Chapter 11: Analysis

Question 1

Fundamental analysis

Answer 1

Fundamental analysis focuses on company-specific financial analysis, but also takes a top-down approach that looks at the following:

-Macroeconomic factors, including fiscal and monetary policy;
-Business cycle and economic indicators (leading, lagging, and coincident);
-Industry fundamentals; and
-Specific company information (balance sheet and income statement).

Question 2

Keynesian Theory

Answer 2

He believed that the economy runs at an “equilibrium” level that is determined by income and spending, and aggregate demand. In other words, if people are out of work, they do not consume or spend money.

=Therefore, it is the government’s responsibility to stimulate the economy to “full employment” by increasing spending.

Question 3

Supply Side Economics

Answer 3

This doctrine says that as long as the government does not meddle with the economy, business will take care of itself. Stable interest rates, money supply, and low inflation achieved through monetary policy will enable business to drive the economy to full employment. Growth is promoted through tax cuts and deregulation.

Question 4

Monetary policy fundamentals

Answer 4

The primary focus of monetary policy is to promote price stability and full employment.

Monetary policy is controlled by the Federal Reserve Board (FRB) or “the Fed.” The main Federal Reserve Bank is in New York, and it controls a system of member banks in major cities across the U.S. The Federal Open Market Committee (FOMC) is the Federal Reserve System’s top monetary policy-making body.

Monetary policy refers to actions taken to influence the money supply and credit in the economy, which in turn affects interest rates. By raising or lowering short-term interest rates, it indirectly controls inflation and employment.

Question 5

Reserve requirement

Answer 5

The most powerful tool the FRB has is the reserve requirement. The reserve requirement is an overnight cash reserve that each Federal Reserve member bank must maintain each night. The FRB will raise this requirement to tighten the money supply, and lower it to increase the money supply. The reserve requirement is the most powerful tool which the FRB has, because it has a multiplier effect throughout the economy.

Each night, every member bank calculates its reserve requirement. If the member is short, it must borrow cash from another member bank or from the main Federal Reserve Bank in New York.

Question 6

Discount rate

Answer 6

the rate the main Federal Reserve Bank charges member banks for loans to meet their overnight loan requirement.

Question 7

FRB Open Market Committee

Answer 7

The FRB Open Market Committee (FOMC) buys or sells treasuries in the secondary market through primary government securities dealers to help stimulate or slow the economy. If the Fed is buying treasuries, they are putting money into the economy. This increases the money supply and stimulates the economy.

Conversely, if they are selling treasuries, they are pulling money out of the economy. This shrinks the money supply, which slows the economy.

Question 8

M1, M2, M3

Answer 8

M1 is a measure of the money supply. It equals cash and demand deposits such as checking accounts.

M2 is a broader measure. M2 equals M1plus savings accounts and some money markets funds.

M3 is broader than M2. M3 equals M2 plus institutional investors and money markets

The FOMC operation has the greatest effect on M1.

Question 9

Global interbank market

Answer 9

In the interbank market, foreign currencies are traded in large blocks. Generally, these are blocks of $1-5 million.

There is no systematic reporting system for last sale information.

Spot transactions are for periods of 1 or 2 days.

Forward transactions are for a time period longer than 2 days, generally, 1, 2, 6, 9, 12, or 18 months.

Question 10

If interest rates rise…

Answer 10

-Bond yields rise (consequently, prices fall).
-The U.S. dollar is strengthened as the FRB is attacking inflation.
-Imports rise because of the stronger dollar’s purchasing power.
-Exports decline because the stronger U.S. dollar means weaker foreign currencies.

Question 11

Disintermediation

Answer 11

Disintermediation is large-scale investor movement into long term debt instruments.

For example, suppose the yield curve is negative. Short-term interest rates are at 10% and long-term rates are 8%. A negative yield curve is a temporary condition believed to signal the start of a down market. In this temporary, uncertain scenario, investors start to favor the certainty of long-term yields over the uncertainty of short-term rates.

