Download Amazing Market Why does the stock market exist? The answer

Amazing Market
Why does the stock market exist?
The answer begins in the formative years of the United States, in our first
capital, New York. This was where the new government looked when it
wanted to borrow money from the public to pay debts from the
Revolutionary War. Following Alexander Hamilton's Report on Public
Credit in 1790, the fledgling government decided to sell bonds and use the
funds to pay back at face value the IOUs both it and the states had issued
to finance the war. These bonds marked the beginning of America's
financial markets because they were the first major issue of publicly
traded securities. Once the bonds were issued, private investors began
trading them among one another.
Essential Liquidity
Hamilton understood the importance of a financial market that provided
liquidity and allowed investors to trade securities among themselves.
Hamilton also understood that unless investors could later sell the bonds
for cash, they'd be unlikely to buy them from the government in the first
place. As a result, early in our nation's history, a stock market was created
to provide investors with the ability to exchange a financial asset for cash.
The stock market enabled the newly established government to sell bonds
to pay the war debt - a debt that Hamilton called "the price of liberty"
because it helped finance the nation's independence. The New York Stock
Exchange made its formal appearance in 1792. It was literally a place on a
New York City street (Wall Street) where people gathered and traded
bonds like those of the new government. "The New York Stock Exchange,
in fact, originated in 1792 as a bond exchange," said former chairman of
the Securities and Exchange Commission (SEC), Arthur Levitt. In 1792 the
word stock referred to a long-term IOU, such as a government bond. The
word didn't mean what it does today, a share of ownership in a
corporation.
New Companies for New Challenges
Stocks, as we now know them, became more numerous in the next century
as the American economy outgrew the business organizations common in
those times. Building a railroad, for instance, was no task for a small
proprietorship or partnership with its limited funds. Instead, it required
large organizations able to attract sufficient savings from the public to
tackle these enormous tasks. A corporation could do just that by selling
shares of ownership to many stockholders. Shareholders would then own
a portion of any earnings, while their potential loss was limited to the
amount each had invested in a company's stock. As Hamilton had earlier
recognized with government bonds, investors will buy new shares of stock
only if they're able to sell them later on if they want their cash back. Here
again the "market of stocks" provided the liquidity for investors to do just
that. By the late 1800s, stocks of publicly owned corporations were trading
on the New York Stock Exchange. When Charles Dow created the Dow
Jones Industrial Average in 1896, it consisted of stocks from the 12
industrial companies shown below:
The first Dow Jones Industrial Average in 1896
American Cotton Oil
Laclede Gas
American Sugar
National Lead
American Tobacco
North American
Chicago Gas
Tennessee Coal & Iron
Distilling & Cattle Feeding
U.S. Leather
General Electric
U.S. Rubber
Source: Dow Jones Indexes
As years passed, new corporations sprang up to provide many new
products and services. The 30 companies comprising the Dow in 2006
offer a glimpse of the dramatic change and growth in our economy since
the Dow's invention many years ago.
Dow Jones Industrial Average in 2006
3M Co.
Exxon Mobil Corp.
McDonald's Corp.
Alcoa Inc.
General Electric Co.
Merck & Co. Inc.
Altria Group Inc.
General Motors Corp. Microsoft Corp.
American Express Co. Hewlett-Packard Co.
Pfizer Inc.
American
International
Home Depot Inc.
Procter & Gamble Co.
Honeywell
Boeing Co.
International
SBC Communications
Caterpillar Inc.
Intel Corp.
United Technologies
Verizon
Citigroup Inc.
IBM
Communications
J.P. Morgan Chase &
Coca-Cola Co.
Co.
Wal-Mart Stores Inc.
DuPont
Johnson & Johnson
Walt Disney Co.
The Dow has changed over time as new companies sold stocks or bonds
and thereby put investors' savings to work. Here again the liquidity
provided by the stock market offered the necessary reassurance for
investors to buy the new stocks when issued. As the new companies grew
and prospered, they were able to provide a return to investors in exchange
for the risk they assumed by buying and owning their stocks.
