Module 4 - Economics and the Markets

Question 1

The FEDERAL RESERVE BOARD (FRB)

Answer 1

More commonly referred to as the Fed, was founded by Congress in 1913. Its purpose is to regulate the economy by establishing the monetary policies of the government, regulate banks, maintain stability of the financial system, and provide financial services to the U.S. government. One of its most visible tasks is the controlling of the federal funds rate and the discount rate. Through the control of these rates, the Fed attempts to keep inflation in check and promote the credit and banking system within the U.S.

Question 2

The Fed can influence the economy through four types of actions. Remember the order with which the Fed uses these methods to control credit and the money supply is

Answer 2

• Open market operations
• Discount rate
• Reserve requirement
• Margin requirements

Question 3

OPEN MARKET OPERATIONS

Answer 3

• The Fed controls the money supply daily through the use of the FEDERAL OPEN MARKET COMMITTEE (FOMC). The FOMC controls the money supply by buying and selling U.S. government securities in the open market. These actions cause a fluctuation in interest rates through the amount of T-bills and other Treasury notes and bonds that it buys and sells.
• If the FOMC buys securities in the open market, more money flows into the economy. This increases the money supply, or eases money, which causes interest rates to go down. As interest rates go down, the prices of Treasury securities go up.

• When the Fed is buying treasury securities, more money is going into the economy, which eases money, lowers interest rates, and increases the money supply.

• If the FOMC sells securities in the open market, less money flows into the economy. This decreases the money supply, or tightens money, which causes interest rates to go up. As interest rates go up, the prices of Treasury securities go down due to the increasing supply.

• When the Fed is selling Treasury securities, less money is going into the economy, which tightens money, raises interest rates, and decreases the money supply.

Question 4

FEDERAL OPEN MARKET COMMITTEE (FOMC).

Answer 4

The FOMC controls the money supply by buying and selling U.S. government securities in the open market. These actions cause a fluctuation in interest rates through the amount of T-bills and other Treasury notes and bonds that it buys and sells.

Question 5

Since all settlement (payment) for Treasury securities is in federal funds:

Answer 5

• If the Fed (FOMC) is buying, overnight lending between banks goes down
• If the Fed is selling, there may be more overnight borrowing by the banks

***The reason for this relationship is that if the Fed is buying securities (T-bills, T-notes, T-bonds), it pays the banks for these securities in their federal funds account. This increases the banks’ reserves, so they don’t have to borrow as much. Banks that sell securities to the Fed will have more money, and the amount of lending from the Fed to the banks decreases. If the Fed is selling, the various banks will have less money in their Fed funds account and will not have enough to meet the bank reserve requirement. This is when they borrow.

• Payment in Fed funds means that the Fed payment will be deposited into the bank’s account at the Federal Reserve Bank. This account is used for meeting the bank’s reserve requirement as well as for purchasing and selling the Fed’s Treasury securities.
• Since the Fed buys and sells repurchase agreements on a daily basis, it influences the market much faster the any other method used by the federal reserve. In contrast, the buying and selling of T-bills takes place on a weekly basis at the auctions. However, since repos are daily transactions, the Fed uses them the most to influence the market.

Question 6

DISCOUNT RATE

Answer 6

• The Fed controls the money supply by changing the DISCOUNT RATE, which is the rate that the Fed lends money to member banks for loans.
• When the Fed increases the discount rate to member banks, fewer banks borrow money, and the supply of money available for loans decreases. The result is that fewer customers borrow due to the higher costs of borrowing. When the Fed increases the discount rate, it discourages borrowing. In contrast, when the Fed decreases the discount rate, it encourages borrowing, because the cost of borrowing is reduced.
• When the Fed changes the discount rate, it influences other interest rates as well. The yields on outstanding short- and long-term corporate, municipal, and U.S. government debt securities are also affected. As interest rates increase, commercial paper, negotiable CDs, T-bills, and bonds all decrease in price, causing their yields to rise. As interest rates decrease, the same securities increase in price, causing their yields to decrease.

Question 7

RESERVE REQUIREMENT

Answer 7

• The Fed can control the money supply through the use of the RESERVE REQUIREMENT. The reserve requirement is the percentage of deposits that the banks must keep on reserve and not loan out to other customers.
• Banks are called intermediaries because they take money in from customers, in the form of savings and checking accounts, and loan it out to others for personal, home, and other types of loans. When money is deposited into banks because interest rates are higher than returns on money market instruments, this flow of funds is called intermediation. When money is withdrawn from banks and used to purchase higher-paying money market instruments, this flow of funds is called disintermediation.

