In 1934, a pair of Columbia Business School professors published a 725-page book called Security Analysis. Benjamin Graham and David Dodd argued that stocks had an intrinsic value that could be calculated by examining a company's financial statements—and that the market's mood swings created opportunities for disciplined investors who did their homework.
Around the same time, Charles Dow—founder of the Dow Jones Industrial Average and The Wall Street Journal—had already pioneered the idea that stock price patterns themselves contained useful information. His followers believed you didn't need to read a balance sheet if you could read a chart.
These two camps—fundamental analysis and technical analysis—have been arguing ever since. The Series 7 expects you to understand both, plus a third approach: portfolio analysis, which focuses not on picking individual securities but on building the right combination of them.
Topic 1: Technical Analysis
Charles Dow never actually called his ideas "technical analysis." He wrote a series of editorials in The Wall Street Journal between 1900 and 1902 observing that stock prices moved in identifiable trends. After his death, followers compiled his observations into what became known as "Dow Theory"—the grandfather of every chart pattern, moving average, and trend line used today.
Technical analysis focuses on price trends to gauge where the market or an individual security may be heading. Technical analysts—sometimes called "chartists"—believe that all relevant information is already reflected in the price, so studying price movements is the most efficient way to make investment decisions.
The core assumption: history tends to repeat itself. If a stock has bounced off a certain price three times before, it might do so again.
The Trend Line
A trend line is the most basic tool in technical analysis. It connects a series of prices over time to reveal the direction of movement.
- An uptrend shows prices making higher highs and higher lows—the line slopes up from left to right
- A downtrend shows prices making lower highs and lower lows—the line slopes down
The simplest question a technical analyst asks: "Is the trend your friend?" If a security is in an established uptrend, technicians expect it to continue until something breaks the pattern.
Seasons (Cyclical Patterns)
Patterns of up-and-down price movements that follow a repeating cycle are known as seasons or seasonal trends. Two classic chart shapes:
- Saucer — a U-shaped pattern where prices gradually decline, bottom out, and then gradually rise. Bullish reversal.
- Inverted Saucer — an upside-down U where prices rise, top out, and then decline. Bearish reversal.
Support, Resistance, and Breakouts
Resistance = the ceiling (price struggles to go higher)
Support = the floor (price struggles to go lower)
A breakout occurs when price pushes through either level.
A resistance level is a price point where a security repeatedly fails to move higher. Think of it as a ceiling that the price keeps bumping against. Sellers tend to emerge at this level, pushing the price back down.
A support level is the opposite—a price floor where buyers consistently step in, preventing the price from falling further.
When the price finally pushes through resistance, that's a breakout—generally considered bullish because the old ceiling has been overcome. If the price breaks below support, the signal is bearish.
Test Tip: Once resistance is broken, it often becomes the new support level (and vice versa). This concept of "role reversal" shows up on exam questions.
Consolidating Market
A market that moves within a narrow range—bouncing between support and resistance without making significant new highs or lows—is said to be consolidating. Also called sideways movement. Consolidation often precedes a significant move in one direction.
Head and Shoulders
The head and shoulders pattern is one of the most recognized reversal patterns in technical analysis. It signals a potential shift from bullish to bearish.
The pattern forms in three peaks:
- Left Shoulder — price rises, then pulls back
- Head — price rises higher than the first peak, then pulls back again
- Right Shoulder — price rises to roughly the same level as the left shoulder, then declines
When the price drops below the "neckline" (the support level connecting the two pullback lows), the pattern is confirmed. Technicians expect further decline.
Reverse Head and Shoulders
The mirror image. If the market has been trending downward and forms a reverse head and shoulders (three troughs with the middle one deepest), it signals a potential bullish reversal. The pattern is confirmed when price breaks above the neckline.
Moving Average
A moving average smooths out short-term price fluctuations to reveal longer-term trends. It's calculated by averaging a security's closing prices over a set number of days.
