Investments: Analysis and Behavior Chapter 2- Equity Markets

Learning Objectives Learn where and how securities are traded. Know how stock market performance is measured. Know sector, industry, and global market indices. Understand the relevant laws governing the investment industry.

Markets Primary Market Secondary Market Market for new securities sold to investors for the first time to raise capital for the issuer Secondary Market Stock exchange where investors trade stocks with each other.

Equity Markets New York Stock Exchange An Agency Auction Market Market in which brokers represent buyers and sellers and prices are determined by supply and demand. www.nyse.com Trading All trading in a specific stock is done at the post where that stock is assigned on the NYSE floor. Trading is managed by the specialist. Employee of a NYSE firm who manages the market for an individual stock

The NYSE is the most prestigious stock exchange in the world Publicly traded company NYSE Euronext General Electric, Citigroup, Wal-Mart, Time Warner, IBM, Coca Cola Has electronic trading system, Arca

American Stock Exchange AMEX is also a specialist auction market The nation’s second largest stock exchange More than 1,000 listings www.amex.com Public Float One of the financial guidelines for listing on the AMEX (market value of $3 million) Common stock held by unaffiliated institutional and individual investors (held by the public, not the company)

Nasdaq Electronic market The largest organized equities (stock) market by trading volume and number of listed companies Negotiated market Market makers are dealers Price determination through bargaining 3,900+ issues more technology firms Dell, Microsoft, Intel www.nasdaq.com

Other U.S. stock markets Nasdaq SmallCap Market 800 small firms seeking Nasdaq market maker sponsorship No penny stocks (defined as price < $1) Over-the-Counter Bulletin Board 3,300+ securities offered by 230+ market makers Penny stocks traded here Electronic Communication Networks (ECNs) Electronic market for institutional investors to trade with each other

Tracking the market Did the market go up or down today? Every day, some stocks increase in price while others decline So, what does an increasing marketing mean?

Dow Averages DJIA Divisor Charles Dow and Edward Davis Jones Credited with inventing the first stock index First stock index created in 1884 11 firms Mostly railroad companies Added up the stock prices and divided by 11. (price average index) DJIA was started in 1896 with 12 stocks. Modern era of 30 DJIA stocks began in 1928. DJIA Divisor Adjustment factor used to account for stock splits

Dow Jones Industrial Average 30 companies Most important and largest firms Selected by the editors of the Wall Street Journal Formula While originally 30, the divisor has been steadily reduced to account for stock splits. In early-2009 the divisor was 0.125552709. At that time, a $1 change in a stock’s price caused the DJIA to change by 7.96 points (=1/ 0.125552709).

Problems with price-weighted averages 3M Co. Alcoa Inc. American Express Co. AT&T Inc. Bank of America Corp. Boeing Co. Caterpillar Inc. Chevron Corp. Citigroup Inc. Coca-Cola Co. E.I. DuPont de Nemours & Co. Exxon Mobil Corp. General Electric Co. General Motors Corp. Hewlett-Packard Co. Home Depot Inc. Intel Corp. International Business Machines Corp. Johnson & Johnson JPMorgan Chase & Co. Kraft Foods Inc. Cl A McDonald's Corp. Merck & Co. Inc. Microsoft Corp. Pfizer Inc. Procter & Gamble Co. United Technologies Corp. Verizon Communications Inc. Wal-Mart Stores Inc. Walt Disney Co. Problems with price-weighted averages Changes in high-priced components move the DJIA more than low-priced components. A 10% price change in a $100 DJIA (like IBM) is $10, and causes a 79.65 point change in the DJIA. A 10% price change in a $5 DJIA (like GM) is 50¢, and causes a 3.98 point change in the DJIA. DJIA returns can be affected by timing of stock splits. Stock splits require changes in the divisor. Mimicking DJIA portfolio returns requires lots of rebalancing due to divisor changes.

Standard & Poor’s 500 Index The 500-firm index started in 1957 Value-weighted index Determine market capitalization of each firm (stock price × shares outstanding) Add up the market capitalization for all 500 firms Scale (Index Base set to 10) 500 leading U.S.-based companies. Chosen by S&P committee. Is not an index of the 500 largest companies. Sector weights set to match overall market. A preferred investment equity benchmark Performance standard to be evaluated against

Index Example Consider 3 stocks. Consider two indices Stock A is $40 and has 300 shares outstanding Stock B sells for $60, outstanding shares of 200 Stock C costs $80 and has 100 shares. Consider two indices Price-weighted average, divisor=2.5 Value-weighted average Base index value = 100 The stock originally sold for $30, $50, and $60 with outstanding shares of 300, 100, and 100, respectively

What is the value of each index? Price-weighed average (40 + 60 + 80) / 2.5 = 72.00 Value-weighted index {($40X300 + $60X200 + $80X100) / ($30X300 + $50X100 + $60X100)} × 100 = {32,000 / 20,000} × 100 = 160.00

