Download Stock Market Basics

GLOBAL STOCK
MARKETS
© Pearson Education Canada, 2003
35
CHAPTER
Objectives
After studying this chapter, you will able to
 Explain what a firm’s stock is and how its rate of return
and price are related
 Describe the global markets in which stocks are traded
and the stock price indexes
 Describe the long-term performance of stock prices and
earnings
 Explain what determines the price of stock and why
stock prices are volatile
© Pearson Education Canada, 2003
Objectives
After studying this chapter, you will able to
 Explain why it is rational to diversify a stock portfolio
rather than to hold the one stock that has the highest
expected return
 Explain how the stock market influences the economy
and how the economy influences the stock market
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Irrational Exuberance?
Do people who buy stocks suffer from irrational
exuberance?
How are stock prices determined?
How does the stock market influence the economy and
vice versa?
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Stock Market Basics
All firms get some of their financial capital from the people
who own the firm.
A large firm has millions owners from whom it raises
billions of dollars.
These owners are called stockholders—the holders of
stock issued by the firm.
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Stock Market Basics
What is Stock?
A stock is a tradable
security that a firm issues
to certify that the
stockholder owns a share
of the firm.
Figure 35.1 shows an
example of a stock
certificate.
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Stock Market Basics
The value of a firm’s stock is called the firm’s equity
capital.
The terms “stock” and “equity” are used interchangeably.
A stockholder has limited liability, which means that if the
firm can’t pay its debts, a stockholder’s liability is limited to
the amount the he/she has invested in the firm.
Stockholders may receive a dividend, which is a share of
the firm’s profit, in proportion to their stock holdings.
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Stock Market Basics
There are two different kinds of stock:
Preferred stock, which entitles the owner to a pre-agreed
dividend before common stock dividends are paid, and to
first claim to the firm’s assets in the event that the firm is
liquidated.
Common stock, which entitles the owner to a share of the
firm’s assets and earnings and to a vote for the firm’s
directors.
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Stock Market Basics
What is a Stock Exchange?
Stocks are tradable, and most people buy their stocks
from other people on a stock exchange, which is an
organized market in which people can buy and sell stock.
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Stock Market Basics
The major Canadian stock exchange is the Toronto Stock
Exchange.
Canadian stocks are also traded on the major U.S. stock
exchanges, which include:
The New York Stock Exchange (NYSE), where the shares
of stock for most of the major corporations are traded.
The National Association of Securities Dealers Automated
Quotation (NASDAQ), where most of the high-tech stocks
are traded.
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Stock Market Basics
Stock Prices and Returns
A stock price is the price at which one share of a stock
trades on a stock exchange.
For example, on October 11, 2002, the stock price for
Bombardier was $3.83 per share.
The annual return on a stock consists of the stock’s dividend
plus its capital gain (or loss) during the year.
A stock’s capital gain is the increase in its price, and its
capital loss is the decrease in its price.
For example the Bombardier stock price had a capital loss of
$13.54 in the year to© Pearson
October,
2002.
Education
Canada, 2003
Stock Market Basics
When the stock’s dividend is expressed as a percent of
the stock’s price, this is called the dividend yield.
For example, during the year ended October 2002,
Bombardier paid dividends of 18¢ per share.
Based on the initial price of the stock at the beginning of
the year, this amounts to a 4.7 percent dividend yield.
The return on a stock expressed as a percentage of the
stock price is called the rate of return.
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Stock Market Basics
When the capital gain loss of $13.54 is decreased by the
dividend of 18 ¢, the total loss for the year is $13.36.
Based on the initial price of Bombardier stock at the
beginning of the year, this total amounts to a rate of return
for Bombardier stock of minus 76.9 percent—a loss of
76.9 percent.
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Stock Market Basics
Earnings and the Price-Earnings Ratio
A firm’s profits are called its earnings.
A firm’s directors decide how much of the earnings to pay
out in dividends and how much to retain to invest in new
capital, which is called retained earnings.
Because earnings are the ultimate source of income for
the stockholders, they carefully scrutinize the firm’s
earnings.
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Stock Market Basics
Firms report their earnings according to strict standards
determined by government regulations and accounting
standards.
Following the Enron scandal in the United States, these
standards have been and will continue to be reviewed
more carefully.
The relationship between earnings and stock price is what
matters most to stockholders.
The price-earnings ratio, which is the stock price divided
by the most recent year’s earnings, is widely quoted for all
firms.