The 200-day moving average is the most widely followed. When a stock's price crosses above its 200-day moving average, technicians interpret this as bullish. When it crosses below, it's bearish. Portfolio managers at major firms watch this level religiously—it's one of those self-fulfilling prophecies where enough people believe in it that it actually affects trading behavior.
Market Strength Indicators
Technical analysts don't just study individual stocks—they study the health of the market itself. Several indicators help gauge market strength:
Short Interest Ratio
The short interest ratio measures how many shares have been sold short relative to average daily trading volume.
Here's the contrarian logic: a high short interest ratio is actually considered bullish. Every short seller eventually has to buy shares to close their position. All those short positions represent future buying pressure—a "short squeeze" waiting to happen.
Odd Lot Theory
This is a classic contrarian indicator. The theory holds that small investors—those buying fewer than 100 shares (an "odd lot")—tend to be wrong at market turning points.
- If odd lot purchases increase → contrarian view: bearish (small investors are buying near the top)
- If odd lot sales increase → contrarian view: bullish (small investors are selling near the bottom)
Test Tip: The odd lot theory and short interest ratio are both contrarian indicators. The exam loves to test whether you understand that these indicators say the opposite of what you might initially expect.
Advance/Decline Index
The advance/decline index measures market breadth—how many stocks are participating in a market move. Each day, the number of advancing stocks minus declining stocks is calculated and added to a running cumulative total.
| Day | Advances | Declines | Net | Cumulative |
|---|---|---|---|---|
| 1 | 600 | 1,400 | -800 | -800 |
| 2 | 800 | 1,200 | -400 | -1,200 |
| 3 | 1,000 | 1,000 | 0 | -1,200 |
A rising advance/decline line is bullish (broad market participation). A declining line is bearish (fewer stocks participating in the rally).
Put/Call Ratio
The put/call ratio compares the volume of put options purchased to call options purchased. A high ratio (more puts than calls) means bearish sentiment prevails among traders. Contrarian technicians interpret this as a bullish signal—when everyone is pessimistic, the market is more likely to go up.
Topic 2: Fundamental Analysis
When Benjamin Graham published The Intelligent Investor in 1949, he introduced a concept he called "Mr. Market"—an imaginary business partner who shows up every day offering to buy your shares or sell you his at a different price. Sometimes Mr. Market is euphoric and overpays. Sometimes he's depressed and offers bargains. Graham's insight was that you should take advantage of Mr. Market's mood swings, not be guided by them. His most famous student? Warren Buffett, who has called the book "by far the best book on investing ever written."
Fundamental analysis examines a company's financial statements to determine its intrinsic value. Where technical analysts study price charts, fundamental analysts study income statements and balance sheets. The goal: figure out whether a stock's current market price is justified by the company's actual financial health.
The Income Statement
The income statement shows a company's financial performance over a period of time—typically a quarter or a year. Think of it as a movie, not a photograph: it captures what happened between two dates.
− Cost of Goods Sold (COGS)
= Gross Profit
− Operating Expenses (SGA, depreciation)
= EBIT (Operating Income)
− Interest Expense
= EBT (Earnings Before Taxes)
− Taxes
= Net Income
Key Income Statement Terms
EBIT (Earnings Before Interest and Taxes) — also called operating income. This shows how well the company's core business performs before financing costs and taxes enter the picture. It's the purest measure of operational profitability.
EBITDA — adds depreciation and amortization back to EBIT. Useful for comparing companies with different capital structures and depreciation methods, because it strips out non-cash charges.
EBT (Earnings Before Taxes) — EBIT minus interest expense. This shows profitability after all expenses except taxes.
Net Income — the "bottom line." This is what's left after all expenses, interest, and taxes. Net income is what's available to shareholders.
Earnings Per Share
Earnings Per Share (EPS) is arguably the single most watched number in all of corporate finance.
