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McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
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 1998-
1999• 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