When the Fed increases the reserve requirement, the banks must keep more of their deposits in reserve, and as a result, they have less money available to lend. If demand for loans exceeds available supply, the costs of borrowing may increase. Higher interest rates (borrowing costs increase) result in fewer people borrowing, which, in turn, result in less money being circulated in the market. Less money in the marketplace results in slower growth.
- If the Fed increases the reserve requirement, it lowers the

When the Fed decreases the reserve requirement, the banks have to keep less deposit money in reserve and therefore have more to lend. This will allow the banks to lend and keep up with the demand, thus lowering interest rates and encouraging more borrowing, which, in turn, results in more money in the market being used.
- If the Fed decreases the reserve requirement, it increases

Question 8

MULTIPLIER EFFECT

Answer 8

Whenever the Fed changes the reserve requirement, the action has a MULTIPLIER EFFECT on the money supply. If the Fed reduces the reserve requirement, the amount of money that can be loaned allows other banks to increase the amount of money that they lend. As an example, if a bank receives a deposit of $1,000,000 and the reserve requirement is 20%, the bank may lend $800,000, which could be deposited into another bank. This, in turn, allows that bank to lend more, and so on. If the reserve requirement is reduced, the banks can lend more money. This is the multiplier effect.

Question 9

MARGIN REQUIREMENTS

Answer 9

The Fed determines the amount investors must deposit when buying securities with Regulations T and U

The Fed regulates the amount that must be deposited by investors when purchasing securities, through Regulations T and U.

• Reg T defines the terms of margin lending by broker/dealers to customers. The rule establishes the initial requirements and defines eligible securities to be used as collateral for margin loans.
• Reg U defines the amount of money that a bank can lend to a customer for purchases of securities.

When the margin requirement is higher, credit is tighter; when the requirement is lower, credit is easier. This only affects the stock and bond market and, thus, the fewest people. For this reason, the changing margin rates for stock purchases is the least used method for influencing the money supply.

Question 10

DEFLATIONARY MOVE

Answer 10

The Fed decreases the flow of money by taking money in from the market. This is considered a DEFLATIONARY MOVE and is done by:
• Selling Treasury securities in the open market
• Raising the discount rate
• Raising the reserve requirement
• Raising the margin requirement

Question 11

INFLATIONARY MOVE

Answer 11

The Fed increases the flow of money by putting more money into the market. This increase is considered an INFLATIONARY MOVE, and is done by:
• Buying Treasury securities in the open market
• Lowering the discount rate
• Lowering the reserve requirement
• Lowering the margin requirement

Question 12

MORAL SUASION

Answer 12

MORAL SUASION is similar to “arm twisting.”
• The Fed influences the banks by persuading them to follow its lead. The Fed can suggest that banks restrict or loosen credit on their own and the Fed can use its authority, if needed.
• If the Fed wants the money supply to decrease, but doesn’t want to raise rates, it will notify the banks and “request” that they increase their reserves. Since self-imposed restrictions are easier to remove, the banks will do so. Moral suasion is the unofficial method of controlling the money supply, but it is not a correct answer for the test.

Question 13

THE FEDERAL FUNDS RATE

Answer 13

The FEDERAL FUNDS RATE is the interest rate that commercial banks charge when borrowing from each other to meet the overnight reserve requirement. This is sometimes called the OVERNIGHT LENDING RATE. Banks would rather borrow from each other to meet overnight reserves than go to the Fed for the money. The Fed also encourages this through the rates charged at the discount window, as well as the scrutiny it places on banks that borrow from the Fed on a regular basis.

The federal funds rate is the MOST VOLATILE of all the interest rates because it changes rapidly each day as banks “bid” for money from each other for overnight lending. This rate changes by the minute from 3 p.m. to 5 p.m. Eastern Standard Time, when the reserve requirement must be met.

The federal funds rate is generally lower than the discount rate set by the Fed. The federal funds rate is the first indicator of changing interest rates because the minimum and maximum each day is set by the Fed, but adjusted by the banks as needed.

Question 14

The rates for money, from highest to lowest, are generally:

Answer 14

• Prime rate
• Call money rate
• Commercial paper rate
• Banker’s acceptances rate
• Discount rate
• Federal funds rate

Question 15

The CALL MONEY RATE

Answer 15

The CALL MONEY RATE is the rate that broker/dealers charge clients for purchases of exchange-listed securities on margin. This is the rate charged on the client’s debit balance.

Question 16

The money supply is divided into three groups: M1, M2, and M3. Note that M1 is the most liquid of all of these and represents the cash that is spent on goods and services on a daily basis.

