Understanding Stock Market

8/8/2019 Understanding Stock Market

1/14

Understanding

Stock MarketFluctuations:The Turmoil at the Heart o

the Capitalist System

JA Worldwide


2/14FINANCIAL L ITERACY WORK READINESS ENTREPRENEURSHIP

IntroductionOn October 9, 2007, the Dow Jones Industrial Index, a popularmeasure o the overall movement in stock prices, hit a record high o14,164. On November 20, 2008, just 13 months later, the Dow closed at7,552, down 47percent rom the peak. Why did stock prices decline so

much? What impact is the decline having on the economy? Is the declinea sign that we are on the brink o another Great Depression? What,i anything, should the ederal government do to arrest the decline?Daunting questions to be sure; to move toward some answers, lets startby reviewing some basics.

Back to BasicsMost major corporations in the United States are publicly owned.Tis means that at some time in the past the ounders o a particularcompany oered stock to the public. More precisely, the ounders sold

their ownership in the company to the public; the public acquired thecommon stock, or ownership shares, also called equity, in the company,and the original owners received money or selling some or all o theirownership shares. Te purchasers o the stock have acquired a share o theearnings and assets o the company.

What is a share o stock worth?What would you be willing to pay per share to acquire one or even50,000 shares o stock in a company? Just stop or a minute and thinkabout the basics noted in the previous paragraph; I hope you said to

yoursel, it depends. I you did, you are correct. Te next question toask is what does it depend on? Te general answer, but one that yieldsall the real insight you need, is that it depends on what return you couldearn by investing your money elsewhere, say on treasury bonds yielding5 percent per year issued by the U.S.government, and what you expectyou could earn by acquiring stock ina company (or group o companies).o anticipate what we will discussin more detail, it should be readily

apparent that i you expect stock pricesto decline, whatever the reason, youprobably will decide to hold less stock

Dow Jones Industrial

Index: The Dow, or short, is

the sum o the daily closing

prices o the 30 largest U.S.

companies. The companies

that make up the Dow areselected by Dow Jones

& Company, which also

publishes The Wall Street

Journal. Those companies

included in the index change

over time to reect changes

in corporate America. Some

o the companies included

currently are Boeing, Exxon

Mobil, Home Depot, Wal-Mart

and Walt Disney.

Written by Raymond Lombra

rofessor of Economics, Pennsylvania State University


3/142

JUNIOR ACHIEVEMENT WWW.JA.ORG

and more treasury bonds and other types o nancial assets. But i you,and many others, sell stock, then stock prices will in act decline!

Te expected return on stock sounds like a daunting concept, but we candemystiy it here.

Expected Return on Stock

Lets assume you want to calculate the expected return on a share o stockover a year. Te return or yield, shown as a percentage, consists othree parts:

e price you will pay for a share today (say $50). e price you expect to prevail in one year (say $53). e dividend per share you expect the company to pay to

shareholders like yourself over the year (say $2).

In this case, the expected return would be 10%, that is, the estimatedincrease in price ($3), typically referred to as a capital gain, plus theestimated dividend ($2), all divided by the price today ($50), or[(53-50)+2)]/50=0.10.

Note the key role o expectations in arriving at the estimated return onstocks. I the price is not expected to change at all, then the expectedreturn will be only 4%, or [(50-50)+2)]/50=0.04.

o be sure you understand this concept, make up an example thatproduces a negative expected return.

Te essential ingredient to generating an estimateo the return on stock compared to other nancialassets is what you expect the company will earn overtime. Te more you think the company will earn,the higher you expect uture dividends and shareprices to be; the latter only makes senseremember ashareholder owns a portion o a rms earnings andits assetsthe higher are earnings, the more investorswill be willing to pay or the stock in the uture.Note or later reerence, it is what you expect thecompany will earn over timenext month, next yearand beyondnot what the company is earning today.

The Great Depression:

The Great Depression was

a worldwide economic

downturn. It started in most

places in 1929, ending at

dierent times in the 1930sor early 1940s or dierent

countries. It was the largest

economic depression in

modern history, and is used

in the 21st century as an

example o how ar the

worlds economy can all. The

Great Depression originated in

the United States; historians

most oten use as a starting

date the stock market crash

on October 29, 1929, oten

reerred to as Black Tuesday.

