Investments: Analysis and Behavior

Chapter 2- Equity Markets

©2008 McGraw-Hill/Irwin

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Learning Objectives

Learn where and how securities are traded. Know how stock market performance is measured. Know sector, industry, and global market indices. Understand the relevant laws governing the investment

industry.

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Equity Markets

New York Stock Exchange An Agency Auction Market

Market in which brokers represent buyers and sellers and prices are determined by supply and demand.

Trading All trading in a specific stock is done at the post where that

stock is assigned on the NYSE floor. Trading is managed by the specialist.

www.nyse.com

2005

NYSE Average Daily Stock Volume (millions) 1,604

NYSE Average Trade Size per Sale (in shares) 334

Number of NYSE Non-US Stocks 453

NYSE Dollar Value of Trading Activity (billions of dollars) $56.1

Programs as % of Total NYSE 56.9%

Companies Listed on the NYSE 2,779

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The NYSE is the most prestigious stock exchange in the world

General Electric, Citigroup, Wal-Mart, Time Warner, IBM, Coca Cola

Some listing standards:Round-lot Holders (holders of at least 100 shares) 2,000

or Total U.S. shareholders 2,200

with monthly trading of 100,000 shares

Or Total shareholders 500

with monthly trading of 1,000,000 shares

Shares Outstanding 1,100,000

Market Value$100,000,000

Aggregate pretax earnings over the last three years of $6,500,000

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AMEX is also a specialist auction market Lower listing standards than NYSE More than 1,000 listings

140+ Exchange Traded Funds 15+ HOLDRs 350+ structured products

www.amex.com

American Stock Exchange

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Electronic market Negotiated market

Market makers are dealers

Price determination through bargaining

3,600+ issues more technology firms Dell, Microsoft, Intel

www.nasdaq.com

Nasdaq

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Other U.S. stock markets

Nasdaq SmallCap Market 800 small firms seeking Nasdaq market maker

sponsorship No penny stocks (price < $1)

Over-the-Counter Bulletin Board 3,000+ securities offered by 300+ market makers Penny stocks traded here

Electronic Communication Networks (ECNs) Electronic market for institutional investors to trade with

each other

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Tracking the market Did the market go up or down today?

Every day, some stocks increase in price while others decline

So, what does an increasing marketing mean?

More stocks rise than fall? Prices increases are larger than price

decreases? Should the size of the companies changing price

matter? Is stock price or capitalization important?

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Dow Averages

Charles Dow and Edward Davis Jones Credited with inventing the stock index First stock index created in 1884

11 firms Mostly railroad companies Added up the stock prices and divided by 11. (price average

index)

DJIA was started in 1896 with 12 stocks

DJUA, DJTA

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Dow Jones Industrial Average

30 companies Most important and largest firms Selected by the editors of the Wall Street Journal

Formula

While originally 30, the divisor has been steadily reduced to account for stock splits. At the beginning of 2006 the divisor was 0.12493117.

Note that a $1 change in a stock’s price causes the DJIA to change by 8 (=1/ 0.12493117)

divisorDJIA

PDJIA

30

1iit

t

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Problems with price-weighted averages

Stock splits require changes in the divisor

Larger priced stocks move the index more than smaller priced stocks for the same % price move. A $100 stock that increases 10% changes

by $10. A $10 stock that increases 10% changes by $1. A change of $10 moves the DJIA ten times more than a $1 change.

Difficult to index to a price-weighted average.

3M Co.

Alcoa Inc.

Altria Group Inc.

American Express Co.

American International Group Inc.

Boeing Co.

Caterpillar Inc.

Citigroup Inc.

Coca-Cola Co.

E.I. DuPont de Nemours & Co.

Exxon Mobil Corp.

General Electric Co.

General Motors Corp.

Hewlett-Packard Co.

Home Depot Inc.

Honeywell International Inc.

Intel Corp.

International Business Machines Corp.

Johnson & Johnson

JPMorgan Chase & Co.

McDonald's Corp.

Merck & Co. Inc.

Microsoft Corp.

Pfizer Inc.

Procter & Gamble Co.

SBC Communications Inc.

United Technologies Corp.

Verizon Communications Inc.

Wal-Mart Stores Inc.

Walt Disney Co.

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Standard & Poor’s 500 Index The 500-firm index started in 1957

Value weighted index Determine market capitalization of each firm (stock price ×

shares outstanding) Add up the market capitalization for all 500 firms Scale (Index Base set to 10)

Generally the largest 500 firms in the U.S. However, it is designed to match the sectors weights of the

overall market composition.

valuebaseIndexQP

QPindexweightedValue tt

00

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Index Example Consider 3 stocks.

Stock A is $40 and has 300 shares outstandingStock B sells for $60, outstanding shares of 200 Stock C costs $80 and has 100 shares.

Consider two indicesPrice-weighted average, divisor=2.5Value-weighted average

Base index value = 100 The stock originally sold for $30, $50, and $60 with

outstanding shares of 300, 100, and 100, respectively

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What is the value of each index?