Answer 16

Remember for Test

Question 17

M1 is composed of:

Answer 17

• All currency in circulation
• Demand deposits
• Interest-bearing checking accounts

Question 18

M2 is all of M1 plus:

Answer 18

• Money market funds
• Small savings and small “time” deposits
• Overnight repurchase agreements
• Overnight Eurodollar deposits

Question 19

M3 is all of M2 plus:

Answer 19

• Large time deposits in commercial and savings
  banks and savings and loans ($100,000 or more) (Large time deposits are also called jumbo CDs.)
• Balances in institutional money funds
• Eurodollars held by U.S. residens in foreign branches of U.S. banks

Question 20

Inflation

Answer 20

Is the increase in the average level of all products in an economy

Question 21

Although inflation is somewhat beneficial, high inflation affects most people negatively, since it causes negative changes in numerous sectors. Three of these are:

Answer 21

• The purchasing power of the dollar — extremely hard on retired people who are on fixed incomes due to pension checks, investments in debt securities, and other fixed incomes
• Interest rates — when prices increase too much, the Fed will increase the cost to borrow money as well, and costs of credit cards also increase causing financial problems for many. In addition, the value of debt issues is decreased with the increase in interest rates.
• Savings and investing — inflation is hard on savings if it is greater than the amount of interest earned, but investing in stocks should help the investor keep up with inflation.
***To counter inflation, the Fed will increase interest rates until the prices of goods level off or even drop to some degree.

Question 22

Deflation

Answer 22

DEFLATION is the decrease in the average price level of all products in an economy.

Deflation occurs when the aggregate demand decreases faster than the aggregate supply.

When there is more supply of products and they exceed the demand for goods, the producers must decrease the price of the goods to attract buyers. As prices decrease, the amount that a dollar buys increases, and thus, deflation occurs. Deflation can be said to increase the real purchasing power of the dollar.

When the Fed increases interest rates and decreases the supply of money, people no longer purchase goods. This causes an overabundance of the goods; therefore, prices fall, people lose their jobs, and deflation begins.

The Fed does not like to see a deflationary period, since this is detrimental to the population as a whole. As people lose jobs, they stop buying, and companies go out of business. During deflationary periods, interest rates are increasing or are very high. To counter deflation, the Fed lowers interest rates, hoping to entice the consumer to borrow for purchases and investments.

Question 23

VELOCITY OF MONEY

Answer 23

The amount of times a dollar is spent in a given period of time is called the VELOCITY OF MONEY. Economist Irving Fisher first explained the concept of the velocity of money (also known as the TURNOVER OF MONEY), in the 1920s. In essence, the greater turnover of a monetary unit for goods and services, the greater the velocity of that monetary unit. The Federal Reserve Board factors the velocity of the dollar into our nation’s monetary policy. Therefore, the faster that money is being used again, the less the Fed has to go in and change the money supply through the buying and selling of Treasury securities in its open market operation. If the velocity of money slows down, the Fed uses its open market operations to inject money into the economy. Any downtrend in velocity could signal a reduction in economic growth — even if the money supply stays the same.

Question 24

In reviewing the factors that affect investing or borrowing, credit conditions become worse with an increase in the following:

Answer 24

• Bankruptcies
• Consumer debts
• Bonds in default
• Tax collection delinquencies
• An increase in companies’ and/or distributors’ inventories
***As a result of poor credit conditions, investing in securities will slow.

Question 25

Credit conditions generally improve when:

Answer 25

• Fewer individuals and businesses declare bankruptcy, consumer debt is reduced, and fewer bonds are in default for payment of interest to investors.
• Real property values increase (housing and other real estate).

Question 26

A RECESSION

Answer 26

A short-term decline in business activity, stock prices, and employment. A recession is also defined as two consecutive quarters of declining business activity, as measured by the Gross Domestic Product (GDP).

Question 27

A DEPRESSION

Answer 27

Defined as a general economic decline with falling prices, high unemployment, and a low confidence in the economy. It is sometimes also defined as six consecutive quarters of declining business activity as measured by the GDP.

Question 28

INTEREST RATES AS ECONOMIC INDICATORS

Answer 28

Besides the federal funds rate, the PRIME RATE is also an indicator of the economy in that it reflects the money supply as well as the demand for money. The prime rate is the rate the banks charge their best customers during these demands. Banks set the prime rate according to demand for money and the rate at which they can get the funds from the Fed.

The demand for money drives the rates higher. Interest rates directly influence bond prices. This is true because as interest rates climb, bond prices drop due to the low demand for the outstanding low-interest bonds.

Question 29

In reviewing the impact of changing interest rates on fixed rate investments, short-term bonds react more quickly to fluctuating interest rates than do long-term bonds. This quick change is due to the need for short-term bonds to adjust to the present rates.

Long-term bonds adjust their prices more. Because the premium or discount of long-term bonds is divided by a larger number (the time to maturity) to achieve the same change rate, these bonds move more in price.

At all times, the par value has a tendency to pull prices to it faster than letting prices be driven away from it.

Utility companies and auto manufacturers are greatly affected by changing interest rates because they borrow for a large amount of their expansion.

When an investor has a municipal bond portfolio, the one risk that cannot be protected against is overall interest-rate risk.

Answer 29

Remember for Test

Question 30

Effects of Interest Rates on Common and Preferred Stocks

Answer 30

In the event of rising interest rates, both common and preferred stock prices will fall, but for different reasons. With common stock, rising interest rates affect the company’s ability to borrow and slows company growth. With preferred stock, the dividend is at a set rate (dollars or percent); thus, with rising interest rates, the dividend decreases and the teeter-totter effect occurs — rates up, prices down.

