The Economy and the Markets

Prices respond to two things: how a company is doing, and how the economy is doing. The exam expects you to read a company's two main statements, place the economy in its cycle, and say which securities do well there. This lesson covers the domestic picture first, then the international one.

The two financial statements

A company publishes financial statements so investors can judge its health. Two of them show up on the exam.

The balance sheet is a snapshot of what a company owns and owes on one specific date. It has three parts:

• Assets: what the company owns, such as cash, inventory, and buildings.
• Liabilities: what the company owes, such as loans and unpaid bills.
• Shareholders' equity: what is left for the owners after the liabilities.

Assets always equal liabilities plus shareholders' equity. That is why it is called a balance sheet.

The income statement covers a period of time, usually a quarter or a year. It starts with revenue (the money from sales), subtracts costs and taxes, and ends with net income (the profit). Divide net income by the shares outstanding to get earnings per share (EPS).

The exam likes to swap these two. Remember: the balance sheet is one day, the income statement is a stretch of time.

The business cycle

The economy grows and shrinks in a repeating pattern called the business cycle. It runs in this order:

1. Expansion: output, jobs, and spending rise.
2. Peak: growth tops out and turns.
3. Contraction: output and jobs fall.
4. Trough: the low point, just before the next expansion.

A contraction that drags on is a recession. A common rule of thumb calls two straight quarters of falling GDP a recession. A depression is a contraction that is deeper and much longer.

Indicators: leading, coincident, lagging

An economic indicator is a statistic that tells you where the economy is heading or where it has been. The exam sorts indicators by timing.

• Leading indicators move before the economy does: building permits, new orders for durable goods, initial jobless claims, stock prices, and the money supply.
• Coincident indicators move with the economy: GDP, industrial production, personal income, and nonfarm payrolls.
• Lagging indicators move after the economy has already turned: the unemployment rate (specifically, how long people stay unemployed), corporate profits, business inventories (the inventories-to-sales ratio), and the CPI.

Inflation is a general rise in prices, which cuts the purchasing power of a dollar. The Consumer Price Index (CPI) measures it by tracking the price of a basket of consumer goods. The Bureau of Labor Statistics publishes the CPI every month. The CPI lags. Students call it leading because it is a headline number, and the exam runs that trap.

What the cycle does to stocks and bonds

Where the economy sits changes which securities hold up. Three labels matter:

• Cyclical stocks rise and fall with the economy. Autos, airlines, steel, and luxury goods are cyclical.
• Defensive stocks hold up when the economy weakens. Food, utilities, and household basics are defensive, because people buy them in any economy.
• Growth stocks belong to companies that reinvest profits to expand fast. They pay small dividends or none.

Bonds answer to interest rates. When rates rise, older bonds with lower coupons look worse, so their prices fall. Bond prices and interest rates move in opposite directions, and rising inflation usually pushes rates up.

Two economic theories

Keynesian theory says the government should manage total demand. When private spending falls, the government spends more or cuts taxes to fill the gap. That is fiscal policy.

Monetarist theory says the money supply is the lever that matters. Milton Friedman argued that steady, predictable growth in the money supply keeps prices stable. That points to monetary policy, which the Federal Reserve runs.

Keep one line: Keynesians reach for government spending and taxes, monetarists reach for the money supply.

The international picture

GDP (gross domestic product) is the value of goods and services produced inside a country's borders. GNP (gross national product) is the value produced by a country's citizens and companies, wherever they produce it. GDP counts the borders, GNP counts the citizens.

The balance of payments records every transaction between the US and the rest of the world over a period. The current account covers trade in goods and services plus income. The capital account covers investment flows. A deficit means more money left the country than came in.

An exchange rate is the price of one currency in another. A weak dollar makes US goods cheaper abroad, which helps US exporters. A strong dollar makes foreign goods cheaper for Americans, which helps importers and US travelers.

How this gets tested

Questions here are short and ask you to sort things. Which phase follows the peak? Contraction. Which indicator lags? The CPI. Which stocks hold up in a recession? Defensive. A weak dollar helps whom? US exporters.