Analysis and Recommendations

The economy and monetary policy

The business cycle has four phases: expansion, peak, contraction, trough. A recession is conventionally two consecutive quarters of declining gross domestic product; a prolonged and severe one is a depression.

Indicators are classified by timing. Leading indicators move before the economy: building permits, new orders for durable goods, stock prices, the money supply, initial unemployment claims, and consumer expectations. Coincident indicators move with it: industrial production, personal income, employment. Lagging indicators move after it: the average duration of unemployment, corporate profits, the prime rate, and the ratio of inventories to sales.

Monetary policy is the Federal Reserve's, and it has three tools. Open market operations — buying or selling government securities through repurchase agreements — is the principal one and is used continuously; buying securities adds reserves and eases, selling drains reserves and tightens. The discount rate is what the Fed charges banks borrowing directly from it. Reserve requirements set how much banks must hold against deposits. The federal funds rate, by contrast, is the market rate at which banks lend reserves to each other overnight, and it is what the Federal Open Market Committee targets.

Fiscal policy is the government's: taxation and spending, set by Congress and the President, not by the Fed. Confusing the two is one of the most reliably tested distinctions in this section.

The economic theories the outline names: Keynesian economics emphasizes demand management through fiscal policy; monetarism emphasizes control of the money supply; supply-side economics emphasizes tax and regulatory reduction to increase output.

Sector behaviour across the cycle: defensive sectors — food, utilities, pharmaceuticals, tobacco — hold up in a contraction because demand is inelastic. Cyclical sectors — autos, construction, heavy machinery, luxury goods, durable goods — move with the cycle and lead in an expansion. Growth stocks are valued on future earnings and are therefore hurt more by rising rates than value stocks are.

International factors: the balance of payments records transactions with the rest of the world; a weaker dollar makes US exports cheaper abroad and imports more expensive at home, which helps US exporters and hurts US importers. That mapping is the same one the currency options lesson used.

Fundamental analysis

Fundamental analysis values a company from its financial statements and its business.

The balance sheet is a position at a moment: assets equal liabilities plus shareholders' equity. Working capital is current assets minus current liabilities. The current ratio is current assets over current liabilities. The quick ratio, or acid test, removes inventory from current assets before dividing, because inventory is the least liquid current asset.

Inventory valuation matters to comparability. Under last in, first out, the most recently acquired inventory is charged to cost of goods sold, which in a period of rising prices raises cost of goods sold and lowers reported earnings. Under first in, first out, the opposite. The same company reports different earnings under the two methods, which is why footnotes are load-bearing.

The income statement is a flow across a period. Earnings before interest and taxes, earnings before taxes, net profit, and earnings before interest, taxes, depreciation and amortization are the intermediate measures the outline names.

The ratios divide into four families.

Liquidity: working capital, current ratio, quick ratio.

Leverage and bankruptcy risk: the debt-to-equity ratio, and the bond ratio — long-term debt as a share of total capitalization.

Efficiency: inventory turnover, and cash flow.

Profitability and safety: the margin of profit ratio (operating income over net sales), the net profit ratio, bond interest coverage (earnings before interest and taxes divided by annual interest), net asset value per bond, and book value per share.

Per-share measures: earnings per share, fully diluted earnings per share, the price-earnings ratio, the dividend payout ratio, and current yield — dividend over market price.

And competitiveness: return on common equity.

A compact way to hold the whole set: liquidity ratios ask whether the company can pay its bills this year, leverage ratios ask whether it can survive a bad year, efficiency ratios ask whether the assets are working, and profitability ratios ask whether the business is worth owning.

One caution the exam rewards: depreciation, depletion and amortization are non-cash charges, so a company can report a loss while generating cash. That is why cash flow is analysed separately from earnings, and why a DPP's paper loss is not the same as a cash loss.

Technical analysis and market sentiment

Technical analysis studies price and volume rather than the business, on the premise that market action discounts everything and that patterns repeat.