The end o the depression

in the United States is

associated with the onset

o World War II, beginning

around 1939. To illustrate the

severity o the downturn in

the U.S., between 1929 and

1933, the unemployment rate

increased rom 3 percent to

25 percent, while the Dowell 89 percent between Black

Tuesday and the summer

o 1932.


4/143

FINANCIAL L ITERACY WORK READINESS ENTREPRENEURSHIP

Tis consideration helps explain why investors are willing to acquire stockin companies today that may be losing money; they expect earnings toemerge at some point. It also helps explain why nancial analysts otensay the stock market is orward lookingstock prices reect expectationsabout what will happen in the uture.

Subsequent to that initial public oering o stock, the shares o thelargest companies are tradedon an exchange. Tis is nothing more thana marketplace where the existing shares outstanding can be bought andsold. Te most prominent exchange is the New York Stock Exchange,located on Wall Street in New York City; this is where the shares o morethan 3,900 U.S. companies are traded every day. Not surprisingly, it isoten reerred to as the heart o our capitalist system.

It is worth dwelling or a moment on that term tradedor everyshare o stock sold, there must be a buyer. On any given day, i the

owners o a particular stock, be they individual investors or so-calledinstitutional investors, such as mutual funds, decide to sell a largernumber o shares than other investors are prepared to buy, the price othe stock will all and keep alling until enough buyers step orward tobuy the total number o shares being oered or sale. Conversely, i morebuyers place orders to purchase a given number o shares o stock on aparticular day than are available or sale, the stock price will rise; its theincrease in the price that will induce some holding the stock to now sellit. Tis interaction between the sellersthat is, holders o the existingsupply o stock who are oering to sell some or all o their holdingsandbuyersthose demanding stock, is what drives stock prices up or down.

On any given day, the price that a stock closes atthe market opens at9:30 a.m. each day and closes at 4:00 p.m. Eastern imecan bethought o as the price that equilibrates supply and demand, that is,brings supply and demand into balance. While this notion is helpulin understanding how stock prices move over time, I think we cando even better.

Institutional Investors:

The largest investors in the

stock market mutual unds,

insurance companies, and

pension unds are typically

reerred to as institutionalinvestors. Institutional

is actually a synonym or

large. They are buying and

selling thousands o shares o

stock in a particular company

compared to the hundreds

o shares more typical o

individual investors.

Mutual Funds: Mutual unds

are companies that pool the

unds o many investors andthen invest in hundreds or

even thousands o stocks,

and perhaps other fnancial

assets. They allow individual

investors to diversiy their

holdings more than might

otherwise be the case by

owning a small piece o the

larger basket o stocks and

other assets held by the

mutual unds.


5/144


Cracking the Code

Here is a selection rom a typical stock page o a major newspaper.Te specic entry is or Gap Inc., a popular clothing store, or November 25, 2008:

High Low Stock Sym Div Yld% PE Vol 100s Close Net Change

12.66 11.82 Gap Inc. GPS .085 2.82 8.9 10,080 12.05 0.01

e quarterly dividend paid by the Gap is 8.5 cents per share,implying an annual dividend o 34 cents per share (4 x 8.5=34).

e price of one share of stock of the Gap at the close was $12.05,down 1 cent rom the close the previous day.

e annual dividend is divided by the closing price to get the currentreturn or yield (Yld %) on the stock; dividing 34 cents by $12.05gives the current yield o 2.82%.

e PE, or price-to-earnings ratio, is 8.9. Stocks with low PE ratioscompared to other rms in the same industry are oten thought to beundervalued, and stocks with higher PE ratios than competitors areoten thought to be overvalued.

e Vol column tells us that the Gap traded 10,080,000 shareson November 25.

e high and low closing prices for Gap stock over the last 52 weeks

indicates that those who bought at $11.82 are happier than those whobought at $12.66.

gh closing price or Gap stock

ver the previous 52 weeks

The quarterly dividend paid by the Gap

The change in the stocks

rom that o the previous The price o one share o

Gap stock at market close

52 weeks Source: CNN Money.com

The current return or yield on the stock

The companys ticker symbol

Price-to-earnings ratio (the price per share

compared to the companys earnings per share)

The name o the company

The number o shares the Gap traded that day

Low closing price or Gap stock

over the previous 52 weeks


6/145


Key PointsThe purchasers o stock own a share o a companys earnings

and assets.

