A Beginner s Guide to the Stock Market

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1 A beginner s guide to the stock market 1 A Beginner s Guide to the Stock Market An organized market in which stocks or bonds are bought and sold is called a securities market. Securities markets that deal in shares, or equities, are known as stock markets. Two of the best known stock markets are the Toronto Stock Exchange and New York Stock Exchange. The trading of existing shares on the stock market indicates that ownership is being transferred; it does not indicate that companies are raising new money from the public, although firms also do raise funds by issuing new shares. The Function of Stock Markets Stock markets have two central functions. First, they provide firms with a means of raising money with which to finance their expansions and operations. Second, they provide individuals and households with a means by which they can invest their savings. In the language of Chapter 15, the stock market is an important part of the financial system, intermediating between firms that require financial capital and households that provide it. Let s look a little more closely at how firms and individuals participate in the stock market. First, consider a firm that is thinking about expanding its facilities or activities. How can it finance the necessary expenditures? One option is to use its existing profits. However, in many cases, and especially for relatively small firms, current profits are not large enough to finance the desired expansion. A second option is to borrow funds from a commercial bank or from other lenders. In some cases, though, the requirement to pay regular interest payments on such loans is unattractive to the management of the firm, who would prefer instead to retain all possible earnings in order to expand the company and consolidate its product line, customer base, and distribution network. A third financing option for a firm is to issue shares of the company and sell these shares to any interested firms or individuals. The buyers of the shares then own a fraction of the firm and are therefore entitled to a percentage of the firm s future profits. In many cases, especially for large firms that require billions of dollars for their expansions, the issuance and selling of new shares is an important source of financing. Stock markets provide firms with the ability to raise money. Firms issue new shares and then sell them to interested buyers. The buyers then have a claim on the firms assets and future profits. The second important function of stock markets is to provide individuals or households with the means of investing their savings in the productive assets of firms. Any individual who wants to save has three alternatives. First, they can keep their money in a box under their bed or, more securely, in a safe-deposit box in a financial institution. However, this alternative earns the individual no interest. The second alternative, very familiar to most of us, is to deposit the savings in an account at a commercial bank. By doing so, we lend our money to the bank at some relatively low rate of interest. One advantage of this alternative, at least in Canada, is that the deposits in a commercial bank, up to $ , are guaranteed by the Canada Deposit Insurance Corporation. Thus, for most individuals with small amounts held at commercial banks, the savings are perfectly secure. A third alternative for an individual or household is to use their savings to purchase shares of companies. When an individual buys shares either existing or newly issued he or she becomes one of the firm s owners. If, at some future date, the individual wishes

2 2 A beginner s guide to the stock market to cease being a shareholder in the firm, he or she can simply sell the shares but can only do so by persuading someone else to buy their shares in the company. Stock markets allow people to put their savings into assets that may earn a good rate of return and are, in general, very liquid. For information on the Toronto Stock Exchange, see its website: For example, if I want to purchase a particular stock that I think will earn a high return, I may do so, even though I know that I will want my money back after only a year. And I can be confident that I will be able to sell the stock a year from now. Nevertheless, although stock markets provide for the quick sale of stocks, they do not guarantee the price at which stocks can be sold. The price at any time is the one that equates the demand and supply for the particular stock, and rapid fluctuations in stock prices are common. Stock market values sometimes display cumulative upward movements, or bull markets. They also sometimes display cumulative downward movements, or bear markets. The Great Depression of the 1930s was preceded by the stock market of 1929, which caused what is still the largest percentage loss of stock values ever to be suffered by investors worldwide. Figure 1 shows the path of the Toronto Stock Exchange Index since 1980 (now called the TSX). Notice the significant decline from 1981 to 1982 during a recession, and also the sharp es in October 1987, July 1998, and the longer of The long-term trend, however, is clearly positive. Over the past twenty years, prices on the TSX have increased at an average annual rate of roughly 5.5 percent. FIGURE 1 The TSX Index, TSX Index Recession in Recession in missing data due to terrorist attacks Year The TSX Index increased at an annual average rate of 5.5 percent between 1980 and There is clearly an upward long-run trend to the price of shares in the TSX Index. But the sharp reduction during the recession is clear, as are the sudden es of October 1987, July 1998, and Note that the vertical scale is logarithmic. This means that equal distances on the scale represent proportional changes. (Source: Bank of Canada. Series V )

