Transcript The Stock Market: What Does it Do and How Has It Performed

5
C H A P T E R SUPPLEMENT
The Stock Market:
–What Does It Do and
How Has it Performed?
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1. The Economic
Functions of the
Stock Market
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The Economic Functions of the Stock Market

The stock market allows nearly anyone to participate in the
risks and opportunities of corporate America. Real returns
for the past two centuries have averaged 7 percent per year.
%
35.0%
Change
29.5%
30
26.1%
26.0%
23.7%
20
20.9%
20.0%
18.2%
17.9%
14.8%
12.1%
10
0
7.0%
0.1%
-2.3%
-3.1%
-10
-5.7%
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Source: Standard and Poor’s.

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During the last 16 years, the broad S&P 500 stock index
indicates that stock investors earned a 15 percent average
annual rate of return.
Double-digit returns were earned during 11 of the 16 years,
while the returns were negative during only 3 of the years.
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How the Stock Market
Works for Savers and Investors

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Savers invest in the stock market as a strategy
to build wealth.
Investors that buy a diverse portfolio of shares
and hold them over long periods of time,
substantially reduce their risks.
Small investors can purchase stock in an
equity mutual fund, a corporation that buys
and holds shares of stock in many firms.
Equity mutual funds have reduced the risk of
stock ownership and attracted large amounts
of funds into the market, helping to push stock
prices upward.
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The Value of Equity Mutual Funds
Value of Stocks Owned Through
Equity Mutual Funds
(billions of $)
2,500
2,000
1,500
1,000
500
0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
Year
Source: Investor Company Institute <www.ici.org>

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The amount of money that people put into U.S. equity
mutual funds in order to hold shares in the ownership
of stocks, rose dramatically in the 1990s.
Purchasing shares in a mutual fund is a simple way for
an individual to buy and hold interest in a large variety
of stocks with one purchase.
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Stocks Are Less Risky When
Held for a Lengthy Time Period
S&P 500 Index
Annualized Total Real Return (%)
61%
60
50
40
27.9%
30
19.4%
20
15.1%
6.4%
10
0.5%
0
-4.2%
-10
-20
-30
-40
-50
-38.9%
552
1-year
periods
504
5-year
periods
444
10-year
periods
324
20-year
periods
Sources: Ibbotson Associates and Merrill Lynch, published in the Merrill Lynch Newsletter,
Insights and Strategies, Vol. 3, No. 4, 1998, p.1.


This graphic highlights the best and worst annualized
performance for each holding period from 1950 – 1996.
It shows that there is less risk of a low or negative return when a
portfolio of S&P 500 stocks is held for a longer period of time.
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How the Stock Market
Works for Corporations

To raise money, a corporation can :

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use retained earnings,
borrow money, or,
sell stock.
(Buyers can, if they wish, later
resell the shares on the stock market)
Each share of the stock is a fractional share in
the firm’s future net revenues.
People buy the stock of a corporation to get
future dividends paid from corporate earnings
and gains derived from increases in share prices.
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How the Stock Market
Works for Corporations

The decisions of a firm’s executives influence the
firm’s stock price.

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When investors (their advisors and fund managers)
believe that the decisions of corporate managers
will increase the firm’s future income, they buy
more of the stock, driving its price up.
When investors believe that bad decisions are being
made, the the stock’s price falls.
Corporate board members are usually
stockholders, and top managers are often given
stock options.

The value of the stock options will rise sharply as
the firm’s stock price increases. This helps bring the
interest of corporate decision makers into harmony
with the interest other stockholders.
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How the Stock Market
Works for the Economy

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The stock market benefits stockholders by
disciplining corporate decision makers to be
more efficient and undertake the most
productive projects.
The price of a corporation’s shares constantly
sends signals to the listed corporation’s board
of directors and managers.

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Changing stock prices reward good decisions
and penalize bad ones.
To increase the firm's value, the firm must
undertake productive projects.
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2. Stock Prices and
the Interest Rate
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Stock Prices and
the Interest Rate
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Underlying the price of a firm’s stock is the
present value of the firm’s expected future net
earnings, or profit.
The value of a share depends on:
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the expected size of future net earnings,
when these earnings will be achieved, and,
the interest rate by which the investor discounts
the future income.
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Stock Prices and
the Interest Rate
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If D represents dividends (and gains from a
higher stock price) earned during various future
years (indicated by the subscripts) & i represents
the discount or interest rate, the present value
of the future income stream is:
D1
D2
D
n
. . .+
+
+
2
n
(1  i )
(1  i )
(1  i )

A higher interest rate reduces the present value
of future returns from holding shares of stock.
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3. The Stock Market
Since 1982:
-- What Caused the
Dramatic Rise?
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The Stock Market Since 1982:
-- What Caused the Dramatic Rise?
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Interest rates and inflation fell.
Corporate earnings were higher.
The improving U.S. economy drew
investment funds from abroad.
Mutual funds expanded their holdings
dramatically.
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4. Is the Stock Market
Too High:
-- Is It a Bubble
That Will Burst?
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Is the Stock Market Too High:
-- Is it a Bubble That Will Burst?
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Stock prices reached levels in early 1999
that were very high by historic standards.
Optimists who think stock price levels will
rise significantly in the near future can make
a plausible case, but pessimists can do the
same for their view.
Investor expectations about an uncertain
future determine current prices, and no one
can forecast future stock prices with
precision or certainty.
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Questions for Thought:
1. A friend just inherited $50,000. She informs you of
her investment plans and asks for your advice. “I
want to put it into the stock market and use it for my
retirement in 30 years. What do you think is the best
plan that will provide high returns at a relatively low
risk?” What answer would you give? Explain.
2. Microsoft stock rose from less than $10 in 1995 to
nearly $100 in early 1999. Microsoft had made
sizeable profits, but never paid a dividend. Why were
people willing to pay such a high price knowing that
they might not get dividends for many years?
3. If an investment advisor gives you a hot new stock
tip, is it likely to be a "sure thing"? Why or why not?
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End
Application 5
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