Chapter 8
       Stocks, Stock Markets, and Market Efficiency

I.     The Essential Characteristics of Common Stock
A. The Dow Jones Industrial Average
      1. The first, and still the best known, stock market index is the Dow Jones
III. Valuing Stocks
       1. People differ in their opinions of how stocks should be valued.
       2. Chartists believe ...
D. The Theory of Efficient Markets
         1. The basis of the theory is the notion that the prices of all financial inst...
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  1. 1. Chapter 8 Stocks, Stock Markets, and Market Efficiency I. The Essential Characteristics of Common Stock 1. Stocks, also known as common stock or equity, are shares in a firm’s ownership. 2. Stocks had two important characteristics: the shares are issued in small denominations and the shares are transferable. 3. 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. 4. The ownership of common stock conveys a number of rights: a. A stockholder is entitled to participate in the shares of the enterprise, but this is a residual claim. Stockholders also have limited liability, meaning that even if a company fails, the maximum amount that the stockholder can lose is the initial investment. b. Stockholders are entitled to vote at the firm’s annual meeting. This includes voting to elect (or remove) the firm’s board of directors. 5. Today’s thriving trade in stock is possible because: a. An individual share represents only a small fraction of the value of the company that issued it; b. A large number of shares are outstanding; c. Prices of individual shares are low, allowing individuals to make relatively small investments; d. As residual claimants, stockholders receive the proceeds of a firm’s activities only after all other creditors have been paid; e. Because of limited liability, investor’s losses cannot exceed the price they paid for the stock; and f. Shareholders can replace managers who are doing a bad job. II. Measuring the Level of the Stock Market 1. 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. 2. These changes affect our consumption and saving patterns, causing general economic activity to fluctuate. 3. 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. 4. Stock market indexes are designed to give us a sense of the extent to which stock prices are going up or down. 5. 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. 6. Stock market indexes provide benchmarks for performance of money managers, comparing how they have done to the market as a whole. 8-1
  2. 2. 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. i. 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. The S&P 500 is neither better nor worse than the DJIA; rather, the two types of index simply answer different questions. ii. 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. The Nasdaq is composed mainly of smaller, newer firms and in recent years has been dominated by technology and Internet companies. 3. 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. B. 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. 8-2
  3. 3. 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. 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. Future dividend payments can be estimated assuming that current dividends will grow at a constant rate per year. 5. 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. 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. 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. 8-3
  4. 4. D. The Theory of Efficient Markets 1. The basis of the theory is the notion that the prices of all financial instruments, including stocks, reflect all available information. 2. If the theory is correct, chartists are doomed to failure, because future price movements are unpredictable. 3. 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. 4. If managers claim to exceed the market average year after year, they must be taking on risk, be lucky, have private information, or markets are not efficient. 5. Pure chance can 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. 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. 8-4