© Pearson Education Canada, 2003
Stock Market Basics
For example, Bombardier’s reported earnings were 11¢
per share in 2002, so its price-to-earnings ratio on October
11 2002 was $3.83 divided by 11 ¢, which equals 34.8.
This ratio is the inverse of the earnings per dollar invested
in the firm.
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Stock Market Basics
Reading the Stock Market Report
Figure 35.2 in the textbook shows a part of a page from
of the Financial Post.
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Stock Market Basics
Stock Price Indexes
Various stock price indexes are used to summarize the
thousands of different stock prices comprising a particular
stock exchange.
These indexes give stockholders information about the
general performance of stocks so they can assess the
general movement of the stock market over time and
compare the price of a specific stock to that of the market.
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Stock Market Basics
The three main stock price indexes are:
 S&P 500 Composite Index
 Dow Jones Industrial Average (DJIA)
 NASDAQ Index
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Stock Market Basics
S&P 500 Composite Index
The S&P composite index is an average of the stock
prices for 500 firms that are traded on the NYSE, the
NASDAQ, and the ASE stock exchanges.
Standard and Poor’s (S&P), a New York financial
information and services company, reports this index.
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Stock Market Basics
Figure 35.3 shows
the composition of
the S&P 500
companies, by
industry.
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Stock Market Basics
Dow Jones Industrial Average
The DIJA or the “Dow,” the best-known index, is an
average of the stock prices for thirty major firms traded
mainly on the NYSE (including Microsoft Corp. and Intel
Corp.).
NASDAQ Index
The NASDAQ index is the average stock price for the
firms that are traded on this worldwide electronic stock
exchange and represents high-tech stocks.
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Stock Market Basics
Four major international indexes are
S&P/TSX
FTSE 100 (London stock exchange)
DAX (German stock exchange)
Nikkei (Japanese stock exchange)
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Stock Market Basics
Stock Price Performance
To assess stock price performance over time, the value of
a stock price index must be adjusted for inflation.
Also, a one dollar increase in stock price from a low value
is a larger percentage increase than the same one dollar
increase from a high value, so we plot stock prices on a
ratio scale.
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Stock Market Basics
Stock Prices
Figure 35.4 shows the inflation-adjusted earnings and
prices of the S&P 500 and the S&P/TSX indexes.
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Stock Market Basics
The historical trend in stock prices is a general rise in
value over time, averaging about 2.7 percent per year.
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Stock Market Basics
Movements in stock prices over time seem to closely
mirror movements in firm earnings, but earnings grew at
an average of only 2.0 percent per year.
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Stock Market Basics
Earnings Per Share
Figure 35.5 shows the price-earnings ratio from 1871 to
2001.
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Stock Market Basics
The long-term average price-earnings ratio is 13.9.
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Stock Market Basics
This ratio ranges from a low of 6.0, (which occurred in
1916) to a high of 27.0 (which occurred in 1894, 1921,
1931, and recently in the years 1999 to 2001).
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Stock Market Basics
The price-earnings ratio persistently returns to its
historical average.
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How Are Stock Prices Determined?
There is no firmly agreed upon theory about what
determines stock prices.
Instead, there are two broad types of explanation:
 Market fundamentals
 Speculative bubbles.
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How Are Stock Prices Determined?
Market Fundamentals
The market fundamentals price of a stock is the price that
people are willing to pay for a stock based on the deep
sources of value that make a stock worth holding.
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How Are Stock Prices Determined?
These deep sources of value are:
 The activities of the firm,
 The stream of profits that these activities generate,
 The stream of dividend payments to stockholders,
 The degree of uncertainty surrounding profits and
dividends
 The attitudes of stockholders toward the timing and
uncertainty of the stream of dividends.
© Pearson Education Canada, 2003
How Are Stock Prices Determined?
For a person to believe that a stock is worth buying, the
utility that the person receives from owning the stock must
be at least as great as the utility that could be obtained
from the funds used to buy the stock.
For a person to believe that a stock is worth selling, the
utility that the person receives from funds freed up by the
sale must be at least as great as the utility that the person
receives from owning the stock.
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How Are Stock Prices Determined?
This assessment is difficult for two reasons:
 People must compare the present with the future and
must compare a definite sum of money with an uncertain
sum.
 People discount uncertain future returns.
© Pearson Education Canada, 2003
How Are Stock Prices Determined?
Discounting Future, Uncertain Returns
To determine a discounted price, we multiply the full price
by a discount factor.
