McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 40 The Stock

Market Crashes

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Chapter Outline

• Stock Prices• Efficient Markets• Stock Market Crashes• The Accounting Scandals of

2001 and 2002• Rebound of 2006-2007 and

the Drop of 2008-2009

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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.

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Stock Prices: How they are Determined

• Fundamentals• Earnings projections• Interest rates

• Non-fundamental• The expected price of the

share in the future.

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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.

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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.

• Non-IPO stock markets are necessary for IPO markets to exist. They allow liquidity, the ability of the investor to get money back out again.

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The Function of Trading

• Regular trading of stock serves to equate the risk-adjusted return to investors across assets.

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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.

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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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Dow Jones Industrials

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S&P 500

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NASDAQ

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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.

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Bubbles

• 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

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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.

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NASDAQ 1999-2003

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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 was not realistic.

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Accounting Scandals of 2001 and 2002

• K-Mart-poor performance • Global Crossing-fraud and very

high risk• Enron-fraud

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Bankruptcy• A legal status entered into when a

company or individual cannot pay its debt.• Bankruptcy is necessary because

• creditors acting in their own interest will seek immediate payment/foreclosure.

• It is in the interests of all creditors that debtors have time to make their payments

• Varieties of Corporate Bankruptcies• Chapter 11 - allows for reorganization• Chapter 13 – allows for orderly sale of all assets

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Enron Case• Accounting fraud was employed so that

the management of the company could overstate profits.

• Managers were paid in stock options to combat the principal-agent problem• The problem that occurs when the owner of

an asset and the manager of that asset are different and have different preferences.

• The Enron-type fraud was of more concern to investors because it introduced a new variety of risk.

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Rebound in 2006-2007 & Drop in 2008-2009

• All international stock markets rose substantially between 2006 and 2007. • The Dow Jones set a record above

14,000

• The Global Financial Crisis in 2008-2009• Dow Jones fell to 6,500