Consequently, investor money moves toward the long end of the curve (into long-term bonds). This further causes long-term yields to drop as greater demand drives long-term bond prices up.

Question 12

Inverted yield curve = Tight money policy

Answer 12

Rates RISE
Yields RISE
Imports RISE
US $ RISE
Stock/Bond Prices FALL
Exports/For $ FALL

Question 13

Normal yield curve = loose money policy

Answer 13

Rates FALL
Yields FALL
Imports FALL
US $ FALL
Stock/Bond Prices RISE
Exports/For $ RISE

Question 14

FRB sells securities…

Answer 14

When the FRB sells securities, it removes money from the money supply, which causes rates to rise. As rates start rising, yield curves turn from normal, positive, and upward sloping to inverted and negative. This means that short-term rates rise higher than long term debt yields. An inverted money supply draws investors from equities and bonds to money market. Soon, a recession provides the cure for inflation. The recession is followed by recovery, then prosperity, and expansion.

Question 15

Relationship between interest rates I

Answer 15

The discount rate is lowest, and is set by the FRB to be charged to any member bank for borrowing. Fed funds impose a slightly higher rate for overnight borrowing between Federal Reserve member banks. Obviously fed funds, the most sensitive money market indicator, are the first rates to be affected by changes in the discount rate.

Always remember: Fed funds are bank-to-bank loans, so they are not money market securities. Fed funds are confusing because they have nothing to do with the FRB (the FED) directly. Fed funds are the overnight loans banks make to other banks with funds they access by dipping into their excess Federal Reserve monies

Question 16

Relationship between interest rates II

Answer 16

Money market rates are usually slightly higher than fed funds. The banks earn money market rates when they invest short-term. Money market rates include the repo rate (especially the overnight repo rate charged on overnight repurchase agreements), commercial paper, bankers’ acceptance, and CD rates.

The prime rates are charged to the best customers, and call loan rates are charged to broker/dealers for customer margin purchases. Of these rates, the highest rate is call loan rate.

Question 17

Repurchase agreements

Answer 17

Repurchase agreements (repos, buy backs or matched sales) are created when a bank dealer sells collateralized securities with a promise to buy them back.

Question 18

Commercial paper

Answer 18

unsecured corporate notes with maturities ranging from 30 to 270 days

Question 19

Bankers acceptances

Answer 19

import/export paper

Question 20

Leading indicators

Answer 20

Leading indicators estimate future economic activity in a business cycle and include the following:

1. Average weekly hours, manufacturing;
2. Average weekly initial claims for unemployment insurance;
3. Manufacturers’ new orders, consumer goods and materials;
4. ISM (Institute for Supply Management) new order index;
5. Manufacturers’ new orders, nondefense capital goods excluding aircraft;
6. Building permits, new private housing units;
7. Standard & Poor’s 500 stock index;
   -Leading Credit Index;
8. Interest rate spread, 10-year Treasury bonds less federal funds; and
9. Average consumer expectations for business and economic conditions.

Question 21

Coincident indicators

Answer 21

Coincident indicators are current indices (show the current phase of the cycle), and the more current the index, the more coincident. The following are some examples of coincident indicators:

1. Payroll employment (excluding agriculture);
2. Personal income (excluding Social Security);
3. Industrial production (GDP); and
4. Manufacturing and trade sales.

Question 22

Lagging indicators

Answer 22

Lagging indicators reflect historical data. They indicate the status of the economy in the past few months and include the following:

1.Average length of unemployment (in weeks);
2. Inventories to sales ratio (manufacturing and trade);
3. Labor cost per unit of output (manufacturing);
4. Average prime rate;
5. Commercial and industrial loans;
6. Consumer installment credit to personal income ratio; and
7. Consumer price index (CPI) for services.

Question 23

Dow Jones average

Answer 23

Dow Jones Average is the oldest and most widely quoted market indicator. It consists of 65 stocks (30 Industrial, 20 Transports, and 15 Utilities).

Since market direction cannot be determined by the movements only in the industrial portion of averages, if transportation and utilities move in the same market direction, all three categories determine the overall confirmation of market direction.

Question 24

Dow Jones industrial average

Answer 24

Dow Jones Industrial Average (DJIA) is the most widely quoted index, and averages the movement of 30 widely held stocks (i.e. IBM, GE, American Express, etc.). However, it is a very narrow measure of NYSE activity because there are more than 3,000 issues listed on the exchange.

Question 25

S&P 500

Answer 25

Standard and Poor’s 500 (S&P 500) is a broader measure of NYSE activity and is comprised of the 500 largest market capitalization stocks in the U.S. Note that S&P 100 consists of 100 stocks out of the 500.

Question 26

NYSE composite index

Answer 26

NYSE Composite Index is the broadest, most accurate measure of NYSE activity because it includes all common issues traded on the exchange (approximately 3,000 issues).

Question 27

NASDAQ market index

Answer 27

FINRA publishes market indices for all NASDAQ issues (approximately 3,200), as well as a NASDAQ 100 stock index. The NASDAQ Composite Index is the broadest measure, covering more than 6,500 stocks, while the other covers only the largest 100 stocks.

Question 28

Wilshire index

Answer 28

Wilshire Index consists of the market value of more than 7,000 NYSE, AMEX, NASDAQ and OTC issues headquartered in the U.S. It is the broadest market indicator.

Note: The index includes all U.S. equities with readily available prices, with thinly-traded and bulletin-board issues excluded.

Question 29

Cyclical Industries

Answer 29

Examples are large appliances and automobiles, heavy equipment, and airplanes.

Cyclical industries have regular, pronounced cycles of growth and contraction. Stocks of companies in cyclical industries perform nicely in a rising market, but suffer badly in a falling market. Cyclical companies produce durable goods, which sell well in healthy economic environments but do poorly during weak phases.

Question 30

Counter-cyclical industries

Answer 30

Countercyclical industries, in direct contrast to cyclical industries, prosper during economic declines and underperform when the economy is growing strongly. Examples include the pawn shop and asset repossession industries. By adding stocks from these industries, a portfolio has a greater possibility of positive performance through a down market.

Question 31

Defensive industries

Answer 31

Defensive industries have less pronounced cyclical variation. Stocks in defensive industries do not experience dramatic growth swings in up markets or declines in weak markets. They tend to have relatively steady performance through all economic phases. Defensive corporations produce basic consumer goods, also known as consumer staples, such as food, alcohol, tobacco, pharmaceuticals, cosmetics. Demand for these basic consumer goods tends to be steady through up and down markets.

Question 32

Growth industries

Answer 32

Growth industries are characterized by rapid development. They are typically fueled by new technological advances.

Question 33

Technical analysis

Answer 33

Technical analysis is used by market makers and traders, particularly day-traders and option players; its usefulness is the determination of price and time. Consists of tracking stock performance and charting advances and declines.

The technician knows market movements, support lines for purchasing stock, and resistance lines for selling stock. Thus, fundamentalists assist in recommending the companies to consider, whereas technicians tell you when to buy and sell.

Question 34

Common indicators for Technical analysis

Answer 34

2. 200 day moving average (Every day analysts chart moving average price over the last 200 days, adding previous day’s price to the average and eliminating the price from 200 days ago.);
3. Advance/decline line charting (Each day the number of stocks advanced is added and number of stocks declined is subtracted starting at zero. On these charts, a rising line indicates that cumulative advances outnumber the declines - bullish. A falling line indicates the opposite: cumulative declines outnumber advances - bearish.
4. Volume analysis (Volume is the number of shares traded in a company’s stock or in the market over a specified period, usually a day. An increase in volume may occur when a company makes an announcement, such as an acquisition or spinoff. Earnings reports, positive or negative, may result in increased volume. Technicians also use volume to assess the health of a trend.);
5. Put/call ratio - If, in the ratio of puts to calls, puts increase dramatically, the market is poised to decline. If the ratio shows a large increase in calls, however, then the ratio becomes bullish.
6. Short interest theory - Short interest (short sales) rising sharply is actually a bullish indicator because the need to cover short sales will bring buyers in to the market when the market begins rising

