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Learn about the basics of stocks, including what they represent, their historical performance, and the pros and cons of stock ownership. Discover the primary and secondary markets and the reasons why companies choose to go public.
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CHAPTER5, Lecture Notes Introduction to Stocks (Lecture) The Stock Market (Chapter 5) “Don’t gamble! Take all your savings and buy some good stock and hold it till it goes up. If it don’t go up, don’t buy it.” -- Will Rogers
Where did the term “Common Stocks” come from? The investors are “Shareholders in Common.” What Are Stocks? • Stocks represent ownership in a corporation • Stocks are Equity Financing – “Equities” • Enable investors to participate in the profits and growth generated by the business enterprise • But stockholders are limited liability owners • Can only lose their investment (unlike a sole proprietor) • Stockholders receive … • Dividends • Optional payments of earnings • Capital Gains – a.k.a. Capital Appreciation • Value of corporation rises as business grows Contrary to what many believe (and how many behave), stocks are not simply millions upon millions of worthless pieces of paper that people trade each day for no reason. They represent ownership in real businesses.
Historical Performance • Over the long-term of modern finance … • The return from the stock market (as measured by the S&P 500) has averaged around 10% to 11% annually for the last eighty years • But in any one year … • It is unlikely that the return will be 10% or 11% • The return has varied from a high of 53.8% to a low of -43.4% • 2008’s return was -38.5%, one of the worst! • And in any given year … • There has been a one-in-three or one-in-four chance of a down market The major exception was the great run-up from 1982 to 2000
Historical Performance (continued)
Rolling 10-Year Period Returns 20% 15 10 5 0 Rolling 10-Year Periods 2003-12 1928–37 1933–42 1938–47 1943–52 1948–57 1958–67 1963–72 1968–77 1973–82 1978–87 1983–92 1988–97 1993–02 1998–07 1953–62 Source: The unmanaged Dow Jones Industrial Average, based on average annual compound returns over 10-year periods.
Historical Performance (continued) • Traditionally, close to half of the return from stocks was from reinvested dividends • Stockholders used to expect 4% to 6% in dividends each year – That was as much or more than bonds returned in interest since stocks were considered much riskier than bonds • The S&P 500 dividend average from 1936 to 2008 is 3.8% • But dividends fell to less than 2% & even 0%! • Capital gains & growth were what people wanted in the 1990’s • The S&P 500 dividend averaged 1.5% from 1997 to 2007 • Reasons given are varied • Dividends were taxed at a higher rate than capital gains • People wanted the business to reinvest the earnings for growth instead of distributing it to the investors • Stocks were no longer considered riskier than bonds • Savings accounts were also paying less than 2% • People lost track of their senses and bid up the prices
Historical Performance (continued)
Historical Performance (continued) • The Pendulum Swings… • The Bear Markets of 2000-2002 and 2008 have changed investors’ perception about dividends • We now see investors and companies focusing more and more attention on dividends • Many companies that never paid dividends in the past are doing so now • Example: Many tech companies are no longer growth stocks. They are mature industries. • Also, the tax law has changed dividends so that they are taxed roughly the same as capital gains “Dividends Don’t Lie.” − Geraldine Weiss “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” − attributed to John D. Rockefeller
Pros & Cons of Stock Ownership • Pros • Allow general public to share in the rewards of business enterprise • Best investment returns over time • Dividends and capital gains • Easy to buy & sell – liquid investment • Limited liability • Increased standard of living for all • Cons • Risky • “Volatile” (industry’s popular euphemism for losing money) • Corporate and financial industry hanky-panky!
Primary versus Secondary Market • Primary Market • The market in which new issues of securities are sold to the public • Initial Public Offering (IPO) • The first public sale of a company’s stock • a.k.a. “Going public”, “Taking the company public” • Most retail investors do not participate in the primary market • (And my recommendation is that we really shouldn’t) • Secondary Market • The market in which securities are traded after they have been issued to the public • The vast majority of transactions take place in the secondary market
Primary Market • Why “Go Public?” • Why do corporations issue common stock? • To raise money to start or expand a business • To help pay for ongoing business expenses • As a way to gain prestige and respect within the investment and industrial communities • As a reward for those who started the business • And also simply because once a business becomes sufficiently large, it becomes very difficult for the owners to “divvy up the spoils” without going public • If you were one of the people who started GE or Coca-Cola or Walmart, how would you sell your share of the business? What are some of the largest private companies?