What is the value of each index after the $40 stock changes to $45? Price-weighed average (45 + 60 + 80) / 2.5 = 74.00 a 2.78% change Value-weighted index {($45X300 + $60X200 + $80X100) / ($30X300 + $50X100 + $60X100)} × 100 = {33,500 / 20,000} × 100 = 167.50 a 4.69% change

Market Capitalization Large-cap Firm value: $10 billion–$200 billion Mid-cap Firm value: $1 billion–$10 billion Small-cap Firm value: $300 million–$1 billion

Additional Popular Indices Russell Indexes Russell 3000 Index of the 3,000 largest market cap U.S. companies. Represents 98% of the investable US equity Russell 1000 Index of the 1,000 largest market cap U.S. companies. Over 90% of investable US equity Russell 2000 Index is comprised of the 2,000 smallest companies in the Russell 3000 Leading small cap index.

Dow Jones Wilshire Dow Jones Wilshire 5000 Composite Index Dow Jones Wilshire 5000 (Full Cap) Price Dow Jones Wilshire 4500 (Full Cap) Price Dow Jones Wilshire 2500 Price Dow Jones Wilshire U.S. Large-Cap Price Dow Jones Wilshire U.S. Mid-Cap Price Dow Jones Wilshire U.S. Small-Cap Price Dow Jones Wilshire U.S. Micro-Cap Price Dow Jones Wilshire U.S. Large-Cap Growth Price Dow Jones Wilshire U.S. Large-Cap Value Price Dow Jones Wilshire U.S. Mid-Cap Growth Price Dow Jones Wilshire U.S. Mid-Cap Value Price Dow Jones Wilshire U.S. Small-Cap Growth Price Dow Jones Wilshire U.S. Small-Cap Value Price Wilshire Large Cap 750 Wilshire Mid Cap 500 Wilshire Small Cap 1750 Wilshire Micro Cap Wilshire All Growth Wilshire All Value Wilshire Large Growth Wilshire Large Value Wilshire Mid Growth Wilshire Mid Value Wilshire Small Growth Wilshire Small Value Wilshire Small Cap 250 Wilshire Small Cap 250 Price Dow Jones Wilshire Dow Jones Wilshire 5000 Composite Index Most comprehensive measure of the U.S. stock market. Designed to represent the performance of all US-headquartered equity securities Contains 4,787 stocks (early 2008) Dow Jones Wilshire 4500 Contains the Wilshire 5000 firms less the S&P 500 firms Considered a mid-cap index

Nasdaq Indexes Nasdaq Composite Index Nasdaq 100 Index. All 5,000+ common stocks listed on the Nasdaq Stock Market. More than 3,000 firms. Market value-weighted. Nasdaq 100 Index. Largest 100 firms on the Nasdaq Stock Market. Large stock index, but technology oriented.

Standard & Poor’s S&P 500 – Popular value-weighted index S&P MidCap 400 Index 400 firms Stocks with market caps of $1.5 to $10 billion S&P SmallCap 600 Index 600 firms Average market cap of $600 million

INDEX (NUMBER) A quantity whose variation over a period of time measures the change in some phenomenon.

Global Stock Indexes Major Local Stock Market Indexes Nikkei (Japan) Dax (Germany) FTSE (UK) Morgan Stanley Capital International Indexes Global, regional, and country indexes. Emerging and developed markets.

Figure 2.3 Global Stock Exchange Indexes

Law instituting public accounting reforms and investor protections Securities Market Regulation Legislation Important to Investors, Issuers of Securities and Brokers/Dealers Securities Act of 1933 Applies to firms going public—issuing new securities Requires firms to register with government Requires firms to provide investors with financial and material information Exempts private placements and small issues Securities Exchange Act of 1934 Focuses on securities trading Creates and authorizes Securities and Exchange Commission (SEC) to enforce statutes, rules, and regulations Protects investors against fraud Sarbanes-Oxley Act Law instituting public accounting reforms and investor protections

Self-Regulatory Organizations (SROs) SEC delegates regulatory authority National Association of Securities Dealers (NASD) Regulates Nasdaq and OTC Monitors sales practices Administers tests and licenses for individuals Ensures accurate sales information NYSE, AMEX, CBOE--business practices and market operations Municipal Securities Rulemaking Board Banks—Fed Reserve, Comptroller of Currency, FDIC

Market Surveillance NYSE’s Stock Watch Intermarket Surveillance Group Flags unusual volume and/or price changes. Investigates questionable trades. Intermarket Surveillance Group Shares information and coordinates efforts to detect manipulation Securities Arbitration Private form of dispute resolution with binding outcomes

Circuit Breakers On Monday, October 19, 1987, the DJIA lost over 22% of its value in a crash. This event lead to the enactment of circuit breakers that pause or close trading during fast moving markets. Breakers are set to 10%, 20%, and 30% of recent DJIA level. At DJIA 10,000, the breakers are daily changes of 1,000, 2,000, and 3,000 points. The first breaker halts trading for 30 to 60 minutes. The second breaker halts trading for 2 hours. The third breaker stops trading for the day.