The value o a share is a unction o the companys uture earnings,

which helps determine the expected return on the stock over time,

compared to the expected return on alternative assets.

What explains changes in the price

o a share o stock?Imagine on one side o the street are the optimists, who currently holdthe stock o Apex Corporation (a hypothetical company). Tey like thecompanys management team, they are optimistic about the competitiveposition o Apex in the industry, domestically and globally, and they areoptimistic about the perormance o the economy. Hence, they expect

the demand or Apexs products to be strong and the companys earningsto grow, more or less steadily, or the oreseeable uture. Simply put, withearnings expected to grow, they expect Apexs dividends and stock price torise in the uture. Tey expect to earn an attractive return on Apex stockcompared to what they might earn on alternative nancial assets; they areoten called the bulls.

On the other side o the street are those who are pessimistic, at least tosome degree about one or more o the actors listed in the precedingparagraph: they might eel other companies in the particular industry orset o industries that Apex competes in will do better competing or new

customers, or they may eel that the United States economy is likely tobe very weak over the next year or two, perhaps slipping into a recession.Such weakness would translate into weaker demand or Apexs productsand, hence, a decline in earnings. Accordingly, these are people whoexpect Apexs dividend and stock price to be relatively at or even all inthe uture. Hence, they are not expecting an attractive return on Apex.Tey oten are called the bears.

Bulls vs. Bears:A piece o

stock market jargon. Bulls

think stock prices will rise,

while bears think they will all


7/146


ake special note o the act that those who participate in the stockmarket, and indeed in many markets that comprise our economy, do notagree on the outlook or Apex and or the economy; it is precisely thisdisagreement and the act that people revise their expectations (changetheir minds) as events unold that leads stock prices to move day-to-day.

Okay, the stage is now set; on a particular day the stock market closeswith the optimists owning all the existing shares of Apex at a price of $20per share. Te market opens the next day. Ask yoursel: what might leadsome o the optimists to decide to sell some stock?

I you said some unexpected bad news about Apexs sales or aboutthe economy, or about anything that would lead at least some o theoptimists/bulls to revise their expectations or Apexs uture protabilitydownward, you would be exactly right! Te resulting expected allo inearnings would in turn lead some o our optimists to be less optimistic,

or less sure, about the rise in the price o Apex stock and dividends thatthey had been expecting; they may even now eel that the stock price willactually all in the uture instead o rising. Given the news, the revisionin expectations, and the resulting move to the pessimistic or bearish sideo the street or at least some Apex stock holders, sales o Apex stock arelikely to rise and the stock price will all. How much it will all cannotbe deduced rom the simple example presented here. Te main pointis the newsbe it company specic, or about the economy as a whole puts downward pressure on the stock price. What we can say is thatthe decline in Apexs stock price will at some point lead some o thepessimists to think that the lower price is attractive even in light o thebad news. Tey will turn out to be the buyers o the stock being oeredor sale by the ormer optimists.

Recession: The U.S. based

National Bureau o Economic

Research defnes a recession

as a signifcant decline in

economic activity spread

across the economy, lastingmore than a ew months,

normally visible in real

GDP growth, real personal

income, employment (non-

arm payrolls), industrial

production, and wholesale-

retail sales. A recession

begins when the economy

reaches a peak o activity

and ends when the economy

reaches its trough. Between

trough and peak, the

economy is in an expansion.

The usual rule o thumb

denoting a recession is two

consecutive quarters (six

months) when the quantity o

goods and services produced

and sold in the economy, real

GDP, declines.

Dividend: Most public

companies pay out a portiono their earnings on a regular

basis to holders o their

common stock.


8/147


o take a particularly dramatic example rom recent headlines, theprice of General Motors stock declined from the $30-40 range inOctober 2007 to about $4 per share in early December 2008 as salesand earnings plummeted in the ace o the worsening nancial crisisthat made it more difcult or potential car buyers to nd loans. Even

as GM announced alling sales and record losses, some were willing toacquire GM stock; rightly or wrongly, they thought eventual support bythe U.S. government would help restore GM to protability. Over theDecember 5, 2008 weekend, it was announced that the Congress wasnear agreement on a support program or Ford, Chrysler, and GM. Whatdo you think happened on Monday in the stock market? I you said, theprice o GM stock probably rose, you are correct. GM rose rom a closeof $4.08 on the previous Friday to $4.93 on Monday.