Primary Market (continued) • Why “Go Public?” (continued) • The corporation does not have to repay the money • It is under no obligation to repurchase the shares of the stock • The shareholder may or may not be able to find someone who will purchase the shares from them • But the corporation is now a public entity • As such, it now has many rights and responsibilities that private companies do not need to worry about • Must file 10K’s & 10Q’s with the SEC • Must have at least one public meeting annually Chapter 5 goes into much detail about IPOs. IPOs do not usually live up to their expectations. The typical IPO loses 50% of its value in one year.
Secondary Markets • Markets in which securities are sold after they have been issued • a.k.a. Aftermarket • Secondary markets provide… • Liquidity • Easy method for transferring ownership of securities • Mechanism for pricing and valuation of securities When people talk about the “stock market,” they are almost always referring to the secondary market.
Types of Secondary Markets • Organized Securities Exchanges • Centralized institutions in which transactions are made in outstanding securities • “Double Auction” Market (Face-to-Face) • Over-the-counter (OTC) Market • Widely scattered telecommunications network through which transactions are made in outstanding securities and smaller IPOs • Quote-based system (On-line) This is an outdated comparison. Due to technology advancements, mergers, and acquisitions, the traditional differences between the two have been erased. And the changes are just gettin’ started!
Organized Securities Exchanges • Historically… • All trading was conducted on an exchange floor • Trading was conducted using a “double auction” • Instead of the “one seller, multiple buyers” that you see at an estate or farm auction, for example, • There were “multiple sellers and multiple buyers” • Brokers on the floor call out prices & quantities • But due to both technology & the sheer massive volume of shares traded, things have changed • Almost all of the trading is now conducted electronically • Some large trades still involve human interaction • But they now consist of far less than 1% of the total number of trades
The New York Stock Exchange • a.k.a. NYSE, the “Big Board” • Traditionally, responsible for over 90% of the volume of transactions on exchanges – 1,900 companies • About $20 trillion of market capitalization (Jun 2016) • Established as a members-only entity in 1792 • When Wall Street really was next to a wall • Companies listed on the NYSE must meet stringent requirements • The largest and most prestigious (traditionally) • Companies can be de-listed(example: Kodak) • If they fail to continue to meet the NYSE requirements
The New York Stock Exchange (continued) • Big Changes at the NYSE • In 2005, purchased Archipelago electronic exchange and the Pacific regional exchange • Became a publicly traded corporation in March of 2006 • When they merged with the Euronext electronic exchange • Phased out face-to-face, double auction trading • In favor of exclusively trading electronically • In 2011, Germany’s stock market tried to purchase the NYSE but was blocked by European regulators • On November 13, 2013, the NYSE was acquired for $11 billion by a 13-year-old derivatives trading firm from Atlanta, Intercontinental Exchange In 1992, on their 200th birthday, if you had told the folks at the NYSE that the next 20 years would see far more changes than in their first 200 years, they would have thought that you were quite insane. Press Release from ICE announcing completion of acquisition of NYSE "The End of the Street" -- The Economist, 16 November 2013
The New York Stock Exchange (continued) • The Floor Brokers • House Brokers • Execute orders on behalf of their firm’s customers or occasionally on behalf of their firm’s own account • Independent Brokers • Provide as-needed execution services to house brokers, member or non-member broker-dealers • Independent of a particular firm • a.k.a. “$2 Brokers” The floor brokers were very worried that the NYSE’s aggressive moves to all-electronic trading meant the end of their way of life. It was not really the end; it was just a big change – from face-to-face interaction to sitting in front of a computer screen all day. Sound familiar?
