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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

Chapter 8

Stocks, Stock Markets, and Market Efficiency

Chapter Overview

The goal of this chapter is to try to make sense of the stock market, to show what

fluctuations in stock value mean for individuals and for the economy as a whole, and to

look at a critical connection between the financial system and the real economy. The

chapter will also explain how it is that things sometimes go awry, resulting in bubbles and

crashes.

Learning Objectives: Establish an understanding of:

The characteristics of common stock

Measures of the level of the stock market

The valuation of stocks

Investing in stocks for the long run

The stock market’s role in the economy

Important Points of the Chapter

For individuals, stocks are a key instrument for holding wealth; for companies, they are

one of several ways to obtain financing. Beyond that, stocks and stock markets are one

of the central links between the financial world and the real economy. Contrary to

popular mythology, stock prices tend to rise steadily and slowly, collapsing only on those

rare occasions when normal market mechanisms are out of alignment. The danger is that

if we are preoccupied with the potential short-term losses associated with crashes, we

lose sight of the gains we could realize if we took a longer-term view.

Application of Core Principles

Principle #4: Markets. We need to understand the dynamics of the stock market, both to

manage our personal finances and to see the connections between stock values and

economic conditions.

Principle #1: Time. Present value analysis can be used to find the value of a stock. The

price of the stock today should be equal to the present value of the selling price and of the

dividend payments made while the stock is held.

Principle #2: Risk. Stockholders require compensation for the risk they face, and the

higher the risk the higher the compensation.

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

Principle #4: Markets. The stock market plays a crucial role in every modern capitalist

economy. The prices determined in the stock market tell us the market value of

companies, which determines the allocation of resources.

Teaching Tips/Student Stumbling Blocks

Pay attention to the text’s careful explanation of the difference between

price-weighted and value-weight stock indices. The text provides excellent

examples illustrating the concepts presented.

This chapter continues the use of present value analysis to analyze how bond

prices are determined. You may wish to begin with a review of the tools from

Chapter 5.

Spend time going carefully through the examples given in the text, paying

particular attention to the assumptions made, and reinforce these concepts by

assigning end-of-chapter problems.

Features in this Chapter

Your Financial World: A Home is a Place to Live

When you own a stock, the issuing firm either pays you dividends or reinvests its profits

to make the business grow. Bonds pay interest. In either case, you receive an explicit

return on your investment. When you buy a house and move in, you get a roof over your

head without paying rent to someone else. When you sell it, you should expect to get

back the original purchase price and no more. The return on your investment was the

housing services you consumed.

Tools of the Trade: Reading Stock Indexes in the Business News

This section provides an illustration of the way business news reports on the performance

of various indices.

Your Financial World: Beware Percentage Changes

Sometimes investment reports imply that it is possible to evaluate a fund’s overall

performance simply by adding the percentage loss over one period to a subsequent

percentage gain. But, as this section illustrates, nothing could be further from the truth.

In fact, as the percentage decline increases, the percentage increase needed to bring a

losing investment back to its original value rises rapidly.

Applying the Concept: The Chinese Stock Market

China reopened its stock market in the early 1990s, and since then the market has grown

rapidly. In the early 1990s the stock exchanges in Shanghai and Shenzhen were primarily

concerned with transferring ownership of state-owned enterprises into private hands.

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Because of government restrictions on stock holdings, stock prices were very high.

When the government reversed course and made shares available to the market, prices

collapsed. This is an example of how changing institutional constraints result in

changing stock prices through the basic mechanism of supply and demand.

Your Financial World: Should You Own Stocks?

This section points out that there are five issues to think about when buying stock:

affordability, liquidity, diversification, management, and costs. The recommendation in

the section is that people consider these issues with regard to choosing an index fund.

In The News: Bubble Spotting

Big speculative bubbles are rare events and are difficult to predict, however, some

placesa appear to be likely places for bubbles to appear. The stock market has a history

of bubbles, including the 1920s, the 1960s, and the 1990s. Home prices have been

booming in some cities, perhaps indicating a bubble. Farmland may also be in a bubble

situation. But, there are no guarantees any of these will actually be a bubble.

Applying the Concept: What Was the Internet Bubble All About?

The Internet bubble changed the way that new companies obtain financing by replacing

venture capitalists with the capital markets. But the distortions caused by unjustifiably

high stock prices warped investors’ decisions, leaving many worthwhile projects

unfunded.