Key PointsIt is the disagreement over the uture

course o company earnings and the

economy that lead some to want to

sell stock and some to buy.

On any given day, as news is digested

by market participants, the bulls and

bears will revise their expectations,

becoming buyers or sellers;

this, in turn, will move stock prices.


9/148


What explains changes in the

overall level o stock prices?So much or Apex and GM stock. What would lead most stock prices toall, such that, say, the Dow Jones Industrial Indexdeclined? Te basic

approach to the answer is the same, except that now its not an individualstock and the ortunes o an individual company that are most relevant,but rather national and global economic orces. In general, any set odevelopments that led stock market investors to expect a recession remember, this would reduce the demand or goods and services beingproduced would, in turn, lead investors to begin to revise downwardtheir expectations or corporate sales and prots. Tis would lead atleast some holders o stock to become sellers (turn bearish), puttingdownward pressure on stock prices, in general.

o reemphasize, the movement o stock prices is orward looking;

price movements reect what typical investors think will happen inthe uture. Tis is one o the reasons that movements in stock pricesoten are thought to be a leading indicator o uture movements in the

overall economy. O course,no indicator is perect andinvestor expectations can turnout to be wrong, so not everymovement in stock pricespresages an economic boom orrecession. Keeping in mind thepossibility o such alse alarms,39 o 42 U.S. recessionsrom 1802 through 1990were preceded by declinesin stock prices o at least 10percent, with the movementin stock prices oten leadingthe subsequent movementin economic activity by sixmonths or more.

Typical Investor: Remembe

that not all investors will have

the same set o expectations;

there is disagreement that

leads some to be bullish and

some to be bearish; its thebalance between the bulls

and bears at a particular

moment that matters.


10/149


Chart on Stock Prices (DJII) and RecessionsTe chart below shows the movement in stock prices (Dow JonesIndustrial Index) since 1980 and economic recessionsthe latter are theshaded areas.

As you can see, during expansions in the economy, the non-shaded areas,stock prices tend to rise, while just beore and during recessions, theytend to all.

Recently, the National Bureau o Economic Research, a group o thenations most distinguished economists, announced that the U.S.

economy peaked in December 2007 and has been in recession since.Reerring back to the rst paragraph o this article, you will rememberthat stock prices peaked earlier, in October 2007. Tis is an example othe typical peaking in stock prices prior to the peak in the economy. Notealso that stock prices have tended to move up beore recessions are over,look at 1982 and 1992; here again, we see evidence that the movementin stock prices proved to be a leading indicator;they moved up in anticipation o a recovery inthe economy. I you watch nancial news oncable channel CNBC, or example, you will nothave to listen or long to hear some discussion

o when the current slump in stock prices willbottom out, presaging the much hoped oreconomic recovery some months later.

Stock PricesRecessionsex Points


11/14JUNIOR ACHIEVEMENT WWW.JA.ORG

Key PointsDevelopments that lead stock market investors to expect a recession

will lead to lower expectations or corporate sales and prots; such

expectations will put downward pressure on stock prices.

Movements in stock prices are orward lookingrefecting what

typical investors think will happen in the uture. Accordingly,movements in stock prices oten are a leading indicator o uture

movements in the overall economy.

How do changes in stock prices aect the economy?So ar, we have ocused on how the economy aects stock prices. Whatabout the other way aroundcan changes in stock prices also aect theeconomy? Te answer is an emphatic YES! Te rst and most obvious

channel oten is reerred to as the wealth eect. According to datapublished by the Federal Reserve, about 90 percent o U.S. householdsown stock directly or through mutual unds and their pension plans.Tus, when stock prices rise substantially, people eel wealthier and arelikely to spend more today on cars, at screen TVs, jewelry, high-endclothes, vacations, and so orth. Tis increase in demand or goods andservices will in turn lead to an increase in output and employment.Conversely, a substantial all in stock prices, as has occurred over thepast year, will lead households to pare back their spending, therebycontributing to a slowing in the economy.

