Lecture Issues in economics today - Chapter 41

The main contents of this chapter include all of the following: The equation of exchange, the quantity theory of money, classical economics, the monetarist school, supply-side economics, the rational expectations theory.

Chapter 41 The Stock Market and Crashes McGraw­Hill/Irwin © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved Chapter Outline • STOCK PRICES • EFFICIENT MARKETS • STOCK MARKET CRASHES McGrawưHill/Irwin â2002TheMcGrawưHillCompanies,Inc.,AllRightsReserved 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 McGraw­Hill/Irwin © 2002 The McGraw­Hill 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 McGraw­Hill/Irwin © 2002 The McGraw­Hill 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 McGrawưHill/Irwin â2002TheMcGrawưHillCompanies,Inc.,AllRightsReserved 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 not involve the company receiving or paying money They are simply the transfer of the asset from one holder to another McGraw­Hill/Irwin © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved The Function of Trading • Regular trading of stock serves to equate the risk-adjusted return to investors across assets McGraw­Hill/Irwin © 2002 The McGraw­Hill 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 McGrawưHill/Irwin â2002TheMcGrawưHillCompanies,Inc.,AllRightsReserved 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 McGraw­Hill/Irwin © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved Dow Jones Indu 1896-2000 D J IA 12000 10000 8000 6000 4000 2000 1896 1902 1908 1914 1920 1926 1932 1938 1944 1950 1956 1962 1968 1974 1980 1986 1992 1998 Year McGraw­Hill/Irwin © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved Standard and P 1870-2000 1600 1400 1200 1000 800 600 400 200 1870 1877 1884 1891 1898 1905 1912 1919 1926 1933 1940 1947 1954 1961 1968 1975 1982 1989 1996 Year McGraw­Hill/Irwin © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved N A S D A Q C o m p o s ite NASDAQ Com 1980-2000 5000 4000 3000 2000 1000 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 Year McGraw­Hill/Irwin © 2002 The McGraw­Hill 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 1929 high until after World War II • October 1987 – Stock Market lost 20% of its value in one day It rebounded quickly McGraw­Hill/Irwin © 2002 The McGraw­Hill 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 Prices rise which creates the expectation that prices will rise further which Repeat steps and McGrawưHill/Irwin â2002TheMcGrawưHillCompanies,Inc.,AllRightsReserved 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 McGraw­Hill/Irwin © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved NASDAQ NASDAQ Comp 1999-2000 5500 5000 4500 4000 3500 3000 2500 2000 01/04/99 03/24/99 06/11/99 08/30/99 11/16/99 02/04/00 04/25/00 07/13/00 09/29/00 12/18/00 Date McGraw­Hill/Irwin © 2002 The McGraw­Hill 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 were not realistic McGraw­Hill/Irwin © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved  ... earnings at an expected interest rate • An increase in earnings increases stock values • A decrease in the interest rate increases stock value McGrawưHill/Irwin â2002TheMcGrawưHillCompanies,Inc.,AllRightsReserved... Determined • Fundamentals – Earnings projections – Interest rates • Non-fundamental – The expected price of the share in the future McGraw­Hill/Irwin © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved... The Function of Trading • Regular trading of stock serves to equate the risk-adjusted return to investors across assets McGraw­Hill/Irwin © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved