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Chapter 38

The Stock Market and Crashes

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Chapter Outline

• STOCK PRICES• EFFICIENT MARKETS• STOCK MARKET CRASHES• BANKRUPTCY

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What are Stocks?

• If a company has “N” shares of stock, each one entitles the owner to a fraction (1/Nth) 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.

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Stock Prices: How they are Determined

• Fundamentals– Earnings projections– Interest rates

• Non-fundamental– The expected price of the share in the

future.

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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.

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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.

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The Function of Trading

• Regular trading of stock serves to equate the risk-adjusted return to investors across assets.

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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.

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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

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Dow Jones Industrials

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S&P 500

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NASDAQ

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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. 1929 high until after World War II.

• October 1987– Stock Market lost 20% of its value in one

day. It rebounded quickly.

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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

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Examples of Bubbles

• The Asian Financial Crisis of 1998-1999– 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.

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NASDAQ 1999-2003

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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.

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Accounting Scandals of 2001 and 2002

• K-Mart-poor performance • Global Crossing-fraud and very high risk• Enron-fraud

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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

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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.