Isues in economics today 6th by guell chapter40

Chapter 40
The Stock
Market
Crashes

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Chapter Outline
• Stock Prices
• Efficient Markets
• Stock Market Crashes
• The Accounting Scandals of 2001 and 2002
• Rebound of 2006-2007 and the Drop of
2008-2009

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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.
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Stock Prices: How they are
Determined
• Fundamentals

• Earnings projections
• Interest rates
• Non-fundamental

• The expected price of the
share in the future.

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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.

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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 do not involve the
company receiving or paying money.

They are simply the transfer of the
asset from one holder to another.
• Non-IPO stock markets are necessary
for IPO markets to exist. They allow
liquidity, the ability of the investor to
get money back out again.
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The Function of Trading
• Regular trading of stock serves to equate
the risk-adjusted return to investors across
assets.

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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.

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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

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Dow Jones Industrials

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S&P 500

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NASDAQ

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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.

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Bubbles
•

A bubble is the state of a market where the
current price is far above its value determined

by fundamentals.

1.

Prices rise which

2.

creates the expectation that prices will rise
further which

3.

Repeat steps 1 and 2

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Examples of Bubbles
• The Asian Financial Crisis of 19981999
• 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.
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NASDAQ 1999-2003

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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 was not realistic.
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Accounting Scandals of 2001 and
2002
• K-Mart-poor performance
• Global Crossing-fraud and very high risk
• Enron-fraud

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Bankruptcy
• A legal status entered into when a

company or individual cannot pay its debt.
• Bankruptcy is necessary because
• creditors acting in their own interest will seek
immediate payment/foreclosure.
• It is in the interests of all creditors that debtors
have time to make their payments

• Varieties of Corporate Bankruptcies
• Chapter 11 - allows for reorganization
• Chapter 13 – allows for orderly sale of all assets

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Enron Case
• Accounting fraud was employed so that
the management of the company could
overstate profits.
• Managers were paid in stock options to
combat the principal-agent problem
• The problem that occurs when the owner of
an asset and the manager of that asset are
different and have different preferences.

• The Enron-type fraud was of more

concern to investors because it
introduced a new variety of risk.

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Rebound in 2006-2007 &
Drop in 2008-2009
• All international stock markets rose substantially
between 2006 and 2007.

• The Dow Jones set a record above
14,000
• The Global Financial Crisis in 2008-2009

• Dow Jones fell to 6,500

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