The Federal Reserve raises rates by 75 basis points. Bond prices drop, the yield curve inverts, and unemployment stays low for another six months. On the Series 65, you need to connect those dots instantly, which indicator is leading, which is lagging, and what the combination signals for your client's portfolio.
The economy moves through four phases in a fixed order: expansion, peak, contraction (recession), and trough. After the trough, expansion begins again.
During expansion, GDP grows, unemployment falls, and corporate earnings rise. The peak marks the highest point, after that, growth slows and eventually turns negative. Two consecutive quarters of declining GDP is the common definition of a recession. The trough is the bottom. Recovery starts there.
KEY: The phase that immediately follows the trough is always expansion. This is a direct exam question.
Not all data points move at the same time. The exam sorts them into three categories based on timing relative to the business cycle.
Leading indicators change direction before the economy does. They predict where things are headed. Key examples: building permits, stock prices (S&P 500), average weekly manufacturing hours, new orders for manufactured...
Common mistakes
- Confusing leading and lagging indicators. The unemployment rate feels like it should predict trouble, but it is lagging (it confirms a recession after it has started. Stock prices feel like they reflect current conditions, but they are leading) markets anticipate 6-12 months ahead. Trap answer: "The unemployment rate is a leading indicator."
- Using book value instead of market price in dividend yield. Dividend yield = Annual dividend / Market price. If you use book value in the denominator, you get a much higher number. With a $1.80 dividend, a $60 market price, and $20 book value, the correct yield is 3.0%.
- Reversing the P/E formula. P/E = Price / Earnings, not Earnings / Price. A stock at $40 with EPS of $8 has a P/E of 5, not 0.20. Earnings / Price gives you the earnings yield, which is a different metric. Trap: 0.20 or 0.2 will appear as a choice.
Bottom line
- Business cycle order: expansion, peak, contraction, trough, then expansion always follows the trough and it repeats
- Leading indicators predict turns; lagging indicators confirm them; coincident indicators measure the present
- Fed raises rates to fight inflation and lowers rates to stimulate growth; bond prices move inversely to rates
- Fed's monetary tools: the federal funds rate, open market operations, the discount rate, and reserve requirements
Exam shortcut
When a question asks about an indicator's type, ask yourself: does this measure predict the future or confirm the past? Anything involving new orders, permits, or consumer sentiment predicts. Anything involving unemployment duration, the prime rate, or corporate profits confirms. The S&P 500 is leading, markets look forward. For ratio questions, check the denominator. Dividend yield and P/E both use market price, not book value. ROA uses total assets.
The full lesson (about 3,293 words, 22 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- A1
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