Question 35

Put/call ratios

Answer 35

If, in the ratio of puts to calls, puts increase dramatically, the market is poised to decline. If the ratio shows a large increase in calls, however, then the ratio becomes bullish.

Short interest (short sales) rising sharply is actually a bullish indicator because the need to cover short sales will bring buyers in to the market when the market begins rising.

Question 36

Breakout - Technical analysis

Answer 36

Breakout — stock price moves through a support or resistance level;

Support occurs where a downtrend is expected to pause due to a concentration of demand.

Resistance occurs where an uptrend is expected to pause temporarily, due to a concentration of supply.

Question 37

Consolidation - Technical analysis

Answer 37

Consolidation — stock price moves within a trading range and there is no clear trend

Question 38

Overbought - technical analysis

Answer 38

Overbought — stock price has risen too far and too quickly and is susceptible to downward pressure

Question 39

Oversold – Technical analysis

Answer 39

Oversold — stock price has dropped significantly and is likely to rebound

Question 40

Beta

Answer 40

Beta is a measure of volatility in relation to the overall market, usually the S&P 500, or a benchmark that is appropriate for a specific portfolio. A stock or portfolio with a beta greater than 1 is more volatile than the market. For example, if a stock has a beta of 1.25, its price fluctuates 25% more than the market.

Question 41

Alpha

Answer 41

Alpha is a measure of risk-adjusted performance. It is the excess return of an investment relative to the market or its benchmark. In simple terms, it is the difference between a security’s actual return and its beta. The point of reference for alpha is beta; therefore, a negative alpha indicates underperformance while a positive one represents a better than expected return.

Question 42

Capital asset pricing model (CAPM)

Answer 42

Used to determine the value of a security.

The model uses the security’s
1. beta,
2. a theoretical risk-free rate of return, and
3. the time value of money.

The CAPM addresses the return that the security should yield given its risk level. That yield is equal to the risk-free rate of return plus a premium for assuming the risk of the investment.

Question 43

Estate tax

Answer 43

KEY: For this exam you should know that all assets not passed on to a spouse are subject to estate taxes. This includes IRAs, annuities, Roth IRAs, and municipal bonds.

The estate tax is a tax on a person’s right to transfer property at death. It includes everything that a person owns or has certain interests in at the date of death.

An estate tax return must be filed if the gross estate of the decedent (increased by the decedent’s adjusted taxable gifts and specific gift tax exemption) is valued at more than the threshold for the year of the decedent’s death. This is called the estate and gift tax exclusion.

Federal law:As of 2023, the person’s entire estate after the first $12,920,000 would be taxable on a graduated scale up to a maximum tax rate. State laws vary.

Any assets left to a spouse or left to charity are not subject to estate tax until the spouse also dies. What is important here is that you know that the inheritance (or estate) tax applies to values in excess of a stated amount.

Question 44

Gift taxes

Answer 44

Even making large gifts during one’s lifetime may be subject to taxation. This is known as the “gift tax.” Currently, the taxpayer may give $17,000 per year per recipient tax free

Question 45

Gifted securities and taxes

Answer 45

If the market value is higher than the donor’s basis, the recipient’s cost basis is equal to the donor’s original purchase price of the security.

If the market value is lower than the donor’s cost basis, the recipient’s basis is equal to the market value of the securities at the time of the gift.