Additional Teaching Tools

In “Drop in energy stocks punctures early market rally” (Business Week, June 9, 2010),

Tim Paradis talks about the changes in the stock market given information gleaned over

the previous few days of information gathering by investors. First, Mr. Paradis discusses

comments made by Ben Bernanke, Chairman of the Federal Reserve, about the overall

state of the economy. Then the effect of the BP oil spill on energy stocks. The oil spill is

expected to increase the costs of these companies doing business.

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Lessons of the Article: Distinguishing fads from fundamentals makes forecasting

bubbles difficult if not impossible. Debate about its causes may persist even after a

bubble bursts. The article highlights “contagious” ideas or fads that lead to speculation,

especially for assets in limited supply. But not every price jump is due to a fad: If the

drivers of the price gains are fundamentals—such as profit prospects, the discount rate,

or demographics—the price rise is not a bubble.

Chapter 08 – Stocks, Stock Markets, and Market Efficiency

Virtual Tools

For more about the Dow Jones Industrial Average (and other indices) visit this site from

Dow Jones:

http://www.djaverages.com/

More good material from Dow Jones, including information on indices in other countries

can be found at:

http://averages.dowjones.com/jsp/index.jsp

The current components of the DJIA can be found at:

http://www.djindexes.com/mdsidx/downloads/fact_info/Dow_Jones_Industrial_Average_

Fact_Sheet.pdf

A history of the Dow can be found on this site from The Motley Fool:

http://www.fool.com/Ddow/HistoryOfTheDow3.htm

The most recent changes in the components of the DJIA are discussed in the article at:

http://money.cnn.com/2004/04/01/markets/dow/

Visit this site from Investopedia.com for information on other countries’ indexes and

some useful links:

http://www.investopedia.com/terms/i/index.asp

For a look at the kind of stock charts used by “chartists” go to:

http://www.stockta.com/

Learn more about charting or technical analysis at this site:

http://www.equis.com/Education/TAAZ/

For More Discussion

In the video entitled “Dow Jones Changes Industrial Index: Honeywell and Altria Are

Out” (February 11, 2007) Business Week talks about a recent change in the Dow Jones

Industrial Average. The video can be found at:

http://www.businessweek.com/mediacenter/video/marketreports/5475ac8c79a2eb0ce9dd

9fab057e64125048c3ec.html.

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

Chapter Outline

I. The Essential Characteristics of Common Stock

A. Stocks, also known as common stock or equity, are shares in a firm’s

ownership.

B. From their early days, stocks had two important characteristics that today are

taken for granted: the shares are issued in small denominations and the shares

are transferable.

C. Until recently, stockowners received a certificate from the issuing company,

but now it is a computerized process where the shares are registered in the

names of brokerage firms that hold them on the owner’s behalf.

D. The ownership of common stock conveys a number of rights:

1. A stockholder is entitled to participate in the shares of the enterprise,

but this is a residual claim (meaning the leftovers after all other

creditors have been paid).

a. Stockholders also have limited liability, meaning that even if a

company fails, the maximum amount that the stockholder can

lose is the initial investment.

2. Stockholders are entitled to vote at the firm’s annual meeting. This

includes voting to elect (or remove) the firm’s board of directors.

E. Today’s thriving trade in stock is possible because:

1. An individual share represents only a small fraction of the value of the

company that issued it;

2. A large number of shares are outstanding;

3. Prices of individual shares are low, allowing individuals to make

relatively small investments;

4. As residual claimants, stockholders receive the proceeds of a firm’s

activities only after all other creditors have been paid;

5. Because of limited liability, investor’s losses cannot exceed the price

they paid for the stock; and

6. Shareholders can replace managers who are doing a bad job.

II. Measuring the Level of the Stock Market

A. Stocks are one way in which we choose to hold our wealth, so when stock

values rise we get richer and when they fall we get poorer.

B. These changes affect our consumption and saving patterns, causing general

economic activity to fluctuate.

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C. We need to understand the dynamics of the stock market, both to manage our

personal finances and to see the connections between stock values and

economic conditions.

D. Stock market indexes are designed to give us a sense of the extent to which

stock prices are going up or down.

E. Stock indexes can tell us both how much the value of an average stock has

changed, and how much total wealth has gone up or down.

F. Stock market indexes provide benchmarks for performance of money

managers, comparing how they have done to the market as a whole.

A. The Dow Jones Industrial Average

1. The first, and still the best known, stock market index is the Dow Jones

Industrial Average (DJIA).

2. It began as an index of 11 stocks, and today is based on the stock prices of 30

of the largest companies in the United States.

3. The index is calculated by adding up the prices of all 30 stocks and dividing

by 30, so the percentage change in the DJIA over time is the percentage

change in the sum of the 30 prices.

