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Stockmarketandtheeconomypptslides 150415223021 Conversion Gate01 PDF
Stockmarketandtheeconomypptslides 150415223021 Conversion Gate01 PDF
1
•Introduction
•Explaining Changes in Stock Prices
•How Stock Markets Affect the Economy
•The Fed and the Stock Market
•Rational Expectation and the Stock Market
INTRODUCTION
Firms raise funds in two ways: THROUGH
Debt finance - bonds and loans
Often, stock market averages will rise and fall at the same
time, sometimes by the same percentage
STOCK MARKET INVESTORS
Direct holdings by HOUSEHOLDS represent the largest portion
of U.S. stock holdings
From US$1 trillion in 1980 to US$5.5 trillion in 2006
Proportion-wise, however, declined from 70.5% to 26.6%
•20-10
2. Explaining Changes in Stock Prices—
Step #1: Characterize The Market
• Price of a share of stock—like any other— is determined
in a competitive market
• The market for a company’s shares as perfectly
competitive
View stock market as a collection of individual, perfectly competitive
markets for particular corporations’ shares
Many buyers and sellers
Virtually free entry
Like all prices in competitive markets, stock prices are
determined by supply and demand
However, in stock markets, supply and demand curves
require careful interpretations
Step #2: Find The Equilibrium
Figure 1 presents a supply and demand diagram for shares of
Corporation X
On any given day, number of Corporation X shares in existence is
just the number that the firm has issued previously
Just because 302 million shares of Corp X stock exist, that does not mean
that this is the number of shares that people will want to hold
-People have different expectations about firm’s future profits
At any price other than $90 per share, number of shares people are
holding (on the supply curve) will differ from number they want to hold
(on the demand curve)
Only at equilibrium price of $90— people satisfied holding number of
shares they are actually holding
Stocks achieve their equilibrium prices almost instantly
Figure 1: The Market For Shares of
Corporation X
$120
90 E
60
D
60
D2
D1
298 million Number of Shares
Figure 2b: Shifts in the Demand for Shares
Curve
(b)
Price
•S The demand curve shifts leftward when
per Share new information causes expectations of:
• lower future profits
• recession
• higher interest rates
60
45
D1
D3
298 million Number of Shares
Step #3: What Happens When Things Change?
Prices can also change due to shifts in supply curve
Supply curve for a corporation’s shares shifts rightward
whenever
1. New round of public offering
2. Stock split:
-When a company divides its existing shares into multiple shares. Although the
number of shares outstanding increases by a specific multiple, the total dollar
value of the shares remains the same compared to pre-split amounts.
-The most common split ratios are 2-for-1 or 3-for-1, which means that the
stockholder will have two or three shares for every share held earlier
3. Large sell-off by institutional investors
Factors that Affect Stock Prices
1. ECONOMIC FACTORS
Interest rates
Most of the significant stock market declines occurred when
interest rates increased substantially
Bonds are better investment option: high interest rate, price of
bonds decline
Exchange rates
Foreign investors purchase U.S. stocks when dollar is weak or
expected to appreciate
Stock prices of U.S. companies also affected by exchange rates
Income or GDP
Expectation of lower income reduces stock prices
Flight to quality to safer fixed income assets
Factors that Affect Stock Prices
2. FIRM-SPECIFIC FACTORS/FIRM FUNDAMENTALS
Expected +NPV investments
Dividend policy changes
Significant debt level changes
Stock offerings and repurchases
Earnings surprises
Acquisitions and divestitures/divestment (a strategy to
remove some of a group's assets under its current business
portfolio)
Factors that Affect Stock Prices
3. MARKET-RELATED FACTORS
January effect – general increase in stock price in January
Noise trading
Trading by uninformed investors pushes stock price away from
fundamental value
Trends
Technical analysis
Repetitive patterns of price movements
Factors that Affect Stock Prices
Integration of factors affecting stock prices
Evidence on factors affecting stock prices
Fundamental factors influence stock prices, but they do
not fully account for price movements
Smart-money investors
Noise traders
Excess volatility
Indicators of future stock prices
Things that affects cash flows and required returns
Variance in opinions about indicators
Factors Affecting Stock Prices
International Fiscal Monetary Economic Industry Firm-
Economic Policy Policy Conditions Conditions specific
Conditions condition
Stock Market
Conditions
Firm’s
Systematic
Risk
(Beta)