The New York Stock Exchange (continued) • The Specialists • Stock exchange members who specialized in making transactions in one or more stocks • The job of the specialist was to manage the auction process. The specialist buys or sells the stock from their own inventory to provide a continuous, fair, and orderly market • The role of the specialists has essentially been squeezed out by technology and the tremendous volume of trading They are involved in only a tiny amount of trading each day • The specialists were replaced by “designated market makers” and “supplementary liquidity providers” in 2009 From time to time, the specialists were either praised or maligned. Suffice to say that the specialists were trying to make a profit just like everyone else. While their goal may have seemed altruistic, they made sure that when the market received benefits from their efforts, so did they. http://www.investopedia.com/university/electronictrading/trading2.asp
The American Stock Exchange • The American Stock Exchange • a.k.a. the AMEX, the “Curb” (?) – Now the NYSE MKT! • Where did that name come from? They started on the curb outside the NYSE! (Image: AMEX Curb Brokers) • Much smaller than the NYSE • Only 3% of the volume of all exchanges • The AMEX started concentrating on securities other than stocks over 20 years ago • Purchased by the NASDAQ in 1998 • Went independent again in 2004 • Acquired by the NYSE in 2008 • They then moved down the street to the same building as the NYSE and their name was changed to NYSE MKT The ETFs were first introduced on the AMEX.
The Regional Stock Exchanges • The regional stock exchanges were modeled after the NYSE and AMEX • Only account for 4% of exchange volume • Chicago • Philadelphia • Pacific • Boston • Denver • Cincinnati Many of the securities listed on the regional exchanges are also available on the NYSE or NASDAQ. Traditionally, the regional exchanges were often places where undesirable or unethical issues were sold. Lately, the regional exchanges have tried to diversify and differentiate themselves from the NYSE and NASDAQ in order to survive. Plus the regional exchanges have not been immune to the rush to consolidate. The NYSE bought the Pacific Exchange and the NASDAQ bought the Philadelphia Exchange.
Options and Futures Exchanges • Options allow traders to sell or to buy an underlying security at a specified price for a given time • The Chicago Board Options Exchange (CBOE) • Futures are contracts that guarantee the delivery of a specified commodity at a specific future date at an agreed-on price • Chicago Board of Trade (CBT) We will discuss options and futures in detail later. Options and futures are also traded on most all the major and regional exchanges now as well as the two major exchanges noted above.
The Over-the-Counter Market • Widely scattered telecommunications network through which transactions of securities are made – a.k.a. OTC • There is no single location as with an exchange • Quote-based system • As opposed to the double auction of the exchanges • Three tiers • NASDAQ – National Association of Securities Dealers Automated Quotation system • The NASDAQ does not want to be associated with the OTC anymore • OTC Bulletin Board – 5,000 securities • OTC Markets Group • nee Pink Sheets – 20,000+ thinly traded securities • It appears that they are trying to clean up their act: OTC Markets The Nether Worlds Stay Away!
The Role of Dealers in the OTC • Dealers are traders who “make markets” by offering to buy or sell certain securities at stated prices – a.k.a. “market makers” • The dealers offer buy and sell quotes from their own inventory of stocks • Whereas brokers simply serve as a go-between between buyers & sellers. They keep no inventory • Ask price – “retail price” • The price a dealer offers to sell a security • Bid price – “wholesale price” • The price a dealer offers to purchase a security • The spread • The difference between the bid and the ask prices The dealers / market makers on the NASDAQ perform roughly the same role as the specialists on the NYSE. http://www.investopedia.com/university/electronictrading/trading3.asp
The Role of Dealers in the OTC (continued) • Unlike brokers who charge a commission dealers make money from the spread of the bid and ask prices • Just as the Casas de Cambio in San Ysidro make money on the difference between the prices in which they buy and sell pesos and dollars • The dealer’s markups or markdowns are not reported to the customers • Whereas the broker’s commissions are reported How do you think the Internet brokers make money on only $5 or $7 per trade? (More later)
The NASD and the NASDAQ • National Association of Securities Dealers Automated Quotation system – NASDAQ • National Association of Securities Dealers (NASD) • Non-governmental organization that used to be responsible for self-regulation of registered representatives (stockbrokers) – (Now done by FINRA) • The NASD is now simply called the NASDAQ • Created the first electronic communications network for trading securities in 1971 • Provides up-to-date bid and ask prices on approximately 2,800 stocks The NASDAQ used to be the arena for small companies to get started. Once they became large enough, they would move to the NYSE. However, since the 1980’s, many prestigious companies decided to stay on the NASDAQ rather than move to the NYSE.