Question 31

The dollar becomes devalued against other currencies for three main reasons:

Answer 31

1. The U.S has a large trade deficit with other countries causing them to have a trade surplus with us.
   – This means that the U.S. is buying more goods from other countries than we are exporting to those countries.
2. The center of economic activity is shifting to fast-growing countries such as China, Japan, and Brazil.
   – This is because products are being made in these
   countries by cheap labor, thus creating trade surpluses those countries and trade deficits for the U.S.
3. The dollar is the underlying backing of all foreign currency.
   –Today, the dollar, not gold, underlies world currencies

Question 32

The devaluation of the U.S. dollar has many effects:

Answer 32

To sum it up and keep it simple:
• If the dollar is DEVALUED, bonds drop in price, yields go up, and U.S. goods become more competitive
• If the dollar is REVALUED (appreciates), bonds go up in price, yields go down, and U.S. goods become less competitive.

Question 33

MONETARIST THEORY

Answer 33

Those who adhere to MONETARIST THEORY believe that the money supply is the most important factor influencing our economy. Monetarists believe that the actions of the Federal Reserve Board represent the largest influence on the business cycles and, thus, on our economy.
• Monetarists believe that the most influence can be exerted on the economy by changing interest rates and the money supply.

Question 34

KEYNESIAN THEORY

Answer 34

Those who promote KEYNESIAN THEORY believe that an economy can only grow if the government increases its spending. For this reason, the Keynesian theory states that there must be increased taxation by the government and increased government spending to motivate the economy.

Keynesians believe that if the government raises taxes and puts more money in the economy through increased government spending, it will result in more money for people to spend. While some people believe that raising taxes takes money out of people’s hands and, therefore, gives them less money to spend, Keynesians feel that the more the government spends, the more prosperous the economy.

Question 35

SUPPLY-SIDE THEORY

Answer 35

The SUPPLY-SIDE THEORY, an opposing theory to the Keynesian theory, holds that good fiscal policy, tax cuts, and less government spending will generate a healthy economy. The supply-side theory suggests that the government should take a passive role in the economy.
• This theory holds that with tax cuts, people have more money in their pockets thus encouraging more spending and, therefore, increased economic growth.

Question 36

LEADING INDICATORS

Answer 36

• STANDARD & POOR’S 500 INDEX (S&P 500) - If this stock index is rising, so should the economy; and if it is declining, the economy may be headed for a downturn.
• BUILDING PERMISTS FROM THE HOUSING STARTS REPORTS — New housing construction projects are indicators that people are increasing their spending. This stimulates the economy.
• DURABLE GOODS (also known as CONSUMER GOODS) — If consumers increase purchases for small appliances and other durable goods (such as cars), it is a sign that consumer sentiment is strong, people are willing to spend money, and thus, the economy will grow. In contrast, when consumers are not spending money on durable or consumer goods, it is a sign that they are concerned about the economy because they are saving money. This indicates that the economy is slowing down.
• MACHINE TOOL ORDERS - This indicator is factory orders for new tools. An increase in tool purchases signifies an increase in demand for labor and larg construction projects — another strong economic sign. A decrease in tool orders signifires a decrease in the economy for the same reasons
• CONSUMER CONFIDENCE INDEX (CCI) - The latest indicator to be used, the CCI is probably the most relevant one in today’s market. Consumer confidence tends to support upward trends in stock prices.

Question 37

COINCIDENT INDICATORS

Answer 37

COINCIDENT INDICATORS tend to move as the economy moves. These indicators usually do not forecast how the economy will go, but rather show the trend that the economy is taking.

Question 38

People interested in economic forecasting commonly use other regularly reported figures:

Answer 38

EMPLOYMENT is actually found in all of the indicators, but becaus it can be a leading, coincidental, or lagging indicator (depending upon which employment is being considered), it is not considered a correct answer for an indicator on the test.

GROSS DOMESTIC PRODUCT (GDP) — The GDP is not an indicator, but a quarterly report showing how the economy is growing or not growing. This is never a correct answer for an indicator on the test. The GDP gives the market value of all goods produced in a country in a given year, equal to the total of consumer spending and government spending, plus the value of exports, minus the value of imports. This figure only includes goods and services produced within the boundaries of the U.S.

Question 39

COINCIDENT INDICATORS

Answer 39

COINCIDENT INDICATORS tend to move as the economy moves. These indicators usually do not forecast how the economy will go, but rather show the trend that the economy is taking.

There are four such coincident indicators. For the exam, know one of them:
• INDUSTRIAL PRODUCTION INDEX — This index generally shows the capacity at which our nation is producing goods. If we are producing at 40% to 60%, we can assume that orders are down, inventories may be built up, and people are not spending. In contrast, if we are at 80% to 90% productivity, people are buying and the economy is strong.