Even i consumers do not own stock, substantialincreases or decreases in stock prices

can lead households to becomemore optimistic orpessimistic about theeconomic outlookand their own utureincomes; this maylead them to spendmore or less todaythan would haveotherwise occurred.


12/14FINANCIAL L ITERACY WORK READINESS ENTREPRENEURSHIP

As you can see in the chart below, movements in stock prices (let scale)are typically mirrored by movements in the index o consumer sentiment(right scale) published by the Survey Research Center at the Universityo Michigan.

Chart on Consumer Confdence and Stock Prices

Not surprisingly, changes in consumer condence in turn lead to changesin consumer spending. Because consumer spending accounts or abouttwo-thirds o total spending in our economy, such changes in consumercondence can have powerul eects on overall economic perormance.

Key PointsWhen stock prices rise, consumers eel wealthier and oten are

more condent about the uture; accordingly, they

will increase their spending, contributing to a

strengthening o the economy.

Conversely, when stock prices all considerably,

consumers eel less condent and less wealthy,

leading then to spend less.The slowdown in spending contributes to a

slowdown in the overall economy.

x Points IndConsumer CondenceStock PricesRecessions


13/14JUNIOR ACHIEVEMENT WWW.JA.ORG

Why did stock prices decline so

much over the past year?Most analysts believe we have witnessed the bursting o a speculativebubble over the past year. What is a speculative bubble? In general, the

increases in stock prices as a bubble builds are ueled by what, with thebenet o hindsight, were unduly optimistic expectations about theperormance o the economy and corporate prots. Te problem is whenthe bubble bursts, as it did in early 2000, the downdrat in stock pricescan spillover into nancial markets. Te resulting instability can disruptthe ow o money and credit so essential to lubricating and nancingeconomic activity. Such disruptions can in turn lead to reductions inspending, production, income, and employment and, thus, a recession, asoccurred in 2001.

Tis time around, as the housing crisis worsened, the spread o mortgage

deaults and the eects on the banks that had extended the loansspilled over into credit markets more generally. Te seizing up o creditmarkets soon led to reductions in output and employment and a crisiso condence among consumers. As they slashed their spending, theeconomy ell into recession and stock prices declined signicantly asprots become losses and expectations about uture corporate earningswere revised downward.

What impact are the declines

having on the economy?Tere is little doubt that the decline in household wealth resultingrom the declines in stock prices and housing prices, and the associateddepressing eects on consumer condence, are having a substantialnegative eect on consumer spending. Tis, in turn, is leading to a largecontraction in production and employment.On Friday, December 5, 2008 the Bureau oLabor Statistics announced that the numbero jobs ell by over 500,000 betweenOctober and November, the largest onemonth decline in 34 years. Tis brought the

total loss o jobs in 2008 to nearly 2 million.


14/14

Are the declines a sign we are headed

or another Great Depression?While nothing can be ruled out, such a cataclysmic development seemsunlikely. First, the Great Depression has been studied extensively and the

missteps in government policy at the time are unlikely to be repeated.Second, the President, President-elect, the Congress and the FederalReserve all seem committed to taking any and all reasonable action toprevent the current recession rom slipping into a prolonged Depression.Tird, governments around the world are taking bold actions to alsohelp shore up the global economy. Tis, too, should prove helpul in themonths ahead.

What, i anything, should the government

be doing to arrest the decline?

o be as precise as possible, it should be emphasized that thegovernmentand here we are talking about the Executive Branch(this is the President and his Cabinet and the agencies they head), theCongress and the Federal Reserve do not and should not care aboutstock prices per se. What they care about is the perormance o theeconomy and the associated well-being o our people. O course, theyare well aware o the act that the decline in stock prices is itsel erodingconsumer wealth and condence and thus contributing to the weaknessin the economy.

In general, the Federal Reserve has responded by taking actions designed

to increase the supply o money and credit and to reduce interest rates.With the cost o borrowing alling, both are expected, at some point,to encourage consumers to resume spending on cars, houses, and otherproducts. At the same time, the new President and Congress will betaking actions to cut taxes on households and perhaps businesses andincrease spending on roads, schools, and in other areas. When stockmarket observers and participants think such actions designed to increasespending on goods and services across the economy are sufcient toturn the economy around, a more bullish sentiment will propel stockprices upward.

Understanding Stock Market

Documents

Transcript of Understanding Stock Market