Market
Risk
Premium
Risk-Free Firm’s
Interest Risk
Rate Premium
Expected
Cash Flows Required Return
to Be by Investors
Generated Who Invest in
by the the Firm
Firm
Price of the
Firm’s
Stock
3. How the Stock Market Affects the Economy?
The Two-Way Relationship Between The Stock Market and the
Economy
•26 of 41
The Wealth Effect
Positive relationship between stock price and households’
wealth
When stock prices rise, so does household wealth
(a) (b)
Price
AS
Aggregate Expenditure
Level
Shock to both
stock market and
macroeconomy
A Shock To the Economy and the Stock Market:
The High-Tech Boom of the 1990s
In spite of all this good news, there were dark clouds on
horizon
A Shock to the Economy and the Stock Market:
The High-Tech Bust of 2000 and 2001
It didn’t work: As 1990s came to a close, and the stock market
continued to soar, Fed faced a new problem - Wealth effect
The Fed and the Stock Market
• Fed continued to raise interest rates to rein in the economy,
– By slowing economic growth and growth in profits
– Through direct effect of higher interest rates on stocks; Fed also
brought down stock prices
AD1 AD1
Real GDP Real GDP
Y1 Y 2 Y1 Y2
Figure 7: The Fed’s Problem in 2000: A
Phillips Curve View
Inflation
(a) (b) rate is above 4%
But if the natural
Inflation
If the natural rate of
Rate Rate the Phillips curve
unemployment is 4%, the
Fed can keep the economy 5.0% C will shift upward
at point A in the long run and the Fed must
choose between
higher inflation . . .
2.5% A 2.5% A D
. . . or recession
1.5% B
PC1 PCP
1 C2
4%Unemployment 4% 5% Unemployment
Rate Rate
UN? UN?
The Fed and the Stock Market
According to Bernanke and Kuttner (2004), on “What Explains
the Stock Market’s Reaction to Federal Reserve Policy?”
Understanding the effect of monetary policy on stock prices is
fundamental to understand the transmission mechanism of monetary
policy through the wealth effect
Analyze the effect of unexpected Fed funds rate changes, as proxied by the
Fed funds future contracts, on various measures of stock market
performance:
The Fed and the Stock Market
FINDINGS:
1. The market responds much more strongly to surprises than expected
actions.
1. Stock prices may respond to unexpected funds rate increases because of:
expected future dividends, real interest rates, and expected future excess
returns
2. The response of equity prices to monetary policy is not through effects on the
real interest rate, but appears to come through its effects on expected future
excess returns
2. A surprise 25 basis point rate decrease leads to a 1.3 percent gain in the
index.
•47 of 35
Making (Some) Sense of the News: Why the
Stock Market Moved Yesterday and Other
Stories
September 1998. Bad news on the economy, leading to an
decrease in stock prices: “Nasdaq stocks plummeted as
worries about the strength of the U.S. economy and the
profitability of U.S. corporations prompted widespread
selling.”
August 2001. Bad news on the economy, leading to an
increase in stock prices: “Investors shrugged off more gloomy
economic news,
and focused instead on their hope that the worst is now over
for both the economy and the stock market. The optimism
translated into another 2% gain for the Nasdaq Composite
Index.”
•48 of 35
Computing the Price
of Common Stock
Valuing common stock is, in theory, no different from
valuing debt securities: determine the future cash
flows and discount them to the present at an
appropriate discount rate.
We will review FOUR different methods for valuing
stock, each with its advantages
and drawbacks.
Computing the Price of Common Stock:
(1) The One-Period Valuation Model
Simplest model, just taking using the expected
dividend and price over the next year.