Question 40

LAGGING INDICATORS

Answer 40

LAGGING INDICATORS usually follow the economy. Once the U.S. economy has established a trend, and people are spending or not spending as the case may be, these indicators show how the trend progressed. They are the last to change as the economy changes. For the exam, know this one:
CORPORATE PROFITS — Companies and their profits always follow the economy, since it is not until after an up or down swing that it can compare its results to the economy and its competitors. The company is able to evaluate its success only after sales have been aggregated and it can evaluate its returns.

Question 41

People interested in economic forecasting commonly use other regularly reported figures:

Answer 41

EMPLOYMENT is actually found in all of the indicators, but because it can be a leading, coincidental, or lagging indicator (depending upon which employment is being considered), it is not considered a correct answer for an indicator on the test.
GROSS DOMESTIC PRODUCT (GDP) — The GDP is not an indicator, but a quarterly report showing how the economy is growing or not growing. This is never a correct answer for an indicator on the test. The GDP gives the market value of all goods produced in a country in a given year, equal to the total of consumer spending and government spending, plus the value of exports, minus the value of imports. This figure only includes goods and services produced within the boundaries of the U.S.
GROSS NATIONAL PRODUCT (GNP) — The GNP is also not an indicator, but a quarterly report showing how the economy is growing or not growing. This is never a correct answer for an indicator on the test. The most accurate method of looking at the GNP is through constant dollars. This report is the same as the GDP except that it does include the cost of goods and services produced by U.S. companies in foreign countries.
CONSUMER PRICE INDEX (CPI) — The CPI is not considered an indicator, but it is a monthly inflationary report that gives consumers an idea of how the dollar is doing and how their buying power is holding. This is never a correct answer for an indicator on the test. Do not confuse this with the CCI above, which is a leading indicator.

Question 42

THE BUSINESS CYCLE

Answer 42

Know the four parts of the BUSINESS CYCLE. Remember them in alphabetical order: E, P, R, T.
• EXPANSION or RECOVERY— when things are getting good and the economy is rising
• PEAK — the high point
• RECESSION or CONTRACTION — when business is
doing poorly and the economy is going down
• TROUGH — the low point.

When answering the question, write down the business cycle in alphabetical order: E P R T. Also draw the figure at right. Then, find the only answer that is in this order, regardless of which part is given first. Even if the order starts with P or R or T, it must be in the order that the business cycle flows. There will only be one answer with the letters
in this order. The answer could even be R T E P.

Question 43

Fundamental Analysts

Answer 43

FUNDAMENTAL ANALYSTS look at the company’s financial performance to determine how the stock will perform. They determine the future movements of stock by watching a company’s:
• Management
• Outlook
• Research abilities
• Earnings
• Dividends
• Balance sheet
• Annual report
• Financial ratios (working capital, current ratio,
debt/equity ratio, and so forth)

Fundamental analysts evaluate a company’s prospects by reviewing the company’s financial statements, the industry, and other economic information. They also rely on technical aspects of the company’s stock performance. Some of the company’s stock measurements include the resistance and support levels (see below), as well as current movements of the company’s stock. However, their main concern is the company’s financial and management performance and how it measures up to the competition in that industry.

Question 44

Technical Analysts

Answer 44

TECHNICAL ANALYSTS look at what is happening in the stock market in general and the individual price action of stocks in similar industries. Technical analysts chart the movement of stock in the industry and look at various theories, including:
• Dow theory
• Odd-lot theory
• Advance-decline theory
• Short interest theory

Technical analysts base their outlook on how the market is moving, how the particular stock is doing in the market, what the P/E ratio is, and where the stock is in relation to the highs and lows for that stock. Technical analysts establish resistance and support levels by charting the stock of a company. The resistance level is when the number of stock sellers outnumbers the number of buyers and the stock price doesn’t seem to move upward past this price. Support level is when the number of buyers outnumbers sellers and the price of a stock begins to rise.

Question 45

Fundamental analysis is the predominant method used to evaluate investments, because most stock price performance is based on expected growth. If an analyst can predict that a company will produce increasing earnings, the company’s stock is generally a good investment.

Answer 45

Remember for Test

Question 46

DOW JONES AVERAGES

Answer 46

The DOW JONES AVERAGE comprises 65 stocks, consisting of:
• The DOW JONES INDUSTRIAL AVERAGE (DJIA) (30 component stocks)
• The Dow Jones Transportation Average (20 transportation stocks)
• The Dow Jones Utilities Average (15 utility stocks)
The Dow Jones Industrial Average is calculated by totaling up the prices of the 30 component stocks and dividing by a divisor (determined by Dow Jones) that will change with stock splits and stock dividends.