Market Signals
By bringing investors together, the stock market performed another
important function. It generated prices that reflected investors' best
estimates of each company's future potential. Technological changes such as the telegraph, ticker tape, telephone, and now the Internet - have
broadened and deepened the market by assembling in one marketplace
buy and sell offers from investors everywhere. The stock prices that
emerge from these offers provide important signals to direct the nation's
savings to those companies most likely to use the money productively. As
investors avoid companies with poor prospects for growth and earnings,
their stock prices fall and thereby direct savings away from them.
Conversely, investors bid up the stock prices of companies with bright
prospects. These companies find it easier to sell new shares to raise money
for their expansion.
The stock market exists to provide investors with the liquidity they require
to invest in the stocks that corporations want to sell to raise funds for their
start-up and expansion. In providing this service, the stock market plays a
more profound role. It identifies and directs the nation's savings to the
most productive companies - companies which then generate the
employment, income, and taxes that support the high living standards we
enjoy today. The stock market accomplishes these important tasks even if
investors themselves have little or no understanding of them. By seeking
the best return in the stock market over the decades, investors have
helped build America's prosperous economy.
What makes the stock market tick?
The explanation begins as far back as April 1892 - the year when
General Electric (Symbol GE) sold its first shares to the public. GE
made the original sale or initial public offering (IPO) with the help of
businesses that identify investors willing to buy the brand-new
shares. The market in which GE sold its shares to these initial
investors is called the primary market or new-issues market.
Few of these investors would have bought the shares unless they were
able to sell them later when they needed cash. The stock market
enabled them to do just that. Shortly after its IPO, GE listed its shares
on the New York Stock Exchange, making them available in the stock
market for the first time.1Anytime the original investors wanted to
"trade-in" shares they had bought from GE, they could go to the stock
market and sell them to other investors. Because GE's stock had
already traded once in the primary market, the market where it trades
among investors is called the secondary market. This market enables
the general public to trade a stock with one another as many times as
they wishafter the stock's original sale in the primary market. The
stock market resembles markets in which people buy and sell used
cars and existing houses. These markets consist of trades made after
the original sale of new cars, new houses, and new stocks.
Auction for Stocks
When GE's stock entered the New York Stock Exchange, it found
itself in an auction market. Acting on behalf of buyers or sellers,
brokers would call out the prices buyers were bidding (the bid price)
and those that sellers were asking (the ask price). A successful
auction, or trade, would occur when brokers matched investors' bid
and ask prices.
When the New York Stock Exchange was founded years before in
1792, brokers who had been conducting auctions under a buttonwood
tree on Wall Street signed the Buttonwood Agreement. They agreed to
include only one another in their auctions and to charge a given
commission on any trades. When these brokers moved indoors the
following year, other brokers remained outdoors, where they
gathered along the curb to auction bonds and stocks not traded by the
buttonwood brokers at the new stock exchange.
AMEX and NYSE
This curbside auction eventually became known as the Curb. Like the
nascent New York Stock Exchange, the Curb was an auction market.
Eventually, the Curb also moved indoors, and in 1953 it adopted the
name American Stock Exchange. The American Stock Exchange
(AMEX) and the New York Stock Exchange (NYSE) are the two
biggest auction markets in the United States.2Owned by its members,
AMEX lists many fewer stocks than the NYSE, but it has pioneered
the development of exchange traded funds (ETFs) and specialized in
trading options, which are special rights to buy or sell stocks at given
prices.
Both exchanges retain their auction markets today, but technological
changes, such as computerized orders, are transforming them. In
2006, the New York Stock Exchange completed its purchase of
Archipelago Exchange, an electronic stock market. The combined
organization, known as NYSE Group, became a public company
traded on the New York Stock Exchange under the ticker symbol of
NYX. The purchase of Archipelago will help the NYSE develop its
"Hybrid Market," which combines automated trading with the best
aspects of the auction market taking place on its trading floor.
