Next page The Stock Market: –What Does It Do and How Has it Performed? 5 C H A P T E R SUPPLEMENT

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. The Economic Functions of the Stock Market

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved Source: Standard and Poor’s. % Change The Economic Functions of the Stock Market n The stock market allows nearly anyone to participate in the risks and opportunities of corporate America. Real returns for the past two centuries have averaged 7 percent per year. n During the last 16 years, the broad S&P 500 stock index indicates that stock investors earned a 15 percent average annual rate of return. 17.9% 0.1% 26.0% 20.0% -3.1% 14.8% 26.1% -5.7% 18.2% 12.1% 7.0% -2.3% 35.0% 20.9% 29.5% 23.7% n Double-digit returns were earned during 11 of the 16 years, while the returns were negative during only 3 of the years.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. How the Stock Market Works for Savers and Investors n Savers invest in the stock market as a strategy to build wealth. n Investors that buy a diverse portfolio of shares and hold them over long periods of time, substantially reduce their risks. n Small investors can purchase stock in an equity mutual fund, a corporation that buys and holds shares of stock in many firms. n Equity mutual funds have reduced the risk of stock ownership and attracted large amounts of funds into the market, helping to push stock prices upward.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 2,500 0 Y ear 2,000 1,500 1, V alue of Stocks Owned Through Equity Mutual Funds (billions of $) Source: Investor Company Institute The Value of Equity Mutual Funds n The amount of money that people put into U.S. equity mutual funds in order to hold shares in the ownership of stocks, rose dramatically in the 1990s. n Purchasing shares in a mutual fund is a simple way for an individual to buy and hold interest in a large variety of stocks with one purchase.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Stocks Are Less Risky When Held for a Lengthy Time Period S&P 500 Index Annualized Total Real Return (%) year periods year periods year periods year periods Sources: Ibbotson Associates and Merrill Lynch, published in the Merrill Lynch Newsletter, Insights and Strategies, Vol. 3, No. 4, 1998, p.1. 61% 27.9% 19.4% 0.5% 15.1% 6.4% -4.2% -38.9% n This graphic highlights the best and worst annualized performance for each holding period from 1950 – n It shows that there is less risk of a low or negative return when a portfolio of S&P 500 stocks is held for a longer period of time.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. How the Stock Market Works for Corporations n To raise money, a corporation can : u use retained earnings, u borrow money, or, u sell stock. (Buyers can, if they wish, later resell the shares on the stock market) n Each share of the stock is a fractional share in the firm’s future net revenues. n People buy the stock of a corporation to get future dividends paid from corporate earnings and gains derived from increases in share prices.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. How the Stock Market Works for Corporations n The decisions of a firm’s executives influence the firm’s stock price. u When investors (their advisors and fund managers) believe that the decisions of corporate managers will increase the firm’s future income, they buy more of the stock, driving its price up. u When investors believe that bad decisions are being made, the the stock’s price falls. n Corporate board members are usually stockholders, and top managers are often given stock options. u The value of the stock options will rise sharply as the firm’s stock price increases. This helps bring the interest of corporate decision makers into harmony with the interest other stockholders.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. How the Stock Market Works for the Economy n The stock market benefits stockholders by disciplining corporate decision makers to be more efficient and undertake the most productive projects. n The price of a corporation’s shares constantly sends signals to the listed corporation’s board of directors and managers. u Changing stock prices reward good decisions and penalize bad ones. n To increase the firm's value, the firm must undertake productive projects.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 2. Stock Prices and the Interest Rate

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Stock Prices and the Interest Rate n Underlying the price of a firm’s stock is the present value of the firm’s expected future net earnings, or profit. n The value of a share depends on: u the expected size of future net earnings, u when these earnings will be achieved, and, u the interest rate by which the investor discounts the future income.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n If D represents dividends (and gains from a higher stock price) earned during various future years (indicated by the subscripts) & i represents the discount or interest rate, the present value of the future income stream is: Stock Prices and the Interest Rate n A higher interest rate reduces the present value of future returns from holding shares of stock.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 3. The Stock Market Since 1982: -- What Caused the Dramatic Rise?

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Interest rates and inflation fell. n Corporate earnings were higher. n The improving U.S. economy drew investment funds from abroad. n Mutual funds expanded their holdings dramatically. The Stock Market Since 1982: -- What Caused the Dramatic Rise?

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 4. Is the Stock Market Too High: -- Is It a Bubble That Will Burst?

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Stock prices reached levels in early 1999 that were very high by historic standards. n Optimists who think stock price levels will rise significantly in the near future can make a plausible case, but pessimists can do the same for their view. n Investor expectations about an uncertain future determine current prices, and no one can forecast future stock prices with precision or certainty. Is the Stock Market Too High: -- Is it a Bubble That Will Burst?

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. A friend just inherited $50,000. She informs you of her investment plans and asks for your advice. “I want to put it into the stock market and use it for my retirement in 30 years. What do you think is the best plan that will provide high returns at a relatively low risk?” What answer would you give? Explain. Questions for Thought: 2. Microsoft stock rose from less than $10 in 1995 to nearly $100 in early Microsoft had made sizeable profits, but never paid a dividend. Why were people willing to pay such a high price knowing that they might not get dividends for many years? 3. If an investment advisor gives you a hot new stock tip, is it likely to be a "sure thing"? Why or why not?

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. End Application 5