend payout is $1,460. The return on your original investment is now almost 9 percent!

Obviously, stock prices don't fluctuate as neatly as in the above example. Many other factors, such as general market conditions, company news and developments (especially earnings reports — quarterly reports of profits, compared with the previous year's figures), interest rates and so on, affect stock prices.

It all boils down to good old supply and demand. If the stock is in demand, its price will rise, since only so much stock is available. If the stock is in supply — watch out! Its value will drop as people try to sell at any price to get their money out. The point is, however, that there are many good-quality stocks with long records of steadily increasing earnings and dividends.

Though inflation and interest rates fell substantially in the mid-1980s, both have been well above historic levels for the past decade and fears persist that they will rise again. Because of this, other types of market securities have begun to compete directly for money that would normally be invested in the stock market.

Traditionally, debt securities — such as U.S. Treasury bills and bonds, corporate bonds, municipal bonds and certificates of deposit — have been used in conservatively managed investment portfolios with Income as the primary objective. High-quality debt securities have offered a low degree of risk and a moderate rate of return, generally lower than rates of return achieved in the stock market.

Debt securities, however, respond to changes in the interest rates. Consequently, during periods of high interest rates, if an investor can achieve a rate of return of around 15 percent on a low-risk security, he may not wish to risk funds in a very uncertain stock market.

More speculative investors have also sought refuge from inflation in the com­modities market. As a result, gold, silver and grain markets witnessed spectacular price fluctuations in recent years. These allocations away from stocks intensified the market decline in early 1984, just as lower inflation and falling interest rates helped it recover in late 1984 and reach record highs in 1985, 1986 and 1987.

So why invest at all?

You may wonder why you should consider an investment in the stock market at a time when economic conditions are so uncertain and other securities may offer an apparently higher return on money invested. The answer lies partially in your investment goals and whether or not your temperament can tolerate the alternatives — trading commodities, for example, requires both constant attention and the undertaking of high risk.

The stock market represents a cross section of business in the most technologically advanced countries in the world. Obviously, the potential of American business is not going to disappear because of temporary dislocations in the economy. While economic growth appears to be slowing in the developed countries and many of the growth industries of the recent past are maturing, this is not to say that no room is left for technological innovation. New industries will arise and old industries will grow from recent depressed levels of profitability. Some patience may be required, but the potential for above-average return will undoubtedly always remain in the stock market and stock trading.

The Center for Research in Security Prices at the Graduate School of Business at the University of Chicago has performed comprehensive studies on stock market prices since 1926. Among the many conclusions drawn from these data, one of the best known is the fact that if investors were to choose any stock at random with sales and purchases at random dates over a period from 1926 to 1960, they would have made a profit 78 percent of the time. The median return on this investment, assuming reinvestment of any and all dividends paid on the stock selected, would have been 9.8 percent compounded annually. These are rather spectacular findings, considering the inclusion of the Great Depression and a major world war in the pertinent time period.