Price-weighed average

(40 + 60 + 80) / 2.5 = 72.00

Value-weighted index

{($40X300 + $60X200 + $80X100) / ($30X300 + $50X100 + $60X100)} × 100

=

{32,000 / 25,000} × 100 = 128.00

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What is the value of each index after the $40 stock changes to $45? Price-weighed average

(45 + 60 + 80) / 2.5 = 74.00 a 2.78% change

Value-weighted index

{($45X300 + $60X200 + $80X100) / ($30X300 + $50X100 + $60X100)} × 100

=

{33,500 / 25,000} × 100 = 134.00 a 4.69% change

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More Popular Indices Russell Indexes

Russell 3000 uses the 3,000 largest U.S. companies

Represents 98% of the investable US equity

Russell 1000 uses the 1,000 largest U.S. companies

Represents 92% of the investable US equity

Russell 2000 uses the 2,000 smallest companies n the Russell 3000

Considered a small cap index.

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Dow Jones Wilshire

Dow Jones Wilshire 5000 Composite Index Most comprehensive measure of the

U.S. stock market Designed to represent the

performance of all US-headquartered equity securities

Contains 4,972 stocks (beginning of 2006)

Dow Jones Wilshire 4500 Contains the Wilshire 5000 firms

less the S&P 500 firms Considered a mid-cap index

Dow Jones Wilshire 5000 (Full Cap) Price

Dow Jones Wilshire 4500 (Full Cap) Price

Dow Jones Wilshire 2500 Price

Dow Jones Wilshire U.S. Large-Cap Price

Dow Jones Wilshire U.S. Mid-Cap Price

Dow Jones Wilshire U.S. Small-Cap Price

Dow Jones Wilshire U.S. Micro-Cap Price

Dow Jones Wilshire U.S. Large-Cap Growth Price

Dow Jones Wilshire U.S. Large-Cap Value Price

Dow Jones Wilshire U.S. Mid-Cap Growth Price

Dow Jones Wilshire U.S. Mid-Cap Value Price

Dow Jones Wilshire U.S. Small-Cap Growth Price

Dow Jones Wilshire U.S. Small-Cap Value Price

Wilshire Large Cap 750

Wilshire Mid Cap 500

Wilshire Small Cap 1750

Wilshire Micro Cap

Wilshire All Growth

Wilshire All Value

Wilshire Large Growth

Wilshire Large Value

Wilshire Mid Growth

Wilshire Mid Value

Wilshire Small Growth

Wilshire Small Value

Wilshire Small Cap 250

Wilshire Small Cap 250 Price

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Nasdaq Indexes Nasdaq Composite Index

All common stocks listed on the Nasdaq Stock Market

3,175 firms Market value-weighted

Nasdaq 100 Index Largest 100 firms on the Nasdaq Stock Market Large stock index, but technology oriented

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Standard & Poor’s

S&P 500 S&P MidCap 400 Index

400 firmsStocks with market caps of $1.5 to $10 billion

S&P SmallCap 600 Index600 firmsAverage market cap of $600 million

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Figure 2.2 The DJIA and S&P 500 Represent Diversified Portfolios of Large-Company Stocks. The Nasdaq Composite Index Tracks Large Tech Stocks

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Global Stock Indexes Major Local Stock Market Index

Nikkei, Dax, FTSE

Morgan Stanley Capital International Indexes Global, regional, and local indexes Emerging and developed markets

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Securities Act of 1933 Applies to firms going public—

issuing new securities Requires firms to register with

government Requires firms to provide

investors with financial and material information

Exempts private placements and small issues

Securities Exchange Act of 1934 Focuses on securities

trading Creates and authorizes

Securities and Exchange Commission (SEC) to enforce statutes, rules, and regulations

Protects investors against fraud

Securities Market RegulationLegislation Important to Investors, Issuers of Securities and Brokers/Dealers

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SEC delegates regulatory authority National Association of Securities Dealers (NASD)

Regulates Nasdaq and OTC Monitors sales practices Administers tests and licenses for individuals Ensures accurate sales information

NYSE, AMEX, CBOE--business practices and market operations

Municipal Securities Rulemaking Board Banks—Fed Reserve, Comptroller of Currency, FDIC

Self-Regulatory Organizations (SROs)

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NYSE’s Stock WatchFlags unusual volume or price changes Investigates questionable trades

Intermarket Surveillance GroupShares information and coordinates efforts to

detect manipulation

Securities Arbitration

Market Surveillance

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On Monday, October 19, 1987, the DJIA lost over 22% of its value in a crash.

This event lead to the enactment of circuit breakers that pause or close trading during fast moving markets.

Breakers are set to 10%, 20%, and 30% of recent DJIA level. At DJIA 10,000, the breakers are changes of 1,000,

2,000, and 3,000. The first breaker halts trading for 30 to 60 minutes. The 2nd breaker halts trading for 2 hours and the

third breaker stops trading for the day. Collars: restricts index arbitrage when DJIA

moves 200 points. “Curbs” are in

Circuit Breakers and Trading Limits

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American Association of Individual Investors Specializes in providing

education in stock investing, mutual funds, portfolios, and retirement planning

Publishes AAII Journal 150,000 members www.aaii.com

National Association of Investors Corporation Mostly known for investors

clubs Publishes Better Investing

Magazine Over 28,000 clubs

registered in 2002! www.better-investing.org

Investment Associations