For example, if you get a 20 percent discount, you pay 80
percent of the full price. In this case, the discount factor is
0.8.
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How Are Stock Prices Determined?
The stock price equation
If P1 is the current price of the stock, P2 is the price of the
stock one period from now, b1 is the discount factor for
period one, and D1 is the dividend in period one, then:
P1 = Expected value of [b1(D1 + P2)].
For example, if your discount factor is 0.8, and you believe
that the dividend per share for the period will be $0.05 and
the future price of the stock will be $1.20, then the price
that you are willing to pay for the stock is
P1 = 0.8  ($0.05 + $1.20) = $1.00.
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How Are Stock Prices Determined?
Expected future value of the stock price
In the stock price equation, today’s stock price depends on
today’s expectation of tomorrow’s price.
The market fundamental expectation of tomorrow’s price is
a rational expectation, which is a forecast that uses all the
available information, including knowledge of the relevant
economic forces that influence the variable being
forecasted.
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How Are Stock Prices Determined?
The stock price equation says that the price of a stock in a
given period depends on the price of the stock in the next
period.
This price equation holds for all future periods of time.
For example,
P2 = Expected value of [b2(D2 + P3)].
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How Are Stock Prices Determined?
This relationship repeats period after period, on into the
future.
The only fundamental is the stream of expected dividend
payments.
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How Are Stock Prices Determined?
Speculative Bubbles
A speculative bubble is a stock price increase is followed
by a price plunge, both of which occur because people
expect them to occur and act on that expectation.
If most people believe that the price of a stock will
increase, they will act on that belief and increase the
demand for a stock.
Stock prices rise immediately based on the expectation of
a rising stock price.
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How Are Stock Prices Determined?
If most people believe that the price of a stock will fall, they
will act on that belief and decrease the demand for a
stock.
Stock prices fall immediately based on the expectation of
a falling stock price.
Forecasting future stock prices depends on predicting
other people’s forecasts for stock prices—guessing
people’s guesses of the future.
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How Are Stock Prices Determined?
Because no one knows the future outcome and everyone
faces the same challenge with the same amount of
information, people are likely to use rules of thumb and
simple theories to help them make forecasts about future
periods.
People may tend to behave in a herd-like manner, acting
upon similar expectations and developing self-fulfilling
prophecies about stock prices.
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How Are Stock Prices Determined?
The Booming Nineties: A Bubble?
Some economists believe that the big increase in stock
prices during the last part of the 1990s resulted from an
anticipated change in the market fundamentals in a “new
economy.”
As earnings expectations are revised upward, prices rise.
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How Are Stock Prices Determined?
Other economists believe that the big increase in stock
prices during the last part of the 1990s was a speculative
bubble.
Robert Schiller in his book Irrational Exuberance explains
the 1990s speculative bubble as a combination of factors
that encouraged people to have an overly optimistic
outlook for future stock prices.
Once prices stopped rising, the optimism ended and
prices fell.
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Risk and Return
Stock price fluctuate unpredictably and holding stocks is
risky.
Generally, the greater the risk, the higher is the rate of
return on a stock.
The additional return that is earned for bearing an
additional risk is called a risk premium.
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Risk and Return
Risk Premium
Recall the stock price equation
P1 = Expected value of [b1(D1 + P2)].
If two stocks have the same expected future price and
dividends, but one stock has a higher risk than the other,
then it has a smaller discount factor (b1), a lower price P1
and a higher expected return than the safer stock.
There is a tradeoff between rate of return on a stock and
its risk.
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Risk and Return
Portfolio Diversification
Diversification of a stockholder’s portfolio of stocks is the
best strategy for addressing this tradeoff.
Investing only the stock with the highest expected rate of
return means being exposed to a high risk and possible
incurring a large loss.
Investing only in the stock with the lowest expected rate of
return minimizes risk, but leaves little chance of a high
return.
Holding many stocks avoids the extremes of risk and
returns.
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The Stock Market and the Economy
The economy affects the stock market through many
channels.
We examine:
 Trends and cycles earnings growth
 Central bank monetary policy
 Taxes
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The Stock Market and the Economy
Trends and Cycles in Earnings Growth
The central question on which investors must take a
position is the expected growth rate of earnings. If
earnings are expected to grow more rapidly in the future,
then stock prices rise.
The main driving forces behind earnings are technological
change and the state of the business cycle.
The long-term trend in earnings has been stable at 2
percent growth per year, adjusted for inflation.
But earnings growth has fluctuated a great deal around
this trend.