Question 47

STANDARD & POOR’S 500 INDEX

Answer 47

STANDARD AND POOR’S 500 INDEX comprises 500 stocks, consisting of:
• 400 industrial stocks
• 20 transportation stocks
• 40 utility stocks
• 40 financial stocks

Question 48

NEW YORK STOCK EXCHANGE COMPOSITE INDEX

Answer 48

The NEW YORK STOCK EXCHANGE COMPOSITE INDEX comprises:
• All industrial stocks on the NYSE
• All transportation stocks on the NYSE
• All utility stocks on the NYSE
• All the financial stocks on the NYSE

Question 49

MOODY’S AVERAGE

Answer 49

MOODY’S AVERAGE comprises 200 stocks:
• 125 industrial stocks
• 25 railroad stocks
• 25 utility stocks
• 15 bank stocks
• 10 insurance company stocks

Question 50

WILSHIRE 5000 TOTAL MARKET INDEX

Answer 50

THE WILSHIRE 5000 TOTAL MARKET INDEX comprises 6,000 stocks found on the NYSE, AMEX, and Nasdaq; for historical reasons, this index is still referred to as the Wilshire 5000.
– This is the broadest measure of the market.
– The averages help show the course of the market and measure the change from the previous day and
previous years.
– As stated, it actually comprises over 6,000 stocks, but it is called the Wilshire 5000 for historical purposes.

Question 51

DOW THEORY

Answer 51

DOW THEORY is a classification of the stock market. It is based on the theory that market trends often precede the trends in prosperity and depression in general business. The Dow Theory bases its assumptions about the performance of stocks on various components of the stock market, including averages of other stocks.

Question 52

ODD-LOT THEORY

Answer 52

The ODD-LOT THEORY is based on the thought that the odd-lot investor (small individual investor) buys at the high points of a stock’s movement and sells at the low points. Therefore, an ODD-LOT TRADER is considered a bad investor. The odd-lot theory is based on the numbers of small investors that purchase small amounts of stock Today odd-lot traders are those people who are purchasing less than 1,000 shares. Any trades less than 1,000 shares is considered an odd lot, and those that purchase these small amounts are an “odd-lot trader.” In essence, the general public.

The odd-lot theory states that when the odd-lot purchases exceed odd-lot sales, the market will drop, and vice versa. In essence, odd- lot traders do just the opposite of what will happen because they wait until they are sure the stock is rising before they buy. Of course, this is when the big traders (mutual funds, etc.) have made profits and are getting ready to sell. Now the prices of the stocks start to fall, so the odd-lotters have to sell or take big losses.

Question 53

ADVANCE-DECLINE THEORY

Answer 53

The ADVANCE-DECLINE THEORY is a ratio and chart based on the number of advancing stocks versus the number of declining stocks. The ratio is the number of advancing stocks in a given day compared to the number of declining stocks on the same day. This ratio is placed on a chart, and the points are connected to develop the advance/decline line. This line is charted with another index, such as the DJIA or NYSE Composite, and the trend lines and movements are compared.

Many people say, “Let the trend be your friend,” and are referring to the advance-decline line trend.

The ADVANCE-DECLINE THEORY states that if the advance- decline index rises faster than the other index, a rise in the market will occur (and vice versa).

Question 54

SHORT INTEREST THEORY

Answer 54

Investors in stock are looking to make money with swings in the market, both up and down.
If investors think the market price of a stock will rise, they will purchase the stock. When the stock is bought, the investor is considered to have a LONG POSITION in the stock. Therefore, PURCHASE = BUY= LONG.

On the other hand, when investors think the stock will be going down in value (such as in the third and fourth quarter of 2008), they have a method of taking advantage of this situation. This position is called a SHORT POSITION. The investors borrow stock from the broker/dealer and then have them sell the stock that they have borrowed, even though they do not own it. (If you have always been told you must own something to sell it, that is not true anymore.)

Investors can sell stock without owning it, but they have to purchase shares of that stock at a later date to replace those borrowed from the broker/dealer. However, they are hoping to making money the only way possible — buy low and sell high. These investors just do it in reverse — sell high and buy low. Therefore, SELL SHORT = SELL WITHOUT OWNING, and eventually replace the borrowed stock.

The SHORT INTEREST THEORY is based on the fact there are investors selling a stock, or many stocks, short. The theory compares the number of shares that are sold short in a given month to the total volume for the month.

If the number of stocks sold short is low, then some investors think the outlook is bearish — when a large buying trend occurs, profit takers may sell off their stock in the near future. This creates a fall in the market. The few short sellers are making profits, while those selling their long positions are hoping to get out before too much damage occurs. In the 1990s, a very low short interest ratio occurred and one of the most bullish markets ever seen soon followed. Eventually, many sellers did take their profits, but other circumstances caused the decline in 2000.

