McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 38 The Stock Market and Crashes

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline STOCK PRICES EFFICIENT MARKETS STOCK MARKET CRASHES BANKRUPTCY

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. What are Stocks? If a company has “N” shares of stock, each one entitles the owner to a fraction (1/N th ) of –The vote in determining membership on the board of directors. –The declared dividends of the company. –The proceeds from a sale of the company.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Stock Prices: How they are Determined Fundamentals –Earnings projections –Interest rates Non-fundamental –The expected price of the share in the future.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Fundamental Value of a Share of Stock The fundamental value of a share of stock is the present value of the projected earnings at an expected interest rate. An increase in earnings increases stock values. A decrease in the interest rate increases stock value.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. What Stock Markets Do An Initial Public Offering (IPO) is when a company sells stock for the first time in an attempt to raise money for expansion and is a very small part of everyday market activity. Most sales of stock do not involve the company receiving or paying money. They are simply the transfer of the asset from one holder to another.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Function of Trading Regular trading of stock serves to equate the risk-adjusted return to investors across assets.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficient Markets Any market is called efficient if all information is taken into account by participants. Under the Efficient Markets Hypothesis the contention is that an average investor with no inside information will fare no better or worse making choices than a someone who spends a great deal of time contemplating their portfolio.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Stock Indexes Stock indexes are a weighted average of stock prices in a particular group and serve to measure the state of the stock market as a whole. Examples include –Dow Jones Industrials –Standard and Poor’s –NASDAQ

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Dow Jones Industrials

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. S&P 500

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. NASDAQ

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Stock Market Crashes October 1929 –Stock market lost more than 25% of its value in a few days. It was not permanently above its Oct high until after World War II. October 1987 –Stock Market lost 20% of its value in one day. It rebounded quickly.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Bubbles A bubble is the state of a market where the current price is far above its value determined by fundamentals. 1.Prices rise which 2.creates the expectation that prices will rise further which 3.Repeat steps 1 and 2

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Examples of Bubbles The Asian Financial Crisis of –Share prices increased dramatically through the 1980s and 1990s. –Currency devaluations and risky investments caused precipitous declines. NASDAQ 2000 –The “tech-heavy” nature of the NASDAQ fueled unrealistic expectations for earnings growth. When that growth did not materialize, the NASDAQ lost 50% of its value in a year. It lost more in 2001.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. NASDAQ

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Tech Stocks Lost Value Fundamental Reasons –Earnings projections dropped –Interest rates rose through 2000; they fell substantially in 2001 but that was due to recession concerns. Realism strikes –The projected growth path of earnings was not realistic.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Accounting Scandals of 2001 and 2002 K-Mart-poor performance Global Crossing-fraud and very high risk Enron-fraud

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Bankruptcy A legal status entered into when a company or individual cannot pay its debt. Bankruptcy is necessary because –creditors acting in their own interest will seek immediate payment/foreclosure. –It is in the interests of all creditors that debtors have time to make their payments Varieties of Corporate Bankruptcies –Chapter 11 - allows for reorganization –Chapter 13 – allows for orderly sale of all assets

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Enron Case Accounting fraud was employed so that the management of the company could overstate profits. Managers were paid in stock options to combat the principal-agent problem –The problem that occurs when the owner of an asset and the manager of that asset are different and have different preferences. The Enron-type fraud was of more concern to investors because it introduced a new variety of risk.