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The Stock Market and the Economy
Figure 35.6 shows the variation in the earnings growth
since the 1870s.
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The Stock Market and the Economy
Three bursts of earnings growth occurred during the
1890s; the 1950s and 1960s; and 1990s.
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The Stock Market and the Economy
Is the booming 1990s stock price increase a sign of a new
economy?
Average earnings growth during the 1990s was 13 percent
per year, compared to the long-term trend of only 2
percent per year.
Historically, there have been many periods of
extraordinarily high rates of earnings growth, but they
have always ended and earnings growth has returned to
its long run average rate.
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The Stock Market and the Economy
The only exception is the Industrial Revolution, which
occurred more than 200 years ago.
If the current “new economy” is just another temporary
burst of earnings growth, when the earnings growth rate
returns to its long-term trend rate stock prices will fall to
bring the unusually high price-earnings ratios back to its
long-term average.
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The Stock Market and the Economy
Central Bank Monetary Policy
The U.S. Federal Reserve (Fed) and the European
Central Bank (ECB) are the most powerful central banks in
today’s world.
When the Fed or the ECB raises interest rates, stock
prices generally fall (and when these banks lower interest
rates, stock prices generally rise).
It is profitable to anticipate the Fed’s and the ECB’s
interest rate policy changes.
If interest rates are expected to rise, then stock prices are
fall.
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The Stock Market and the Economy
Taxes
Three types of tax can influence stock prices
 Capital gains tax
 Corporate profits tax
 Transactions (Tobin) tax
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The Stock Market and the Economy
The capital gains tax is a tax on income generated
through realized capital gains.
A realized capital gain is a gain that is obtained when a
stock is sold for a higher price than was paid for it.
When the capital gains tax rate is increased, the expected
return on owning a stock falls, so stock prices fall.
Lowering the capital gains tax in the United States at the
beginning of the 1990s contributed to the booming stock
market in that decade.
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The Stock Market and the Economy
The corporate profits tax is a tax on corporate income.
The higher the corporate profits tax, the lower are
earnings, and the lower are stock prices.
A transactions (Tobin) tax is a tax that could be (but is not
presently) applied to a stock market transaction.
Economist James Tobin, for whom the tax is named,
believes that this type of tax would increase the cost of
speculative purchasing and selling of stock.
The speculative pressures for creating a stock market
bubble would be decreased proportionally to the tax.
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The Stock Market and the Economy
We examine two influences of stock prices on the
economy
 Wealth, consumption expenditure, and saving
 The distribution of wealth
Wealth, Consumption Expenditures and Saving
Wealth is the market value of assets.
The wealth effect is the influence of changes in wealth on
consumption expenditures and savings levels in the
economy.
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The Stock Market and the Economy
Disposable income is income minus income taxes.
A household can either spend disposable income on
consumption or place it in savings.
The saving rate is the percentage of disposable income
devoted to saving.
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The Stock Market and the Economy
Saving can be defined in two ways:
Saving = Disposable income minus consumption
expenditure
Saving = Wealth at the end of the year minus wealth at the
start of the year.
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The Stock Market and the Economy
Figure 35.7 shows the
personal savings rate in
Canada and the United
States measured as
disposable income minus
consumption expenditure.
The trend in this definition
of saving is downward
during the 1990s.
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The Stock Market and the Economy
Figure 35.8 shows
personal saving data since
1981 using data that both
include and exclude
capital gains.
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The Stock Market and the Economy
When capital gains are
included in the definition of
savings, the level of
personal savings does not
fall off, but rather varies
around a constant level.
Neither measure of saving
is accurate and the truth is
at some unknown point
between the two.
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The Stock Market and the Economy
The Distribution of Wealth
When the stock prices rise by as much as they did during
the 1990s, stockholders become much wealthier.
Those households with the greatest holdings of stocks
enjoyed the greatest increase in wealth.
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The Stock Market and the Economy
Figure 35.9 shows
the level of wealth
in the United States
(adjusted for
inflation) for
households at
various levels of
income in 1992,
1995 and 1998.
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The Stock Market and the Economy
The increases in
wealth among the
richest households
(incomes over
$100,000 per year)
were far higher than
the increase in
wealth amongst the
middle-income or
low-income
households.
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The Stock Market and the Economy
Stock price
increases tend to
increase
economic
inequality.
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GLOBAL STOCK
MARKETS
THE
END
© Pearson Education Canada, 2003
35
CHAPTER