If a company has convertible bonds, stock options, or warrants that could create additional shares, it must also report fully diluted EPS—which assumes all convertible securities have been converted to common stock.
Test Tip: Fully diluted EPS will always be equal to or lower than basic EPS, never higher. More shares in the denominator = smaller number. The exam tests this concept frequently.
The Balance Sheet
The balance sheet shows a company's financial position at a specific point in time—a snapshot, not a movie. It answers one fundamental question: what does this company own, what does it owe, and what's left for shareholders?
Assets = Liabilities + Shareholders' Equity
This equation must always balance. If it doesn't, someone is going to prison.
Assets (what the company owns):
- Current Assets — cash, accounts receivable, inventory, prepaid expenses (convertible to cash within 12 months)
- Fixed Assets — property, plant, and equipment (PP&E)
- Intangible Assets — goodwill, patents, trademarks
Liabilities (what the company owes):
- Current Liabilities — accounts payable, notes payable, accrued liabilities, wages payable (due within 12 months)
- Long-term Liabilities — bonds, mortgages, long-term debt
Shareholders' Equity (what's left for owners):
- Common stock (par value) + Capital in excess of par + Retained earnings
If a company's total equity is $1,528,000 and it has 100,000 shares outstanding, its book value per share is $15.28. If the stock trades at $25, the market is valuing the company at roughly 1.6× its book value—suggesting investors believe the company is worth more than its accounting value.
Measures of Liquidity
Liquidity ratios measure a company's ability to pay its short-term obligations. The exam focuses on three:
Positive working capital means the company has enough short-term assets to cover short-term debts. Negative working capital is a red flag.
A current ratio above 1.0 means the company can cover its short-term debts. Higher is generally better.
The quick ratio (also called the acid test) is a more conservative measure. It strips out inventory because inventory can't always be converted to cash quickly. If a company passes the acid test, it can meet short-term obligations even without selling any inventory.
Measures of Financial Leverage
Leverage ratios reveal how much debt a company carries relative to its equity and assets.
Higher debt-to-equity = more leverage = more risk. A company financed primarily by debt is more vulnerable in downturns because interest payments are mandatory regardless of profitability.
A ratio above 0.5 means more than half of the company's assets are financed by debt.
This measures whether a company can comfortably pay the interest on its debt. A ratio of 5× means the company earns five times its interest expense. Higher is better—and lenders pay very close attention to this number.
Inventory Valuation
How a company values its inventory affects its reported profits and tax liability. The exam tests four methods:
| Method | COGS | Reported Profit | Taxes |
|---|---|---|---|
| FIFO (First In, First Out) | Lower | Higher | Higher |
| LIFO (Last In, First Out) | Higher | Lower | Lower |
| Average Cost | Middle | Middle | Middle |
| Specific Identification | Actual cost per item | Varies | Varies |
Test Tip: Remember "FIFO = Fatter Income" in a rising price environment. Because the oldest (cheapest) inventory is sold first, COGS is lower and profits appear higher. LIFO has the opposite effect.
Inventory Turnover = COGS ÷ Average Inventory. Higher turnover means the company is selling inventory more quickly—generally a sign of efficiency.
Accounts Receivable Turnover = Net Sales ÷ Average Accounts Receivable. Higher is better—the company is collecting on credit sales more efficiently.
Cash Flow Statement
The cash flow statement tracks actual cash moving in and out of the company. It has three sections:
- Operating Activities — cash from day-to-day business operations
- Investing Activities — cash from buying/selling assets and investments
- Financing Activities — cash from issuing stock, paying dividends, borrowing
A company can report positive net income but still have negative cash flow (and vice versa). The cash flow statement reveals the truth behind the accounting.
Valuation Ratios
The P/E ratio is the most widely used valuation metric. A high P/E may indicate the stock is overvalued—or that investors expect strong future growth. A low P/E may indicate undervaluation—or that the company's prospects are dim.