The concepts the outline names: trend lines; support, the level where buying has repeatedly emerged; resistance, the level where selling has; a breakout through either; consolidation and stabilization; moving averages; and the chart patterns — the saucer and inverted saucer, and the head and shoulders, which is read as a reversal of an uptrend, with the inverted form reversing a downtrend.

Overbought and oversold describe a market that has moved far and fast in one direction and is due, on this analysis, for a correction.

Market sentiment indicators appear in the same section: the put-call ratio; short interest — which technicians read contrarily, since every short position is a future buy order; trading volume; market momentum; the availability of investable funds; and index futures.

For municipal securities specifically, the Bond Buyer indexes from lesson 4.4 serve the same purpose, along with the thirty-day visible supply and the placement ratio.

The exam does not ask you to endorse technical analysis. It asks you to recognize the vocabulary and, occasionally, to identify which discipline a given input belongs to: earnings per share is fundamental, a moving average is technical.

Portfolio theory

Risk divides into two kinds and the distinction drives every diversification question.

Systematic risk is market risk. It affects the whole market and cannot be diversified away — which is why it is hedged with index products rather than diversified against.

Unsystematic risk is specific to an issuer or an industry — business risk, credit risk, regulatory risk. It can be diversified away by holding many different issuers.

Beta measures a security's or a portfolio's volatility relative to the market. A beta of 1.0 moves with the market; above 1.0 is more volatile; below 1.0 less. Beta measures systematic risk only.

Alpha is the return above what beta would predict — the portion attributable to selection rather than to market exposure. A positive alpha is the manager's contribution.

The capital asset pricing model expresses the expected return on a security as the risk-free rate plus beta times the market risk premium. Its practical use on the exam is the idea that expected return is compensation for systematic risk only, because unsystematic risk could have been diversified away for free.

Diversification can be by asset class, by issuer, by industry, by geography, and for bonds by maturity and by rating. Asset allocation — the split among stocks, bonds and cash — is a strategic decision, and rebalancing returns a drifted portfolio to its targets. A strategic allocation is the long-run policy; a tactical allocation deviates from it deliberately.

For bond portfolios, duration measures interest rate sensitivity, and the strategies the outline implies are laddering — spreading maturities evenly to smooth reinvestment — and barbell — combining short and long maturities.

Other risks worth naming for the recommendation questions: inflation or purchasing power risk, which is what a portfolio entirely in cash is exposed to; reinvestment risk, absent only from zero-coupon instruments; call risk; liquidity risk; currency risk; legislative and political risk; and timing risk.

Building the recommendation

The exam's recommendation questions have a consistent shape: a customer profile, an objective, and four candidate products. Work them in a fixed order.

Read the objective first. Preservation of capital, current income, growth, tax advantage, speculation. This alone eliminates options in most questions.

Read the time horizon and liquidity needs. Money needed in eighteen months is not going into an illiquid product, a long bond, or anything with a surrender charge, whatever the customer's risk tolerance.

Read the tax status. A high bracket points toward municipals; a low bracket away from them. A tax-deferred account rules municipals out entirely.

Read the risk tolerance and the existing holdings. Concentration in one position is a problem to solve, not a preference to accommodate.

Then check the remaining candidates against the specific disqualifiers the course has established: no municipals in an IRA; no leveraged or inverse ETF as a long-term hold; no uncovered writing for a customer without the approval and the resources; no illiquid product against a near-term need; no share class whose ongoing cost exceeds an available alternative doing the same job.

A few standing matches worth having ready. Preservation of capital and short horizon: money market instruments, Treasury bills, bank instruments. Current income, taxable account, high bracket: municipal bonds. Current income, tax-deferred account: corporate bonds. Growth over decades: equity, and equity funds for a customer without the assets to diversify directly. Inflation protection: TIPS, and equities over the long run. A known future obligation on a known date: zero-coupon bonds, because there is no reinvestment risk. Protection of an appreciated position without selling: a protective put, or a collar if the customer wants it to cost nothing.

And the meta-rule that resolves close calls: the recommendation must be in the customer's best interest, not merely defensible. Where two products would both work, cost decides, and Regulation Best Interest says so explicitly.