4. The DJIA measures the return to holding a portfolio of a single share of each

of the stocks included in the average.

5. The DJIA is a price-weighted average, giving greater weight to shares with

higher prices.

6. The stocks included in the average have changed in order to reflect the

changes in the structure of the American economy.

7. Of the original 11 stocks only General Electric remains in the index.

B. The Standard & Poor’s 500 Index

1. The Standard & Poor’s 500 Index differs from the DJIA in two major respects;

first, it is constructed from the prices of many more stocks and second, it uses

a different weighting scheme.

2. The S&P 500 is based on the value of 500 firms, the largest firms in the U.S.

economy.

3. Unlike the DJIA, the S&P 500 tracks the total value of owning the entirety of

those firms.

4. In the index’s calculation, each firm’s stock price receives a weight equal to its

total market value, so the S&P 500 is a value-weighted index.

5. Larger firms are more important in the S&P 500.

6. The S&P 500 is neither better nor worse than the DJIA; rather, the two types

of index simply answer different questions.

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

C. Other U.S. Stock Market Indices

1. Besides the DJIA and the S&P 500, the most prominent indices in the United

States are the Nasdaq Composite Index or Nasdaq and the Wilshire 5000.

2. The Nasdaq is a value-weighted index of over 5000 companies traded on the

over-the-counter market (OTC) through the National Association of Securities

Dealers Automatic Quotations service.

3. The Nasdaq is composed mainly of smaller, newer firms and in recent years

has been dominated by technology and Internet companies.

4. The Wilshire 5000 is the most broadly based index in use and covers all

publicly traded stocks in the United States, including all the stocks on the New

York Stock Exchange, the American Stock Exchange and the OTC (together

these total to more than 6,500 stocks, contrary to the name).

5. Like the Nasdaq and the S&P 500 the Wilshire 5000 is value-weighted.

D. World Stock Indices

1. Every major country in the world has a stock market, and each of these

markets has an index.

2. For the most part, these are value-weighted indices.

3. To analyze the performance of these different markets it is useful to look at

percentage changes, but percentage change isn’t everything.

III. Valuing Stocks

1. People differ in their opinions of how stocks should be valued.

2. Chartists believe that they can predict changes in a stock’s price by looking at

patterns in its past price movements.

3. Behavioralists estimate the value of stocks based on their perceptions of

investor psychology and behavior.

4. Still others estimate stock values based on a detailed study of the

fundamentals, which can be analyzed by examining the firm’s financial

statements. In this view the value of a firm’s stock depends both on its current

assets and estimates of its future profitability.

5. The fundamental value of stocks can be found by using the present value

formula to assess how much the promised payments are worth, and then

adjusting to allow for risk.

6. Chartists and Behavioralists focus instead on estimates of the deviation of

stock prices from those fundamental values.

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

A. Fundamental Value and the Dividend-Discount Model

1. As with all financial instruments, a stock represents a promise to make

monetary payments on future dates, under certain circumstances.

2. With stocks the payments are in the form of dividends, or distributions of the

firm’s profits.

3. The price of a stock today is equal to the present value of the payments the

investor will receive from holding the stock, which in the example given in

the text is the selling price of the stock in one year’s time and the dividend

payments received while the stock is held.

4. This can be extended for longer holding periods.

5. If a stock does not pay dividends the calculation can still be performed; a

value of zero is used for the dividend payments.

6. Future dividend payments can be estimated assuming that current dividends

will grow at a constant rate per year.

7. Assuming that the firm pays dividends forever solves the problem of knowing

the selling price of the stock; the assumption allows us to treat the stock as we

did a consol.

8. This relationship is the dividend-discount model.

B. Why Stocks Are Risky

1. Stockholders receive profits only after the firm has paid everyone else,

including bondholders.

2. It is as if the stockholders bought the firm by putting up some of their own

wealth and borrowing the rest.

3. This borrowing creates leverage, and leverage creates risk.

4. Stocks are risky, therefore, because shareholders are residual claimants.

5. Any variation in the firm’s revenue flows through to stockholders dollar for

dollar, making their returns highly volatile.

C. Risk and the Value of Stocks

1. The dividend-discount model must be adjusted to include compensation for a

stock’s risk.

2. The required return a shareholder needs is the sum of the risk-free interest rate

and the risk premium, sometimes called the equity risk premium.

3. Recall that the risk-free rate can be thought of as the interest rate on a U.S.

Treasury security with a maturity of several months.

4. The higher the risk premium investors demand to hold a stock, the lower its

price; the higher the risk-free return, the lower the stock’s price.