Computing the Price of Common Stock: (1) The
One-Period Valuation Model (cont..)
- Higher than ave may mean the market is expected earnings to rise in the
future. Eventually PE will return to normal level
- -High PE may indicate market’s perception that the firms earnings are low
risk and willing to pay premium for it
Computing the Price of Common Stock: The
Price Earnings Valuation Method
•66 of 35
Anomalies in the Stock Market
Anomalies are empirical results that seem to be inconsistent
/unexplained by the theories of asset-pricing behavior.
Puzzling behavior of stock market as it does not conform with the
predictions of accepted models of asset pricing
They indicate either market inefficiency (profit opportunities) or
inadequacies in the underlying asset-pricing model: contradict the
EMH
Some examples are
1. The Size effect
2. The “Incredible” January Effect
3. P/E Effect
4. Day of the Week (Monday Effect)
1. The Size Effect
Small firm effect
In the early 1980’s, a number of studies found that the
stocks of small firms typically OUTPERFORM (on a risk-
adjusted basis) the stocks of large firms
This is even true among the large-capitalization stocks
within the S&P 500: smaller (but still large) stocks tend to
outperform the really large ones
1. The Size Effect
1. The Size Effect
The small-firm effect
•71
Average annual return for 10 size-based
portfolios (1926-2006):
•72
1. The Size Effect
Some explanations:
The smaller-firm portfolios tend to be riskier. But even when
returns are adjusted for risk using the CAPM, there is still a
consistent premium for the smaller-sized portfolios
Thus, while size per se is not a risk factor, it perhaps might
act as a proxy for the more fundamental determinant of risk.
Theories: tax issues, low liquidity of small firm stocks, large
information costs in evaluating small firms, inappropriate
measurement of risk for small firm stocks
This pattern of returns may thus be consistent with an
efficient market in which expected returns are consistent
with risk
•73
2. The “Incredible” January Effect
Stock prices tend to experience abnormal price rise from
Dec to January that is predictable, thus inconsistent with
the random walk behavior
Stock returns appear to be higher in January than in
other months of the year
It may also be related to end of year tax selling
Investor has incentive to sell stocks before year-end
(reducing price) because they can take capital losses on
their tax return and reduce their tax liability
Then repurchase in January (increasing price)
2. The “Incredible” January Effect
The January effect is tied to tax-loss selling at the end of the
year:
Many people sell stocks that have declined in price during the
previous months to realize their capital losses before the end of
the tax year
Such investors do not put the proceeds from these sales back
into the stock market until after the turn of the year. At that point
the rush of demand for stock places an upward pressure on
prices that results in the January effect
The evidence shows that the ratio of stock purchases to sales of
individual investors reaches an annual low at the end of
December and an annual high at the beginning of January
•75
3. The P/E Effect
• P/E ratio: the ratio of a stock’s price to its earnings per share.
It has been found that portfolios of “low P/E” stocks generally
outperform portfolios of “high P/E” stocks: Portfolios of low
P/E ratio stocks have higher returns than do high P/E
portfolios
• Thus, unless the CAPM beta fully adjusts for risk, P/E
will act as a useful additional descriptor of risk, and will
be associated with abnormal returns if the CAPM is
used to establish benchmark performance
•77
4. The Day of the Week Effect
• Based on daily stock prices from 1963 to 1985, Keim
(1984) found that returns are higher on Fridays and
lower on Mondays than should be expected.
• This is partly due to the fact that Monday returns actually
reflect the entire Friday close to Monday close time
period (weekend plus Monday), rather than just one day.
• However, after the stock market crash in 1987, this effect
disappeared completely and Monday became the best
performing day of the week between 1989 and 1998.
5. Market Over-Reaction
• Stock prices may over-react to news announcements and
pricing errors are corrected only slowly
• Also related to excessive volatility: fluctuations in stock
prices may be much greater that is warranted by
fluctuations in their fundamental value
• Shiller (1981) along with other studies seemed to produce
a consensus that stock market prices appear to be driven
by factors other than fundamentals