Chapter 41 The Stock Market and Crashes

Chapter 41The Stock Market and CrashesChapter OutlineSTOCK PRICESEFFICIENT MARKETSSTOCK MARKET CRASHESWhat are Stocks?If a company has “N” shares of stock, each one entitles the owner to a fraction (1/Nth) ofThe vote in determining membership on the board of directors.The declared dividends of the company.The proceeds from a sale of the company.Stock PricesHow they are DeterminedFundamentalsEarnings projectionsInterest ratesNon-fundamentalThe expected price of the share in the future.The Fundamental Value of a Share of StockThe fundamental value of a share of stock is the present value of the projected earnings at an expected interest rate.An increase in earnings increases stock values.A decrease in the interest rate increases stock value.What Stock Markets DoAn Initial Public Offering (IPO) is when a company sells stock for the first time in an attempt to raise money for expansion and is a very small part of everyday market activity.Most sales of stock do not involve the company receiving or paying money. They are simply the transfer of the asset from one holder to another.The Function of TradingRegular trading of stock serves to equate the risk-adjusted return to investors across assets.Efficient MarketsAny market is called efficient if all information is taken into account by participants.Under the Efficient Markets Hypothesis the contention is that an average investor with no inside information will fare no better or worse making choices than a someone who spends a great deal of time contemplating their portfolio.Stock IndexesStock indexes are a weighted average of stock prices in a particular group and serve to measure the state of the stock market as a whole.Examples includeDow Jones IndustrialsStandard and Poor’sNASDAQStock Market CrashesOctober 1929Stock market lost more than 25% of its value in a few days. It was not permanently above its Oct. 1929 high until after World War II.October 1987Stock Market lost 20% of its value in one day. It rebounded quickly.BubblesA bubble is the state of a market where the current price is far above its value determined by fundamentals.Prices rise which creates the expectation that prices will rise further which Repeat steps 1 and 2 Examples of BubblesThe Asian Financial Crisis of 1998-1999Share prices increased dramatically through the 1980s and 1990s.Currency devaluations and risky investments caused precipitous declines.NASDAQ 2000The “tech-heavy” nature of the NASDAQ fueled unrealistic expectations for earnings growth. When that growth did not materialize, the NASDAQ lost 50% of its value in a year. It lost more in 2001.Why Tech Stocks Lost ValueFundamental ReasonsEarnings projections droppedInterest rates rose through 2000; they fell substantially in 2001 but that was due to recession concerns.Realism strikesThe projected growth path of earnings were not realistic.