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

D. The Theory of Efficient Markets

1. There are two explanations for why stock prices change continuously.

2. One is based on fundamental values; when fundamentals change, prices must

change with them.

3. This line of reasoning gives rise to the theory of efficient markets. The basis

of the theory is the notion that the prices of all financial instruments, including

stocks, reflect all available information.

4. As a result, markets adjust immediately and continuously to changes in

fundamental values.

5. If the theory is correct, chartists are doomed to failure, because future price

movements are unpredictable.

6. If the theory is correct then no one can consistently beat the market average;

active portfolio management will not yield a return that is higher than that of a

broad stock-market index.

7. If managers claim to exceed the market average year after year, they must be

taking on risk, be lucky, have private information (which is illegal), or

markets are not efficient.

8. Pure chance can, in fact, explain that a few achieve higher than expected

returns.

IV. Investment in Stocks for the Long Run

1. Stocks appear to be risky, and yet many people hold substantial proportions of

their wealth in the form of stock.

2. The explanation for this is the difference between the short term and the long

term; investing in stocks is risky only if you hold them for a short time.

3. In fact, according to the analysis presented in the chapter, when held for the

long term, stocks are less risky than bonds.

V. The Stock Market’s Role in the Economy

1. The stock market plays a crucial role in every modern capitalist economy.

2. The prices determined there tell us the market value of companies, which

determines the allocation of resources.

3. So long as stock prices accurately reflect fundamental values, this resource

allocation mechanism works well. At times, however, stock prices deviate

significantly from the fundamentals and prices move in ways that are difficult

to attribute to changes in the real interest rate, the risk premium, or the growth

rate of future dividends.

4. Shifts in investor psychology may distort prices; both euphoria and depression

are contagious.

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5. When investors become unjustifiably exuberant about the market’s future

prospects, prices rise regardless of the fundamentals, and such mass

enthusiasm creates bubbles.

6. Bubbles are persistent and expanding gaps between actual stock prices and

those warranted by the fundamentals.

7. Bubbles inevitably burst, creating crashes.

8. Bubbles affect all of us because they distort the economic decisions

companies and consumers make.

9. If bubbles result in real investment that is both excessive and inefficiently

distributed, crashes do the opposite; the shift to excessive pessimism causes a

collapse in investment and economic growth.

10. When bubbles grow large enough and result in crashes the stock market can

destabilize the real economy.

Terms Introduced in Chapter 8

bubble

common stock

dividend-discount model

dividends

Dow Jones Industrial Average

equity

fundamental value

limited liability

market capitalization

mutual fund

Nasdaq Composite Index

price-weighted average

residual claimant

Standard & Poor’s 500 Index

stock market

stock-market indexes

theory of efficient markets

value-weighted index

Wilshire 5000

Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

S&P 500 Stock Price Index SP500

Dow Jones Industrial Average DJIA

Wilshire 5000 WILL5000IND

CBOE Volatility Index: VIX VIXCLS

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

Market value of equities of nonfarm nonfinancial

Corporations

MVEONWMVBSNNCB

Total net worth (market value) of nonfarm nonfinancial

corporations

TNWMVBSNNCB

Total net worth (historical cost) of nonfarm nonfinancial

corporations

TNWHCBSNNCB

Corporate equities held by households CEABSHNO

Lessons of Chapter 8

1. Stockholders own the firms in which they hold shares.

a. They are residual claimants, which means they are last in line after all

other creditors.

b. They have limited liability, so their losses cannot exceed their initial

investments.

2. There are two basic types of stock market index.

a. The Dow Jones Industrial average is a price-weighted index.

b. The S&P 500 is a value-weighted index.

c. For every stock market in the world, there is a comprehensive index that is

used to measure overall market performance.

3. There are several ways to value stocks.

a. Some analysts examine patterns of past performance; others follow

investor psychology.

b. The fundamental value of a stock depends on expectations for a firm’s

future profitability.

c. To compensate for the fact that stocks are risky investments, investors in

stock require a risk premium.

d. The dividend-discount model is a simple way to assess fundamental value.

According to this model, stock prices depend on the current level of

dividends, the growth rate of dividends, the risk-free interest rate, and the

equity risk premium.

e. According to the theory of efficient markets, stock prices reflect all

available information.

f. If markets are efficient, then stock price movements are unpredictable, and

investors cannot systematically outperform a comprehensive stock market

index like the S&P 500.

4. Stock investments are much less risky when they are held for long periods than

when they are held for short periods.

5. Stock prices are a central element in a market economy, because they ensure that

investment resources flow to their most profitable uses. When occasional bubbles

and crashes distort stock prices, they can destabilize the economy.

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

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