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Chapter 7
The Stock Market
©Thomson/South-Western 2006
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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.
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Figure 7-1
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Table 7-1
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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.
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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.
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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.
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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.
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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.
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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)
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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.
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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
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Table 7-2
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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
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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.
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Figure 7-2
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Figure 7-3
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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.
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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.
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Figure 7-4
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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.
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Figure 7-5
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Table 7-4
The Tendency for Mean Reversion in Returns from Stocks
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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.
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The “Tech Wreck”
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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.
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