A P/B ratio above 1.0 means the market values the company above its accounting (book) value. Most healthy, growing companies trade above book value.
Financial Footnotes
Don't skip the footnotes. Financial statement footnotes can reveal accounting methods used, contingent liabilities, related-party transactions, and off-balance-sheet items. On the exam—and in real life—the footnotes can completely change your interpretation of the numbers.
Topic 3: Portfolio Analysis
In 1952, a 25-year-old graduate student named Harry Markowitz published a 14-page paper called "Portfolio Selection" in The Journal of Finance. His insight was deceptively simple: investors should evaluate securities not in isolation but in the context of their entire portfolio. Diversification wasn't just common sense—it could be mathematically optimized. That paper earned him a Nobel Prize in Economics in 1990 and launched the entire field of modern portfolio theory.
Portfolio analysis shifts the focus from individual securities to how those securities work together. The central question: how do you build a portfolio that maximizes return for a given level of risk?
Systematic vs. Nonsystematic Risk
Nonsystematic risk (company-specific, diversifiable) — can be reduced by adding
more positions to a portfolio.
Systematic risk (market risk, non-diversifiable) — cannot be diversified away.
It affects the entire market.
If your portfolio holds only one stock, a single piece of bad news can devastate its value. That's nonsystematic risk—risk that's specific to a company or industry. Add more positions across different sectors and this risk shrinks.
But no amount of diversification eliminates systematic risk. When interest rates rise, nearly all bond prices fall. When the economy enters a recession, most stocks decline. That's market-wide risk, and it's always present.
Beta
Beta measures the correlation between a security's price movement and the overall market (typically the S&P 500, which has a beta of 1.0).
| Beta | Meaning | Example |
|---|---|---|
| > 1.0 | More volatile than the market | High-tech stocks (beta ~1.2) |
| = 1.0 | Moves in line with the market | Broad market index fund |
| < 1.0 | Less volatile than the market | Utility companies (beta ~0.8) |
A stock with a beta of 1.2 is expected to be 20% more volatile than the market. If the market rises 10%, that stock should rise about 12%. If the market drops 10%, expect a 12% decline.
Test Tip: High beta = high risk = high expected return. Conservative clients should hold lower-beta portfolios. Aggressive growth investors tolerate higher betas.
CAPM and the Risk Premium
The Capital Asset Pricing Model (CAPM) provides a framework for calculating the expected return on a security.
The risk-free rate is typically the Treasury bill rate. The difference between the market return and the risk-free rate is the risk premium—the additional return investors demand for taking on market risk.
Alpha
Alpha measures the difference between a security's actual return and its expected return (as predicted by CAPM).
- Positive alpha: the investment outperformed expectations. A fund manager who consistently generates positive alpha is "beating the market."
- Negative alpha: the investment underperformed expectations.
This is the heart of the active vs. passive management debate. Active managers believe skilled analysis can generate positive alpha. Passive investors argue that after fees and taxes, most active managers fail to deliver it consistently—which is why index funds exist.
Asset Allocation Strategies
Strategic Asset Allocation
Strategic asset allocation sets target percentages for each asset class based on the investor's objectives, risk tolerance, and time horizon.
| Asset Class | Target | Minimum | Maximum |
|---|---|---|---|
| U.S. Government T-Bills | 20% | 5% | 50% |
| Corporate Bonds | 30% | 15% | 50% |
| Large-Company Stocks | 50% | 25% | 75% |
The minimum and maximum ranges allow tactical adjustments based on market conditions—without letting the manager go all-in on a single bet.
Tactical Asset Allocation
Within the strategic framework, a manager can make tactical adjustments—shifting weights toward asset classes that appear undervalued or away from those that appear overvalued. The minimum/maximum constraints prevent extreme positions.
Active vs. Passive Management
Active management relies on fundamental analysis to identify undervalued securities within each asset class. The goal is to generate returns above the benchmark (positive alpha). The trade-off: higher fees, higher transaction costs, and potential tax consequences from frequent trading.
