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Transcript
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