The trading floor is a far cry from the primitive market under the
buttonwood tree years before. An investor can now place an order
with a broker to buy GE's stock by using the Internet, the telephone,
the mail, or even by visiting a broker's office. The broker then
transfers the order electronically or by phone to the floor of the
NYSE. A floor broker there routes the order to a specialist post (there
are 17 of them) that handles GE's stock. Other brokers gather there
and participate in a continual auction of GE's stock and those of more
than 100 other companies assigned to that post. The specialist at the
post oversees the auction and may even buy or sell shares to maintain
"a fair and orderly" market.3
During these auctions floor brokers representing buyers present their
bid prices, while other brokers representing sellers present their ask
prices. By matching these bid and ask prices, the auction enables
investors from all over the world to trade with one another.
The Nasdaq Stock Market
The auction markets of the NYSE and the AMEX are different from
the stock market that Microsoft (Symbol: MSFT) chose for its listing
when it sold its first shares to the public in 1986. Just like GE many
years before, Microsoft initially sold its shares on the primary market
before choosing to list on the Nasdaq Stock Market.
Established in 1971, NASDAQ is a newcomer compared to the NYSE
and the AMEX. The NYSE, the oldest market, is known for its listings
of Blue-Chip companies - large companies with sound finances and
proven track records. In contrast, NASDAQ is known for newer,
smaller companies that often specialize in technology. Thanks to its
rapid growth, NASDAQ now lists the most stocks and has the highest
trading volume of any U.S. stock market. In 2000, it began selling
shares to the public and now lists its stock on - you guessed it, The
Nasdaq Stock Market. Its ticker symbol is NDAQ.
The word NASDAQ began as an acronym for National Association of
Securities Dealers Automated Quotation system. NASDAQ has always
been an electronic marketplace and has never had a physical trading
floor like the NYSE or AMEX. In its early years, the market relied on
telephones to communicate investors' orders and trades. Computers
eventually replaced telephones, turning NASDAQ into a highly
developed electronic network.
An important part of that network consists of market makers. These
firms buy, sell, and hold listed stocks, just as clothing stores buy, sell,
and hold inventories of clothes. Investors who buy and sell NASDAQ
stocks are likely to trade directly with one of these 400 or so market
makers. Besides market makers, NASDAQ provides other means of
executing trades. One of them is electronic communication networks
(ECNs), which are electronic trading systems that automatically
match buy and sell orders at specific prices. NASDAQ encourages
qualifying ECNs and other firms to join its network. "The basic
philosophy of NASDAQ is one of 'open architecture,'" explains a
publication of the exchange. "Participation is not limited to any fixed
number of participants."4 In 2005, NASDAQ acquired its own ECN by
purchasing Instinet.
The Market Works
The stock market has come a long way since its youthful years. It's
grown to include three major markets, several regional markets, and
even an OTC Bulletin Board and Pink Sheets market for trading stock
that don't meet the listing requirements of the larger exchanges. The
market has also changed dramatically, often pushed and prodded
along by new technologies ranging from the stock ticker in 1867 to
computers and the World Wide Web today. Investors have benefited
over the years from a deeper and broader market that has enabled
them to trade in less time and at lower costs. Companies have
benefited from a streamlined stock market that has enabled them to
sell shares in the primary or new-issues market to fund their startup
or expansion. But the nation in general has also benefited. As the
stock market has become more efficient over time, it has helped our
economy grow. And that growth, in turn, has pulled up living
standards all across America.
General Electric, Investor FAQs When the Dow Jones Industrial
Average made its appearance four years later, General Electric's stock
was one of the 12 stocks it contained. GE is the only one of those 12
original stocks still included in the Dow.
1
The New York Stock Exchange has many more companies listed and
has a much larger trading volume than AMEX. And while the NYSE is
world renowned for its trading of stocks, AMEX specializes in other
investments, such as options, and has pioneered the development of
Exchange Traded Funds (ETFs).
2
See "How A Stock Is Bought And Sold," The New York Stock
Exchange
3
4
Market Mechanics, The Nasdaq Stock Market