Passive management accepts that markets are generally efficient and uses index funds to match market returns at minimal cost. No attempt is made to beat the market—just to capture its returns with the lowest possible expenses.
Constant Dollar Plan: A fixed dollar amount is allocated to equities. If equities rise above this amount, the excess is transferred to bonds. If equities fall below, bonds are liquidated to buy equities back to the target dollar amount.
Constant Ratio Plan: A fixed percentage is allocated to equities. As prices change, the portfolio is rebalanced to maintain the target percentage across asset classes.
Investment Styles
Indexing
Using index funds that mirror a broad market benchmark (S&P 500, S&P 400 Mid Cap, etc.) to achieve diversification efficiently. The premise: markets are efficient, so trying to beat them wastes time and money.
Growth Investing
Selecting stocks based primarily on earnings growth or stock price momentum. Growth investors seek companies whose earnings are growing faster than the market average, often accepting higher valuations in exchange for higher expected growth.
Value Investing
Selecting stocks that appear fundamentally undervalued relative to their peers. Value investors examine P/E ratios, price-to-book ratios, and other fundamentals to find solid companies that are temporarily out of favor. The expectation: over time, the market will recognize the company's true worth and the stock price will rise to reflect it.
Key Terms Glossary
| Term | Definition |
|---|---|
| Technical analysis | Study of price trends and chart patterns to predict future movements |
| Trend line | Line connecting prices over time to show direction |
| Support level | Price floor; buyers step in preventing further decline |
| Resistance level | Price ceiling; sellers emerge preventing further rise |
| Breakout | Price pushing through support or resistance |
| Head and shoulders | Bearish reversal pattern with three peaks |
| Moving average | Average of closing prices over a set period (e.g., 200 days) |
| Short interest ratio | Shares sold short ÷ avg daily volume; high = contrarian bullish |
| Odd lot theory | Small investors tend to be wrong; contrarian indicator |
| Advance/decline index | Net advances minus declines; measures market breadth |
| Put/call ratio | Put volume vs. call volume; high ratio = contrarian bullish |
| Fundamental analysis | Examining financial statements to determine intrinsic value |
| EBIT | Earnings Before Interest and Taxes (operating income) |
| EBITDA | EBIT + Depreciation + Amortization |
| EPS | Net Income ÷ Shares Outstanding |
| Fully diluted EPS | EPS assuming all convertible securities are converted |
| Current ratio | Current Assets ÷ Current Liabilities |
| Quick ratio (acid test) | (Current Assets − Inventory) ÷ Current Liabilities |
| Debt-to-equity | Total Debt ÷ Total Equity |
| Interest coverage | EBIT ÷ Annual Interest Expense |
| FIFO | First In, First Out; lower COGS, higher profits in rising prices |
| LIFO | Last In, First Out; higher COGS, lower profits in rising prices |
| P/E ratio | Market Price ÷ EPS; most widely used valuation metric |
| P/B ratio | Market Price ÷ Book Value per Share |
| Systematic risk | Market risk; cannot be diversified away |
| Nonsystematic risk | Company-specific risk; reduced through diversification |
| Beta | Measure of a security's volatility relative to the market (S&P 500 = 1.0) |
| Alpha | Actual return minus expected return |
| CAPM | Expected Return = Risk-Free Rate + Beta × (Market Return − Risk-Free Rate) |
| Strategic asset allocation | Setting target percentages for each asset class |
| Active management | Seeking alpha through security selection |
| Passive management | Index-based approach; match market returns at low cost |
Chapter 17 brings together the analytical tools that drive investment decisions: reading charts, reading balance sheets, and building portfolios that match a client's risk profile. Whether those decisions add value after fees is a debate that has launched a thousand academic papers and at least one very successful index fund company in a suburb outside Philadelphia.