Lecture Issues in economics today - Chapter 41

The main contents of this chapter include all of the following: The equation of exchange, the quantity theory of money, classical economics, the monetarist school, supply-side economics, the rational expectations theory.

Chapter 41

The Stock Market and Crashes

Chapter Outline

• STOCK PRICES

• EFFICIENT MARKETS

• STOCK MARKET CRASHES

What are Stocks?

• If a company has “N” shares of stock,

each one entitles the owner to a fraction (1/Nth) of

– The vote in determining membership on the board of directors

– The declared dividends of the company

– The proceeds from a sale of the company

Stock Prices How they are Determined

• Fundamentals

– Earnings projections – Interest rates

• Non-fundamental

– The expected price of the share in the future

The Fundamental Value of a

Share of Stock

• The 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 Do

• An 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 Trading

• Regular trading of stock serves to

equate the risk-adjusted return to investors across assets.

Efficient Markets

• Any 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 Indexes

• Stock 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 include

– Dow Jones Industrials – Standard and Poor’s – NASDAQ

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2000

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1896 1902 1908 1914 1920 1926 1932 1938 1944 1950 1956 1962 1968 1974 1980 1986 1992 1998

Year

Dow Jones Industrial Average

1896-2000

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400

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1870 1877 1884 1891 1898 1905 1912 1919 1926 1933 1940 1947 1954 1961 1968 1975 1982 1989 1996

Year

Standard and Poor's 500

1870-2000

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2000

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1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

Year

NASDAQ Composite

1980-2000

Stock Market Crashes

• October 1929

– Stock 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 1987

– Stock Market lost 20% of its value in one day It rebounded quickly

• A bubble is the state of a market

where the current price is far above its value determined by fundamentals.

1 Prices rise which

2 creates the expectation that prices will

rise further which

3 Repeat steps 1 and 2

Examples of Bubbles

• The Asian Financial Crisis of 1998-1999

– Share prices increased dramatically through the 1980s and 1990s.

– Currency devaluations and risky investments caused precipitous declines.

• NASDAQ 2000

– The “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.

2000

2500

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3500

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4500

5000

5500

Date

NASDAQ Composite

1999-2000

Why Tech Stocks Lost Value

• Fundamental Reasons

– Earnings projections dropped – Interest rates rose through 2000; they fell substantially in 2001 but that was due to recession concerns

• Realism strikes

– The projected growth path of earnings were not realistic