Investments: Analysis and Behavior

1. Investments: Analysis and Behavior Chapter 2- Equity Markets ©2008 McGraw-Hill/Irwin

2. 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.

3. Equity Markets www.nyse.com • 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.

4. 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

5. AmericanStockExchange • 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

6. Nasdaq • Electronic market • Negotiated market • Market makers are dealers • Price determination through bargaining • 3,600+ issues • more technology firms • Dell, Microsoft, Intel www.nasdaq.com

7. 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

8. 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?

9. 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

10. 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)

11. 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.

12. 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.

13. Index Example • Consider 3 stocks. • Stock A is $40 and has 300 shares outstanding • Stock B sells for $60, outstanding shares of 200 • Stock C costs $80 and has 100 shares. • Consider two indices • Price-weighted average, divisor=2.5 • Value-weighted average • Base index value = 100 • The stock originally sold for $30, $50, and $60 with outstanding shares of 300, 100, and 100, respectively

14. 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

15. What is the value of each index after the $40 stock changes to $45? • Price-weighed average (45 + 60 + 80) / 2.5 = 74.00a 2.78% change • Value-weighted index {($45X300 + $60X200 + $80X100) / ($30X300 + $50X100 + $60X100)} × 100 = {33,500 / 25,000} × 100 = 134.00 a 4.69% change

16. 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.

17. 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

18. 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

19. Standard & Poor’s • S&P 500 • S&P MidCap 400 Index • 400 firms • Stocks with market caps of $1.5 to $10 billion • S&P SmallCap 600 Index • 600 firms • Average market cap of $600 million

21. 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

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

24. Self-Regulatory Organizations (SROs) • 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

25. Market Surveillance • NYSE’s Stock Watch • Flags unusual volume or price changes • Investigates questionable trades • Intermarket Surveillance Group • Shares information and coordinates efforts to detect manipulation • Securities Arbitration

26. Circuit Breakers and Trading Limits • 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

27. Investment Associations • 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