Stock and Stock Markets

Essential Characteristics of Common Stock (History)

1. 16th century: 1st appeared as way to finance voyages of explorers 2. Idea was to spread risk through join-stock companies (organizations that issued stock and used proceeds to finance several expeditions at once 3. In exchange for investing, stockholders received share of company's profits

World Stock Indexes

1. About a third of all countries in world have stock market and each has index 2. Most are value-weighted indexes 3. Investors view global stock markets as means to diversify risk away from domestic markets 4. However, there is now increased correlation of global markets

Bubbles

1. Affect everyone: distort economic decisions that companies and consumers make 2. Companies sell share for prices that are too high 3. Companies invest too much 4. Those not in euphoria invest too little 5. People think they are wealthier than they are and spend too much 6. Virtous Cycle

Mutual Funds Pros

1. Affordability: small initial investment 2. Liquidity: can withdraw quickly (end of day prices) 3. Diversification: portfolios of stocks, or sector funds 4. Management: professionals 5. Cost: look for low management fees

Theory of Efficient Markets

1. Basis: notion that prices of all financial instruments reflect all available information 2. Market adjusts immediately and continuously to changes in fundamental values 3. Implies stock price movements are unpredictable 4. Active Portfolio management will not yield higher return than of broad stock-market index

Why Stocks are Risky

1. Bondholders and preferred shareholders are paid first 2. Borrowing creates leverage, which creates risk 3. More debt, more leverage and greater owners' risk 4. Shareholders are residual claimants 5. In contrast, bond holders receive fixed nominal payments and paid before stockholders in event of bankruptcy

Bubbles and Crashes

1. Both euphoria and depression: contagious 2. When investors become unjustifiably exuberant, prices rise regardless of fundamentals 3. Creates bubbles, persistent and expanding gaps between actual stock prices and those warranted by fundamentals 4. Bubbles: usually lead to crashes 5. Explains jagged pattern in annual stock returns

Valuing Stocks

1. Chartists or technical analysts: believe they can predict changes by looking at patterns or past movements 2. Behaviorists: estimate value of stocks based on perceptions of investor psychology and behavior 3. Fundamental Analysts: estimate stock based on both its current assets and on estimates of future profitability and use use judgement 4. Quantitative analysts: build complex quantitative models to screen stocks based on preferred formula or algorithm. these models can use either fundamental or technical inputs 5. Fundamental value of stock: based on timing and uncertainty of returns it brings 6. We can use information we have already studied to compute fundamental value of stocks 7. Fundamental analysts use many different approaches to valuing stocks: dividend discount model, expected value

Why They Matter

1. Companies use stocks as a way to obtain financing 2. Central link between financial works and real economy 3. Tell us current and potential value of company 4. Allocate scarce resource

Standard & Poor's 500 Index

1. Constructed from prices of many more stocks than DIJA 2. Based on value of 500 largest firms in U.S. economy (tracks total value of owning entirety of those firms) 3. Uses value-weighted index where larger firms carry more weight 4. Primary index for equity managers 5. If firm is priced at $100 and has 10 million shares outstanding, its total market value or market capitalization is worth $1 billion 6. Price weighted index gives more importance to companies with high market value (Price per se is irrelevant)

Valuing Stocks: Dividend-Discount Model

1. Current price is present value of next years price plus dividend 2. Price today is present value of sum of dividends plus present value of price at time stock is sold n years from now

Crashes

1. Do opposite 2. Shift from over-optimism to excessive pessimism causes collapse in investment and economic growth, vicious cycle 3. Rage stock market swings alter economic prospects even if grounded in fundamentals 4. During recent financial crisis, incentive to pull back on investment amplified recessions of 2007-2009

Top 10 Financial Bubbles

1. Dutch Tulip Bubble 1636 2. South Sea Bubble 1720 3. Late 20's US Bubble 1927-1929 4. Credit explosion in Mexico late 1970's 5. Japan real estate and stocks 1985-1989 6. Scandinavia 1985-1989 7. Asian Tigers 1992-1997 8. Mexico Foreign Debt Crisis 1990-1993 9. Dot Com Bubble 1996-2000 10. Subprime RE Bubble 2005-2008

Key Takeaways

1. Equities: shares in firm's ownership. More upside, but more downside than bonds 2. Equity markets: tracked with indexes, some more reflective than others 3. Methods to value stocks differ greatly 4. Stock-based equity investment vehicles for individuals are usual funds and ETF's, the latter growing MUCH faster 5. Can be manic depressive in short.medium term. Equity investments proven compelling over longer term

Dow Jones Industrial Average

1. First and best known stock market index 2. Based on stock prices of 30 of largest companies in U.S. 3. Measures value of purchasing single share of each of stocks in index

Mutual Funds Cons

1. Majority of US Mutual Fund manners have underperformed in 10 out of last 12 years 2. 2012: 57% of active managers underperformed 3. Fees (which are for management and administration and occasionally to compensate sales people, which averaged 77bps in 2012) are large when you consider underperformance, under pressure for industry, down 20% since 1990

Wilshire 5000

1. Most broadly based index in use; covers all public traded stocks in U.S. 2. Value-weighted and is best measure of overall market wealth

Exchange Traded Funds

1. Mutual funds that are traded like stocks on stock exchange 2. Huge growth area, assets now over $1 Trillion, double from 2009 3. Key difference: offer instant liquidity vs mutual funds so can be traded like stocks, add appeal to institutional investors 4. Index ETF's: most popular 5. So popular now, account for more than 20-30% of US trading volume 6. Cheap vs mutual funds at 10-35 bps of management fees vs 77 bps for index mutual funds 7. Industry ETF's are popular trading tool for institutional investors and retail investors alike, rapidly expanding into 401 k's

Other US Stock Market Indexes

1. Nasdaq Composite Index 2. Wilshire 5000

Bubbles and Crashes: Dot-Com Bubble

1. Nasdaq: composed of numerous small start-ups and large information technology firms 2. Doubled in value from September 1999 to March 2000 then fell by 70% over next year 3. New idea-based companies could gain financing directly from capital markets instead of relying on venture capitalists 4. Downside were large losses to investors and warped investors' decisions

DIJA

1. Percentage change over time is percentage change in sum of 30 prices 2. Price-weighted average, which gives greater weight to shares with higher prices 3. Behavior of higher priced stocks dominated movement of price-weighted index 4. Dow is NOT good benchmark index

Evidence Suggests Both That

1. Prices are unpredictable 2. Professional money managers cannot beat index like S&P 500 regularly . Returns are 2% lower on average

Essential Characteristics of Common Stock

1. Shares issued in small denominations, allowing investors to buy as little or as much as they wanted 2. Shares were transferable, an owner could sell them to someone else 3. Although one used to receive a stock certificate, most stockholder no longer do (information is all computerized which is safer and makes it easier to transfer)

Strict Market's Role in Economy: Bubbles and Crashes

1. Stock markets tell us value of companies (guides allocation of resources) 2. When stock prices accurately reflect fundamental values, resource allocation mechanism works well 3. However, stock price sometimes deviate significantly from fundamentals

Fundamental Value and Dividend-Discount Model

1. Stock represents promise to make monetary payments on future dates, under certain circumstances 2. These payments usually in form of dividends 3. If a company is sold, stockholders receive final distribution that represents their share of purchase price

Ownership of Common Stock Conveys Rights

1. Stockholder is entitled to participate in profits of enterprise 2. Entitled to vote at firms annual meeting 3. Entitled to receive dividends if they are paid

Investing in Stocks for Long Run

1. Stocks appear to be risky, but people hold substantial proportion of portfolio in stock 2. Either stocks are not risky or people are not that risk-averse 3. Average real return was 8% per year 4. Minimum return: -34% (2008) 5. Maximum return: 31% (1996) 6. Professor Jermey Siegel: investing in stocks is risky only if you hold them for short time 7. Minimum return: 2.5% 8. Maximum return: 11.3% 9. 1871-1992: No 30 year periods where bonds outperformed stocks

Equity Investment Vehicles

1. Stocks buy individual equities to form portfolio 2. Mutual funds actively managed by fundamental analysts (active) 3. Index funds (passive) 4. Industry and Index ETF's (passive)

But We Do See Managers Who Claim to Exceed Market

1. They have inside information, which is illegal 2. Taking on risk and compensated as such 3. Lucky 4. Markets aren't efficient

Nasdaq

1. Value-weighted index of over 5000 companies traded on over-the-counter (OTC) market 2. Primarily composed of smaller, newer firms and has recently been dominated by technology and Internet companies

What If Company Does Not Pay Dividends

1. We estimate when the company will start paying dividends and use present value framework 2. We must know something more about annual dividend payments

Market Level of Stock Market

1. What drives stock market (connections between stock values and economic conditions)? 2. How do we measure fluctuation in stock values (concept is value of stock market, stock-market indexes)? 3. Stock Indexes (show how value of an average stock has changed, show how much total wealth has gone up or down, provide benchmarks for performance of money managers)

However, Stockholders have Limited Liability in Firm

Even if a company fails completely, maximum amount shareholder can lose is their initial investment

Mutual Funds

Prepackaged mutual funds are popular way to buy stocks

Although Stockholder is Entitled to Participate in Profits of Firm, They are Merely a Residual Claimant

Stockholders are paid last, only after all other creditors have been paid