1

Chapter 7

The Stock Market

©Thomson/South-Western 2006

2

Long-Term Stock Market Behavior

Most economists favor the Standard and Poor's 500 index as the index most representative of broad trends in the stock market.

To graph long-term stock market behavior, we use a logarithmic scale so that you can interpret changes in the slope of trends in the figure as indicating changes in the trend growth rate of stock prices.

Two major "bull markets“--extended periods of above-normal growth of stock prices—occurred since World War II. The first extended from the late 1940s through the mid-1960s. The second extended from 1982 through the end of the 20th century.

A bear market is one with a significant decline. (2000-2003)

Over the long term, stock returns outpace returns from other assets.

3

Figure 7-1

4

Table 7-1

5

Stock Prices as a Barometer of Economic Sentiment

A nation’s stock market serves as a barometer of public sentiment about the nation’s economic prospects.

Since the early 1980s:

the U.S. suffered only two short and mild recessions; the expansion that began in early 1991 ran a full decade; inflation has been low, and unemployment has been low.

Expectations for an economy’s performance in general and for corporate profits in particular can become detached from reality. Late 1920s and 1990s were examples of speculative “bubbles” in

the U.S. stock market Bubbles occur when stock prices are far above those warranted

by economic conditions and prospects.

6

The Connection Between Stock Prices And Economic Activity

The link between stock prices and economic performance reflects causation running in both directions.

A good economy features rising stock prices because people are willing to pay higher prices for shares of stock as companies’ sales and profits increase.

Rising stock prices feed back to boost consumption, investment, and economic activity.

7

A Good Stock Market Increases Consumption and Investment

Consumption People spend a portion of their increased capital

gains and dividend income.

Investment It lowers cost of capital.

Higher stock prices enable companies to raise more revenue per share of stock issued, which counteracts the concern shareholders might have about diluting the value of existing shares.

8

Virtuous Cycles

An upward-trending stock market contributes to the capital formation process, which increases real economic performance, which increases stock prices, which increases capital gains and capital gains tax

revenues, which lowers budget deficits which lowers interest rates, which increases

investment and consumption,

and so on.

9

Vicious Cycles

A downward-trending stock market inhibits the capital formation process, which decreases real economic performance, which decreases stock prices, which decreases capital gains and capital gains tax

revenues, which increases budget deficits, which raise interest rates, which decreases investment

and consumption,

and so on.

10

Examples of Good Times Gone Bad

1970s Energy Crises

1990s: Iraq’s invasion of Kuwait

9/11 (though the stock market had already come down from its March 2000 highs)

11

Measuring Stock Market Performance

Numerous indexes of stock market performance are available, each intended to serve as a benchmark for a particular segment of the overall market.

A good stock index should: quickly convey information to a large number of investors; encompass a large enough number of companies so that

company-specific developments do not unduly influence the index;

consider the trading frequency of stocks, and account for the price changes of individual stocks over

time so that each stock’s relative importance in the index is a function of its price. This requires a frequent updating of the weights applied to each firm.

12

U.S. Stock Market Indexes The Dow Jones Industrial Average (DJIA):

a simple un-weighted average of the prices of 30 very large, actively traded U.S. stocks

The Standard and Poor’s 500 Index (S&P 500): a weighted index which includes 500 large U.S. corporations;

therefore it is much broader than the DJIA. The New York Stock Exchange Composite Index:

an index of all (>3,000) stocks listed on the New York Stock Exchange

National Association of Securities Dealers Automated Quotations (NASDAQ) an index of small, "unlisted," and "over the counter" (>5000) stocks

Other Stock Market Indexes The American Stock Exchange (ASE) The Russell 1000, 2000, and 3000 indexes

13

Table 7-2

14

Importance of Dividend Reinvestment

A stock’s total return includes both the appreciation in the stock price and the dividends received.

Stock market indexes ignore the returns earned from dividends.

In the long run, continual dividend reinvestment becomes an important portion of the total return from stocks. Thus, you cannot simply look at the relative performance of the index as some indices may report on stocks that yield smaller dividends than other indices do—e.g., a blue-chip stock index vs. a growth or small capitalization fund. The blue chip stocks regularly distribute dividends, while small cap companies reinvest any profits into new product development rather than paying dividends.

Dividend yield:

the annual dividend expressed as a percentage of the stock price

15

The Stock Market: Risk And Returns

Scholars have created stock price indexes going back 200 years.

One dollar invested in 1802: in a “representative” stock

would have appreciated to approximately $6 million by 2004 ($400,000 after adjusting for inflation), and

would have earned long-run returns of 8 percent annually. One dollar invested in (rolled over) U.S. government bonds in 1802

would be worth about $700 adjusted for inflation. One dollar invested in gold in 1802 would be worth only about $1.25,

adjusted for inflation. Over short periods, stocks are much more risky than bonds.

Several episodes reflect significantly negative returns from stocks over two-year periods.

Few episodes of investment in government securities reflect negative returns.

16

Figure 7-2

17

Figure 7-3

18

What Determines The Price Of A Share Of Stock?

The present value formula we explored in chapter 5 applies to stock prices, as it does to any financial asset.

The value of a share of stock is a function of the discounted flow of future dollar payments expected from each share of the stock, PV or Price = R1 / (1 + i) + R2 / (1 + i)2 + ... + Rn / (1 + i)n

Reasons for discounting: Positive real interest rates Inflation Risk

Market risk Default risk The compensation for the additional risk inherent in buying stocks

rather than bonds is called the equity risk premium.

19

Impact of Various Events on Stock Prices

Stock prices can rise based on general types of factors: those that increase the numerators (future

payments expected from stocks) those that decrease the denominators (the

discount rate applied to these expected future earnings) Expected inflation may decline. The nation's real interest rate may decline. The equity risk premium that agents require to buy

stocks rather than bonds may decrease.

20

Figure 7-4

21

Stock Market Valuation Indicators

The price earnings (P/E) ratio: ratio of the stock share price to the current annual earnings per share. P/E ratio varies widely from stock to stock. Traditionalists believe that P/E ratios exhibit mean

reversion--that is, they tend to ultimately revert to their long-term averages.

The 100-year average of the S&P500 stocks’ P/E is 16.

The dividend yield is the annual dividend per share expressed as a percentage of the current price of the stock.

The price-to-book ratio is the ratio of the price of a share of stock to the book value of the company.

22

Figure 7-5

23

Table 7-4 The Tendency for Mean Reversion in Returns from Stocks

24

Bubbles

If stock prices reach “bubble” levels, stock prices might fall precipitously, decrease gradually or increase very slowly for an extended period of time, or the stock market could crash.

25

The “Tech Wreck”

26

Should The Federal Reserve React To Perceived Bubbles In Asset Markets?

Arguments in Favor of Fed Intervention Excessive increases in asset prices (stocks and real

estate) lead to economic instability. Excessive borrowing results from inflated collateral

values. When the bubble bursts insolvencies ensue. The Fed should use the traditional benchmark

measures of valuation and use monetary policy to dampen “irrational exuberance.”

Arguments Against Fed Intervention It is unrealistic to expect the Fed to reliably identify

asset price bubbles as they develop. The Fed’s responsibility is conducting monetary

policy, not to manage asset prices. The Fed may do more damage than good.