In the gift of securities, a gift tax is paid by the donor if the value exceeds $17,000. The tax paid increases the gift’s cost basis. If the recipient sells the securities later, the recipient pays capital gains taxes on the gains above the cost basis.

The appreciated value at the time of donation becomes the recipient’s cost basis and is referred to as the “stepped-up basis.”

Ex: if you were to give a friend $12,000 worth of stock purchased five years earlier for $7,000, they would be liable to pay long-term capital gains taxes on a profit of $5,000 should they sell straightaway.

i.e. The recipient inherits the gifter’s cost basis.

But know that losses are treated slightly differently: If the stock depreciates after it was gifted and the recipient decides to sell it, then the fair market value (FMV) on the date of the transfer is used to determine the loss.

Charitable donations are not subject to gift tax. In addition, the donor is not required to pay capital gains tax on the appreciated value of the security.

Question 46

Inherited securities and taxes

Answer 46

Ex: Consider a person who inherited 100 shares from a deceased relative. The cost basis of these shares is equal to their value on the day of the owner’s death. In other words, taxes will be based on this new cost basis, as opposed to the original cost. After providing a death certificate, proof of identity, probate court order, and others, the heir can either transfer the shares into their account or sell the shares for the proceeds. Ultimately, this has the potential to save significant sums of money due to the tax loophole.

If a security is inherited, the beneficiary gets a stepped-up basis, that is, the cost basis to the beneficiary is “stepped-up” (or “stepped-down” if the value has declined) to the fair market value of the securities on the day of the deceased’s death.

Note: The holding period is always considered long-term regardless of the deceased’s actual holding period.

Question 47

Cost basis options

Answer 47

First-In, First-Out, or FIFO. Under FIFO, the first shares purchased are the first shares sold. In a rising market, this is the worst option for the investor, because it typically results in the highest reported capital gain, and hence, tax.

If the securities are mutual fund shares, the investor may choose the weighted average method. Under this method, the investor calculates an average cost per share, which is used as the sale price.

The investor must disclose to the IRS which option was selected. If the investor fails to do this, the IRS chooses FIFO. This is usually the best option for the IRS, and the worst for the investor.

Question 48

Wash Sales

Answer 48

When an investor sells a security in order to establish a tax loss, it is possible that the IRS may not recognize the loss. If the investor repurchases essentially the same security within 30 days of the sale, this is known as a wash sale, and the loss is disallowed. The defining period applies to both, 30 days prior to, and 30 days after the sale. In other words, if the investor wishes to take a capital loss resulting from a stock sale, the investor must not purchase the stock within a 61-day window: 30 days before the sale, trade date, and 30 days after the sale. During this window, the investor may not purchase the stock or any security which is substantially identical. Substantially identical securities include:

-Convertible bonds or preferred stock which convert into the stock;
-A long call option on the stock;
-A short put on the stock; or
-The stock itself.

The two least effective of the four repurchases are selling put options (this gives you your maximum gain or premium while attempting to deduct a loss) and buying the stock. If the test questions ask which will defer the loss or disallow the loss, the best answer is sell puts.

If the investor violates the wash sale rule, the investor may not claim the capital loss on the stock sale.

Question 49

Corporate dividend exclusion

Answer 49

When a U.S. corporation owns common or preferred stock of another domestic corporation and receives a dividend, the owning corporation may exclude 50% of the dividend from its taxation.

For example, if one domestic corporation owns stock in another one and receives a $10,000 dividend, the investing corporation is taxed on $5,000 of the dividend.

Question 50

1035 Exchange

Answer 50

The following are allowable exchanges when effected directly between trustees:

-A life insurance policy for another life insurance policy, an endowment contract, or an annuity contract;
-An endowment contract for another endowment contract or an annuity contract; or
-An annuity contract for another annuity contract.

There will be no income tax on these transactions, as long as the policies or annuities exchanged are on the same life.

Note that an exchange of an annuity for a life policy is not eligible for 1035 exchange treatment. “Same to same” is acceptable.