Business and Economic Factors

Economies do not grow in a straight line. They move through a repeating rhythm of ups and downs called the business cycle, and the exam wants you to recognize each phase and what is happening to growth and jobs along the way. There are four phases:

1. Expansion: the good times. GDP is growing, employment is rising, and consumer spending is climbing.
2. Peak: the high point, where growth plateaus and the economy is running about as hot as it gets before it turns.
3. Contraction: the downturn. GDP falls, unemployment rises, and spending pulls back. The classic definition to memorize: two consecutive quarters of declining GDP is a recession.
4. Trough: the low point, where the economy bottoms out and sets up for the next recovery.

One subtlety the exam likes: because unemployment is a lagging indicator, it tends to keep climbing into the trough and peaks at or just after the bottom, even as the economy starts to turn back up.

Economists watch dozens of statistics to figure out where the economy is and where it is headed. The exam groups them into three families by their timing relative to the economy, and the whole game is knowing which family a given indicator belongs to.

Leading indicators (they move first)

These turn before the economy does, so they help predict where things are going:

• Stock market performance (the S&P 500)
• Building permits for new housing
• New orders for durable goods
• Consumer expectations and confidence surveys
• Initial unemployment claims (inverted, since rising claims signal a slowing economy)
• The money supply (M2)
• The shape of the yield curve

Lagging indicators (they confirm after the fact)

These turn after the economy has already shifted, so they confirm a trend rather than predict it:

• The unemployment rate
• Corporate profits
• The Consumer Price Index (CPI)
• Outstanding bank loans and the average duration of unemployment
• The prime rate

Coincident indicators (they move in step)

These rise and fall at the same time as the economy:

• GDP
• Industrial production
• Personal income
• Nonfarm employment

Prices do not sit still, and the direction and speed they move tells you a lot about the economy. Four terms cover the possibilities, and the exam expects you to tell them apart:

• Inflation is a sustained rise in the general price level. It erodes purchasing power and is measured by the CPI and PPI. The Fed targets roughly 2% annual inflation.
• Deflation is a sustained fall in prices. It sounds nice but is dangerous: if things will be cheaper later, people put off buying, which can drag the economy into a downward spiral.
• Stagflation is the nasty combination of stagnant growth and high inflation at the same time. It is the worst of both worlds, because the usual fix for one makes the other worse.
• Disinflation is simply a slowdown in the rate of inflation. Prices are still rising, just more slowly. Do not confuse it with deflation.

What it means for investments

Rising inflation hits fixed-income investors hardest, since a bond's fixed coupon buys less each year (TIPS are the built-in hedge). Equities can offer partial protection when companies are able to pass higher costs on to customers, and real assets like real estate, commodities, and gold tend to hold up well when prices are climbing.

The FINRA outline expects you to know two competing schools of thought on how to steer an economy. You do not need the academic depth, just which lever each one favors.

Keynesian economics

Keynesians believe the government should actively manage the economy through fiscal policy, meaning spending and taxation. In a recession, the prescription is to spend more or cut taxes to prop up demand. The focus is on aggregate demand as the engine of output.

Monetarist economics

Monetarists argue the economy is best managed through monetary policy, by controlling the money supply. Their view is that the Fed should aim for steady, predictable growth in the money supply: too much fuels inflation, too little tips the economy toward recession.

The SIE will not ask you to analyze a company's books, but it does expect you to know what the two main financial statements show.

The balance sheet

A balance sheet is a snapshot of a company's financial position at a single moment in time. It is built on the fundamental accounting equation, assets = liabilities + shareholders' equity: what the company owns equals what it owes plus what is left over for the owners. Assets are things like cash, inventory, and property; liabilities are debts and payables; shareholders' equity is the residual, assets minus liabilities.

The income statement

An income statement (or profit and loss statement) covers a period of time rather than a single moment, and shows revenue, expenses, and the resulting profit or loss: revenue minus expenses equals net income. From there, earnings per share (EPS) is simply net income divided by the number of shares outstanding.

Not all stocks react to the economy the same way, and the exam uses three labels for the difference:

• Cyclical stocks rise and fall with the business cycle, doing well in expansions and poorly in downturns. Think autos, travel, and luxury goods, the things people buy freely when times are good and cut first when they are not.
• Defensive stocks hold steady regardless of the cycle, because they sell things people need no matter what: utilities, food, and healthcare.
• Growth stocks are companies focused on rapid earnings growth. They typically reinvest their profits rather than paying dividends.

U.S. markets do not exist in a vacuum, and the exam tests a few ways the global economy reaches your portfolio.

GDP versus GNP

Two measures of national output sound alike but count different things:

GDP is the headline number and the one the SIE cares about. A rising GDP signals expansion; two consecutive quarters of falling GDP is the textbook definition of a recession.

The balance of payments

The balance of payments tracks every economic transaction between a country and the rest of the world, in two parts. The current account covers trade in goods and services plus investment income; when a country imports more than it exports, it runs a trade deficit. The capital account covers cross-border investment flows in both directions. A persistent trade deficit sends more dollars abroad, which can weigh on the dollar's value.

Exchange rates and your returns

When a U.S. investor owns foreign securities (or ADRs), the return depends on two things: how the investment performed and what the exchange rate did. A strengthening dollar reduces foreign returns, because each unit of foreign currency converts back into fewer dollars. A weakening dollar increases them. This currency effect is layered on top of the investment's own gain or loss.