On the other hand, in the second half of 2008 large hedge funds (do not confuse these with mutual funds who cannot sell short) started shorting stocks of many financial companies, including banks, broker/dealers, insurance companies, and others. There was a “huge” short interest ratio for a few months. A big fall occurred in the market for that short- period of time, but eventually, those hedge funds had to cover their short positions, and a bull market ensued. (Yes, there was a lot of carnage during the decline, but we came out stronger in the long run)

Since broker/dealers must report their short positions in customer’s accounts, this information is readily available. If the number of stocks being sold short is high, the outlook is for a strong market because the short sales will have to be covered, which means a large amount of buying in the near future. This creates a large demand for the stock and a rise in the market.

On the other hand, if a stock is shorted in the market, the stock may not be a good investment. This is what happened to many financial institutions in precarious positions in 2008. The hedge funds shorted the stock of banks and broker/dealers into bankruptcy. The bullish market expected from the “short interest ratio” on those corporations and financial institutions never materialized.

Question 55

Bull Market

Answer 55

A BULL MARKET is a market on the rise or in an upswing. A fun way to remember this it to think of a bull attacking — bulls fight by swinging their heads up. An investor who is bullish expects investments to grow.
Investors can take three positions that are always considered BULLISH:
• Owning stock, or being LONG THE STOCK • Owning calls, or LONG CALLS
• Writing or selling puts, or SHORT PUTS`

Question 56

Bear Market

Answer 56

A BEAR MARKET is a market that is falling or on a downswing. A fun way to remember this it to think of bears in a fight, swinging their paws down on their opponents. An investor who is BEARISH expects investments to decline.

Investors can take three positions that are always considered bearish:
• Selling stock short, or owning a SHORT POSITION
• Buying puts, or LONG PUTS
• Writing or selling calls, or SHORT CALLS

Question 57

ALPHA

Answer 57

ALPHA is a volatility measurement based on the past volatility, independent of market-related factors, of a company’s stock price. The price is compared with fundamental changes within the company and its industry sector. This method uses “1” as the starting point (as do most of the following measurement methods). An alpha of 1 indicates that no change is expected. An alpha of 1.50 would forecast a 50% increase in market value; an alpha of .75 would forecast a 25% decline in market value. A high alpha indicates lower risk.

Question 58

BETA (also called the BETA COEFFICIENT)

Answer 58

BETA (also called the BETA COEFFICIENT) is a volatility measurement based on the comparison of a stock’s market price movements against the movement of a stock market index. Again, “1” is the starting point. A beta of 1 indicates that the stock’s price (or a portfolio’s market value) will go up and down as the market index rises and falls by the same percentage. If the beta is other than 1, the stock will move up and down in proportion to the beta (sometimes referred to as SYSTEMATIC RISK.) A beta of more than one indicates that the stock’s price will be more volatile than the index or general market. A beta of less than one indicates the stock will move less than the index or the general market movement.

The beta coefficient may be used in assembling a portfolio of securities. By mixing high-beta stocks with low-beta stocks, the investor can seek higher returns in rising markets (high-beta portion) and reduce downside losses in declining markets (low-beta portion). The betas for most stocks are available from research organizations such as Value Line and others.

Question 59

HEAD AND SHOULDERS TOP FORMATION

Answer 59

HEAD AND SHOULDERS TOP FORMATION is a reversal of an upward trend of stock, meaning the start of a bear market.

Question 60

HEAD AND SHOULDERS BOTTOM FORMATION

Answer 60

HEAD AND SHOULDERS BOTTOM FORMATION is a reversal of a downward trend in the
stock, meaning the start of
a bull market.

Question 61

RESISTANCE LEVELS

Answer 61

A resistance level is the highest level to which a
stock will rise because of a price barrier. The resistance price is based on a predominance of sellers versus buyers in the market. This can also be stated that the resistance level is the level BELOW which a stock will stay.
• When the price of a stock reaches this level, a large selling trend occurs because the stock price is high. This decreases demand for the stock, which results in the stock price falling.

Question 62

Support Level

Answer 62

A SUPPORT LEVEL is the lowest level to which a stock will fall because of a price barrier. The support price is based on a predominance of buyers verses sellers in the market. It can also be stated that the support level is the level ABOVE which a stock will stay.
• When the price of a stock reaches the SUPPORT LEVEL, a large buying trend occurs because the stock price is low. This increases demand for the stock, which results in the stock price rising.

Question 63

General Points about Resistance and Support

Answer 63

• The stock may not always hit the barrier, but will come very close to it. Then it will reverse the trend.
• Stocks will break these barriers, but they are considered to be on their way to the next barrier when they do.

Question 64

BREAKOUT

Answer 64

A BREAKOUT is when a stock goes above the present resistance level on its way to the next resistance level or when a stock drops below a support level in a large sell-off, and is on its way down to the next support level.

Question 65

SELLING CLIMAX

Answer 65

A SELLING CLIMAX is when there is a large sell-off of a stock. After a steady decline with little volume, a sudden drop with heavy volume occurs.

Question 66

SAUCER STOCK MOVEMENT

Answer 66

Technical analysts refer to situations on charts where stocks that have been decreasing in value hit their lowest point and are now moving up in a “saucer” movement.
• This is typically when “chartists,” also known as technical analysts, put in buy orders on the stock.
• This is a bullish position.