3 A beginner s guide to the stock market 3 There is clearly some association between fluctuations in the stock market and those in the economy, but is there a causal connection? Do stock market fluctuations cause business cycle fluctuations, or is it the other way around? Causes of Stock Market Swings Before we can answer these questions, we need to know a little about how stock markets work. In particular, what causes stock market prices to fluctuate? When investors buy a company s stocks, they are buying rights to share in the stream of dividends to be paid out by that company. They are also buying an asset that they can sell in the future for a gain or a loss. The value of a stock thus depends on two factors: first, what people expect the stream of future dividend payments to be, and, second, what price people expect to receive when the stock is sold. (If the price rises, the owner earns a capital gain; if the price falls, the owner suffers a capital loss.) Both influences make dealing in stocks an inherently risky operation. Will the company be profitable in future years, and thus be more likely to pay high dividends? Will the price of the stock rise so that current shareholders will earn a capital gain if they sell their shares? The Influence of Present and Future Business Conditions Many influences affect stock market prices, including the state of the business cycle and the stance ofgovernment policies. Cyclical Forces. If investors expect a firm s earnings to increase, the firm will become more valuable and the price of its stock will rise. Such influences cause stock prices to move with the business cycle, being high when current profits are high and low when current profits are low. These influences also cause stock prices to vary with a host of factors that influence expectations of future profits. A poor crop, destruction of trees by acid rain, an announcement of new defence spending, a change in the exchange rate, and a change in the governing political party can all affect profit expectations and hence stock prices. Policy Factors. Changes in monetary policy affect the economy by first changing interest rates. Such changes, or just the expectation of them, will have effects on stock prices. For example, suppose that the threat of future inflation leads the Bank of Canada to tighten monetary policy sharply, thus raising interest rates. Shareholders will now want to sell their shares for two reasons. First, higher interest rates imply that any given stream of future dividends now has a lower present value (see Chapter 28). Second, higher interest rates will reduce the flow of profits (and dividends) from firms as the economy slows down (which is exactly the intention of the monetary tightening). For both reasons, stocks will be a less attractive investment relative to the alternatives (mainly bonds), and so holders of stocks will decide to sell. Everyone cannot do this, however, because only so many stocks are available to be held at any given time. As all investors try to sell their stocks, prices fall. The fall will stop only when the expected rate of return to investment in stocks, based on their lower purchase price, makes stocks as attractive as alternative investments. Then investors will no longer try to shift out of stocks en masse.

