SIE Chapter 13: Securities Analysis

Success by God's Hand

Systematic Risk

Risk affecting the whole market that can’t be diversified away

• Includes market risk

• Interest rate risk

• Reinvestment risk

• Inflation risk

Interest rate risk

The risk that bond prices fall as interest rates rise

Reinvestment risk

The risk of having to reinvest interest/dividends at a lower rate

Purchasing power (inflation) risk

The risk that returns don’t keep pace with inflation

Nonsystematic risk (diversifiable) risk

Firm or industry specific risk that can be eliminated through diversification

Liquidity (marketability) risk

Difficulty trading a security without negatively effecting its price

Capital risk

The risk of losing the entire investment

• More notable in options and warrants at expiration

Timing risk

Buying or selling at the wrong time

Business risk

A company underperforming expectations

Diversification

Spreading out investments:

Geographically, across maturities, credit ratings, sectors, and asset types

Portoflio rebalancing

Periodically buying and selling to restore a target asset allocation as markets drift a portfolio out of balance

Hedging

Taking a protective position (through options, diversification, and inflation resistant assets) to reduce risk but limits the upside

Fundamental analysis

Studies a company’s financials, management, and industry to determine whether a security is mispriced and what to buy

Balance Sheet

A snapshot of a company’s assets, liabilities and stockholder’s equity on a specific date in time

*Note: Equity section has par value of stock, APIC, treasury stock, and RE

Technical analysis

Studies price charts, volume and market sentiment to time trades; it assumes history and patterns tend to repeat

Broad based vs narrow-based indices

Broad based indices: reflect the whole market (ex. SP 500, Dow Jones Industrial Average)

Narrow-based indices: reflect one sector or industry (ex. Dow Jones Transportation Average)

Dow theory

Major market trends are considered confirmed when the DJIA and Dow Jones Transportation Average move in the same direction

Monetary policy vs Fiscal Policy

Monetary policy: The Federal Reserve’s control over money supply and interest rates

Fiscal policy: Government control over spending, borrowing and taxes

Easing (Federal reserve easing)

Increasing the money supply by lowering interest rates, which causes more borrowing and spending but also can increase inflation

Tightening: Federal reserve tightening

Decreasing the money supply by raising interest rates leading to less spending and lower inflation and stronger dollar

Open market operations

Buying and selling government securities through the FOMC (Federal Open Market Committee)

-This is the main tool the Federal reserve uses to control the money supply

Discount rate (federal reserve)

The interest rate the 12 Federal Reserve banks charge member banks for loans

Reserve requirement

The percentage of deposits banks must hold in reserve

Balance of Payments (BoP)

The net flow of money into vs out of the US from international transactions

Leading indicators of how the economy will perform in the future

M2 money supply (the fed’s estimate of money people have on hand)

Stock price

Fed funds rate

Discount rate (fed loan rate to members)

New construction (# building permits)

Unemployment claims

Orders for durable goods

Yield curves

Consumer sentiment

Coincident indicators

Reflect how the economy is doing right now:

Industrial production, personal income, GDP, employment rate, retail sales

GDP v GNP

GDP: Total goods/services produced in the US in a year

GNP: GDP + us residents’s and business’s abroad

NOTE: both GDP and GNP are measured in constant dollars (meaning inflation is factored in)

Cyclical Compnay vs Defensive company vs Growth company

• Cyclical company: performance reflects the economy (economy good they perform good, economy bad they perform bad)

• Defensive company: stable regardless of the economy (utilities, food, tobacco)

• Growth company: Grows fast than the market and reinvests profits rather than paying dividends to investors

Keynesian theory vs Supply-side theory vs monetarist theory

Keynesian Theory: Government fiscal intervention should stimulate demand

Supply side (Reaganomics) Theory: Lower taxes and less regulation allow the private economy to grow on its own

Monetarist theory: The money supply (fed policy) is the primary driver of economic performance