You may see a reference to an “inverted saucer” which is a bearish position.
• This is typically when “chartists,” also known as technical analysts, put in sell orders on the stock.
• This is a bearish position.

Question 67

DEFENSIVE ISSUE

Answer 67

A DEFENSIVE ISSUE is an equity issue that holds its price, even in periods of economic downturn. Examples are:

• Utility stocks
• Food stocks
• Liquor and tobacco stocks

Question 68

DEFENSE ISSUE

Answer 68

A DEFENSE ISSUE is an equity issue that manufactures defense items for a country. Examples are:
- Aerospace
- Airplane manufacturers

Question 69

CORPORATE BOND ANALYSIS

Answer 69

Fundamental analysts look for indicators of the issuer’s ability to pay interest on corporate bonds when it is due and the principal at maturity.
Fundamental analysts consider two important ratios:
• Debt/equity ratio
• Fixed charges coverage

Question 70

DEBT/EQUITY RATIO

Answer 70

The DEBT/EQUITY RATIO is the ratio of funded debt of a corporation to the amount of equity making up the capitalization of the company. Since it is a ratio, it is a calculation based on:

Debt/Equity

Question 71

FIXED CHARGES COVERAGE

Answer 71

FIXED CHARGES COVERAGE is a method analysts use in determining if a company can pay the interest, or principal and interest, when due.

Question 72

Two formulas used to calculate fixed charge coverage are:

Answer 72

The interest coverage ratio:
Total Revenues - Expenses/ Yearly Interest

The debt service coverage ratio:
Total Revenues - Expenses Yearly/Interest and Principal Payment

Note: Debt service is composed of both principal and interest.

Question 73

In analyzing general obligation bonds, municipal bond analysts look at:

Answer 73

• Past performance in payment of interest
• Per capita income of the population
• Projected population growth of an area
• Industrial development of an area

Question 74

Long Positions

Answer 74

Long positions are taken when an investor believes the market in a particular security, or in securities in general, will rise because of demand.
• The investor is hoping to buy low and sell high — the only way to make money.
• This investor is considered to be a BULLISH INVESTOR; meaning that the investor thinks the market will rise. Bullish investors take a position on their security (stock, bond, or option) and are hoping to buy low, sell high, and make money by the rise in the market price of their security.

Question 75

Short Positions

Answer 75

Short positions are taken when an investor believes the market in a particular security, or in securities in general, will fall for one of many reasons.
• This investor is hoping to sell high, and then, when the time is right to buy low. Once again this is the only way to make money, except in reverse order from long positions. Normally an investor buys and later sells that security, but in the case of a short sale, the investor first sells the security, then after a time the investor buys the security to replace what was borrowed. When selling short, an investor is borrowing the stock or bond from the broker/dealer, but will have to purchase and replace it at some future time. This investor is considered to be a BEARISH INVESTOR, meaning that the investor thinks the market will decline.
• Bearish investors are those who have taken a position by selling first on their security (stock, bond, or call option) and are hoping to buy low later because of a fall in its market price.

Question 76

Short Against The Box

Answer 76

A SHORT AGAINST THE BOX is actually two different positions on the same stock. This is an investor who owns the stock and then sells it short. This used to be done at the end of the year to lock in a profit on their stock, but defer the taxes on the profit to the next year. This technique is no longer allowed as a method to lock in profits and reduce taxes. It should not be on the test, but know it just in case.

Question 77

Arbitrage

Answer 77

ARBITRAGE is taking advantage of a price discrepancy on one stock in two markets or between two securities.
• The most common arbitrage is buying a security in one market and selling it short in another market — generally where the stock is selling for more in one market than in the other.
– The sell side, for a bona fide arbitrage, must be a short sale.
– If the sale is not a short sale, then both transactions are required to be paid for.
• When a person buys stock on one exchange and sells it later on the same day, but not in a short sale, the transaction is called “DAY TRADING.”
– Day trading is the constant buying and selling of
securities, trying to time the market and take advantage of stock movement during the day.
– Note that day trading is similar to market arbitrage, but there is no short sale in day trading, while arbitraging requires a short sale to take place.
– A person is considered a day trader when the majority of their trades is buying and selling on the same day, and they do at least four day trades in a five-day period.
• Another type of arbitrage is buying a convertible bond when the bond and stock prices are not equal.
– One method of describing this arbitrage is “the bond is selling below parity with the stock” it is convertible into.
– The other method of describing this arbitrage is “the stock is selling above parity with the bond.”
– In both of these cases an investor can purchase the bond, convert the bond into stock, and then sell the stock in the open market for more value than the bond was purchased.
– If the bond is selling above parity, then an arbitrage is not available since the investor cannot purchase the stock, convert the stock into the bond, and then sell the bond at a higher price. Only the bond can be converted and only into the stock.