4 4 A beginner s guide to the stock market Speculative Booms In addition to responding to a host of factors that reasonably can be expected to influence the earnings of companies, stock prices often develop an upward or downward movement of their own, propelled by little more than speculation that feeds on itself. In major stock market booms, people begin to expect rising stock prices and hurry to buy while stocks are cheap. This action bids up the prices of shares and creates the capital gains that justify the original expectations. Such a situation is an example of a self-fulfilling prophecy, which we first encountered in Chapter 21. Investors get rich on paper, in the sense that the market value of their holdings rises. Money-making now looks easy to others, who also rush in to buy stocks, and new purchases push prices up still further. At this stage attention to the firm s actual profits all but ceases. If a stock can yield, say, a 50 percent capital gain in one year, it does not matter much if dividends rise or fall slightly. Everyone is making money, so more people become attracted to the get-rich-quick opportunities. Their attempts to buy push prices up even further. Eventually, something breaks the period of unrestrained optimism. Some investors may begin to worry about the very high prices of stocks in relation not only to current dividends but also to possible future dividends, even when generous allowances for growth are made. Or it may be that the prices of stocks become depressed slightly when a sufficiently large number of persons try to sell out in order to realize their capital gains. As they offer their stocks on the market, they cannot find purchasers without some fall in prices. Even a modest price fall may be sufficient to persuade others that it is time to sell. However, every share that is sold must be bought by someone. A wave of sellers may not find new buyers at existing prices, causing prices to fall. Panic selling may now occur. This is a very simple and stylized description of a speculative cycle, yet it describes the basic elements of market booms and busts that many believe have recurred throughout stock market history. In the United States, it happened in the Jay Cooke panic of 1873 and in the Grover Cleveland panic of The biggest boom of all began in the mid- 1920s and ended on Black Tuesday, October 29, The collapse was dramatic, with U.S. stocks losing about 50 percent of their value in about two months. Nor did it stop there. For four years stock prices continued to decline, until the average value of stock on the New York Stock Exchange had fallen from its 1929 high of $89.10 per share to $17.35 per share by late Speculative behaviour means that stock market prices do not always just reflect the fundamentals that underlie the expected profitability of companies; in this sense, the stock market is sometimes said to be overvalued or undervalued. However, the extent of the over- or undervaluation is difficult to determine, and hence it is hard to predict when, and by how much, prices will correct. For example, consider the dramatic upswing that increased prices on the TSX by 103 percent between August 1998 and August 2000 (the bull market in the United States was even more dramatic). During this period, the Canadian economy was experiencing healthy growth, and the rising stock prices no doubt reflected the resulting favourable profit outlook of companies. However, many doubted that the full increase was justified by underlying business opportunities and hence felt that there may have been a speculative component to the rise in stock values. The happened in the fall of 2000 and early 2001 when the TSX declined from over to 7600 in six months, a drop of over 30 percent. By the time this book went to press in the fall of 2003, the stock market was still well below its pre- levels from For a wonderful discussion of the history of speculative booms (and their aftermath), see John Kenneth Galbraith, A Short History of Financial Euphoria, 1990, Viking Press.

5 A beginner s guide to the stock market 5 Stock Market Swings: Cause or Effect of Business Cycles? Stock markets tend often to lead, and sometimes to follow, booms and slumps in business activity. In both cases the causes usually run from real business conditions, whether actual or anticipated, to stock market prices. This is the dominant theme: the stock market as a reflector. Stock market fluctuations are usually a consequence, rather than a cause, of the business cycle. For example, an economy that is growing steadily over a number of years will generally have rising profits. The increase in profits will cause stock market prices to rise. Conversely, an economy that enters a recession with high unemployment and bankruptcies will naturally have low profits. These low profits will cause stock market prices to fall. Though we have said that stock market movements are usually the consequence of the business cycle, it is sometimes true that the stock market is the cause of the business cycle. The value of the stock market influences the wealth of households, which ultimately own the market, either directly or through their pension funds. (The direct holding of stocks by households has become much more common in the past decade with the widespread availability of mutual funds.) And, as we saw in Chapter 21, changes in household wealth lead to changes in desired consumption spending. Thus, as prices rise in the stock market, the increase in household wealth will generally lead to increases in aggregate demand. This will naturally have an effect on real GDP and the price level. In addition, firms use the stock market to issue new shares in order to finance investment spending. When stock market prices are high, they find this a very attractive way to raise new money and thus may choose to undertake new investments, thereby adding to aggregate demand. For these reasons, many people believed that the dramatic fall in stock value in the October 1987 would cause households to curtail their consumption spending in response to their perceived fall in wealth. On this basis many forecasters predicted that the stock market would lead to a serious downturn in economy. After the event, such gloom-and-doom forecasts turned out to be inaccurate; apparently, people did not perceive the fall in the stock market as an indication that their permanent incomes or wealth had fallen dramatically, and hence they did not reduce their consumption spending. Investment Marketplaces or Gambling Casinos? Stock markets fulfill many important functions. It is doubtful that the great aggregations of financial capital that are needed to finance modern firms could be raised under a private-ownership system without them. There is no doubt, however, that they also provide an unfortunate attraction for many naive investors, whose get-rich-quick dreams are more often than not destroyed by the fall in prices that follows the occasional speculative booms that they help to create. To some extent public policy has sought to curb the excesses of stock market speculation through supervision of security issues. Public policy seeks, among other things, to prevent both fraudulent or misleading information and trading by insiders (those in a company who have confidential information). All in all, the stock market is both a real marketplace and a place to gamble. As in all gambling situations, players who are less well informed and less clever than the average player tend to be losers in the long term.

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