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Questions and Answers
What is the primary action taken by the Bank when inflation rises during an economic expansion?
What effect does raising short-term interest rates typically have on long-term bond yields?
What does a 'tilting of the yield curve' refer to?
Which of the following is NOT a typical result of rising inflation?
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What is a potential result of long-term bond yields falling?
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How do manufacturers typically respond to the rise in inventory and labor costs due to inflation?
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Which sector includes an industry group focused solely on Energy?
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Which industry group is classified under Consumer Staples?
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What is a challenge in classifying an industry based on the product or service it sells?
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Which sector is associated with the industry group 'Pharmaceuticals, Biotechnology and Life Sciences'?
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Which sector encompasses 'Banks' as one of its industry groups?
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The sector that covers 'Telecommunication Services' is known as what?
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Which of the following industry groups is NOT found within the Industrials sector?
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Which sector includes 'Utilities' as the sole industry group?
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What does a price breaking through the moving average line from above indicate?
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How do contrarian investors use sentiment indicators?
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What can a sentiment indicator showing that 80% of investors are bullish imply?
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What does the theory of cycle analysis assume?
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What occurs when the moving average line itself starts to fall?
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What is the primary role of the 65-week moving average mentioned?
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What is a characteristic of defensive industries?
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Which factor is NOT a characteristic of blue-chip companies?
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What happens to bank stock prices when interest rates rise?
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What defines speculative industries?
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How do utility companies fit into the classification of defensive stocks?
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What is a common trait of shares in emerging industries?
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What primarily attracts investors to speculative shares?
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Which of the following is true regarding the price sensitivity of bank stocks?
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Which statement best describes growth companies?
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What is the primary consequence of the consolidation phase in emerging industries?
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Study Notes
Inflation and Short-term Interest Rates
- When inflation rises during economic expansion, central banks often raise short-term interest rates.
- The purpose of raising rates is to slow economic growth and control inflation.
- This action can lead to more moderate growth or even a growth recession, a temporary economic slowdown.
Yield Curve Tilting
- When short-term rates increase to slow economic growth, long-term bond yields might fall.
- This indicates that investors believe the economic slowdown is appropriate.
- When short-term yields rise and long-term yields fall, this change in the yield curve is called tilting.
- The rise in short-term interest rates slows down the increase in bond yields.
- Long-term bond yields continue to rise, but at a slower pace.
- As short-term rates rise, economic growth usually slows.
- Long-term bond prices stabilize and fall below equity prices for a short time.
- With each increase in short-term interest rates, long-term bond yields fall.
- Investors buy long-term bonds, assuming a slower economic growth will reduce the need for higher interest rates in the near future.
- Increased long-term bond purchases push their yields lower, indicating bond market participants are satisfied with the slower economic growth.
- A drop in long-term rates reduces competition between equities and bonds.
- Over time, higher real bond yields increase competition between bonds and equities, slowly undermining equity markets.
Impact of Inflation
- Inflation creates uncertainty, undermining future confidence.
- These factors lead to higher interest rates, lower corporate profits, and lower price-earnings multiples.
- Inflation increases inventory and labor costs for manufacturers.
- Manufacturers pass on these higher costs to consumers in the form of higher prices.
- The Global Industry Classification Standard (GICS) classifies industries into eleven sectors and 25 industry groups, although some sectors have only one industry group.
Defensive Industries
- Defensive industries have stable returns on investor equity and perform well during recessions.
- Blue-chip companies, with high investment quality, maintain earnings and dividends through economic cycles.
- These companies often have dominant market positions, strong internal financing, and effective management.
- Canadian banks are considered blue-chip industries, but their stock prices are sensitive to interest rate changes.
- As interest rates rise, banks need to increase deposit rates to attract funds.
- A significant portion of bank revenue comes from fixed-rate mortgages, leading to a profit squeeze when rates rise.
- Bank stock prices are particularly sensitive to changes in long-bond yields.
- Utility companies (gas, water, electricity) are also considered defensive, blue-chip stocks due to consistent earnings over economic cycles.
- However, utility stocks with high debt levels are sensitive to interest rate changes.
Speculative Industries
- All common share investments are speculative due to ever-changing stock market values.
- The term "speculative industry" refers to industries with high risk and uncertainty because of limited analyst information.
- Shares of such companies are called speculative shares.
- Emerging industries are often considered speculative.
- The profit potential of new products attracts many companies, leading to initial rapid growth.
- During industry consolidation, many companies fail, and a few emerge as leaders.
- These leaders' success is based on factors such as better management, financial planning, products, services, or marketing.
- The term "speculative" can also apply to large companies whose shares are treated as speculative.
- Growth companies with exceptional growth expectations can have their shares bid up to high multiples of earnings per share.
Technical Analysis
- Technical analysis uses patterns to predict future price trends.
- Technicians study supply and demand effects on prices.
Efficient Market Hypothesis
- The efficient market hypothesis states that security prices reflect available information, representing true value.
Random Walk Theory
- The random walk theory assumes that price changes are random and unrelated to past changes.
Sentiment Indicators
- Sentiment indicators measure investor expectations.
- Contrarian investors use these indicators to determine the majority's future price expectations and invest in the opposite direction.
- Contrarians believe a majority of investors expecting price increases indicates limited buying power for further price growth.
- Sentiment indicators should be used as supporting evidence for other technical indicators.
- Services measuring market sentiment (bullish or bearish) can indicate overbought conditions, especially when other indicators confirm it.
Cycle Analysis
- Cycle analysis helps forecast market direction, movement, and peak or trough timing.
- The theory assumes cyclical forces drive market price movements.
- Cycles can range from a few days to decades.
- The four general cycle categories are long-term (over 2 years), seasonal (1 year), primary/intermediate (9-26 weeks), and trading (4 weeks).
- Cycle analysis is complicated by the presence of multiple cycles at any given time.
- Cycle analysis identifies the timing of market peaks or troughs.
- Combine cycle analysis with trend analysis and chart formations to confirm market turns and action steps.
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