The NASD and the NASDAQ (continued) • The NASDAQ is now a three-tier system • NASDAQ Global Select Market • 1,550 “crème de la crème” • Companies that would easily qualify for the NYSE • NASDAQ Global Market • nee NASDAQ National Market • 760 larger companies • NASDAQ Capital Market • nee NASDAQ SmallCap Market • 790 smaller companies The NASDAQ began positioning itself as the “Securities Market of the Future” as it became apparent that the traditional face-to-face, double auction model was not adequate to keep up with the massive increase of trading. The NASDAQ market capitalization is roughly $12 trillion. Listing of Nasdaq Companies
Alternative Trading Systems • Third market • Over-the-counter transactions made in securities listed on the NYSE, AMEX, or one of the other organized exchanges • Institutional investors who trade in large blocks of securities get to use the third market • Mutual funds, insurance companies, pension plans, etc. • Reduced transaction costs • But still facilitated by a dealer • Example: Intermarket (became the NASDAQ Intermarket)
Alternative Trading Systems (continued) • Fourth market • Traditionally, transactions made directly between large institutional buyers and sellers of securities • Allowed the institutions to bypass the dealers • Get rid of the middleman • Electronic Communications Networks (ECNs) • Privately owned electronic trading networks that automatically match buy and sell orders that customers place electronically • Examples: Archipelago (became the NYSE Arca), BATS With the advent of the Internet, the third and fourth markets successfully started to court retail customers. This got the attention of the NYSE and the NASDAQ!
“But Isn’t the Stock Market All Just One Big Malignant Casino?” The Answer is “Yes” and “No” • “Yes” • There are many individuals who see the markets as one big crap-shoot • For them, the way to riches is to buy and sell, buy and sell, buy and sell • We call them speculators • “No” • Many others look at the capital markets as a way to participate in the growth & prosperity of the global economy • We call them investors It is very difficult and you are up against the best in the business. Neophytes become very upset when the market turns against them. a.k.a. traders With a long-term orientation, investors are usually very well rewarded. “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” − The Intelligent Investor, Benjamin Graham
“Oh, Yeah, But What About Enron? Aren’t Corporations All Crooks?” • Fraud and accounting trickery and gimmicks have always been with us • They are always going to be with us • “Because that is where the money is!” • Normally, but not always, those firms are relegated to the nether reaches of the OTC • But for every one Enron, there are hundreds – no, thousands! – of companies that continue to do business with integrity and honesty (uh, usually… ) In 1973, it was Equity Funding. In 1986, it was Ivan Boesky and Vagabond Inns. In 2002, it was Enron, Global Crossing, Tyco, and WorldCom. In 2008, it was Fannie, Freddie, Lehman, Citi, WaMu, and AIG. And don’t forget Madoff! Ten or twenty years from now, during the next big bull market craze, someone else will take their place.
Recap: Securities Markets • The securities markets exist to allow investors a safe, cost-effective method to participate in the success of the global economy • And even with all the underhanded shenanigans, they have performed very well • They are changing at breakneck speed • And the change is accelerating Whether or not we ever have one or more global, 24-hour trading markets remains to be seen. But it is exciting (and, for some, scary) to watch, especially for those of us who have a stake in the outcome.
Bull Markets vs Bear Markets • Bull Market • Favorable markets normally associated with rising prices, investor optimism, economic recovery, and government stimulus • Bear Market • Unfavorable market normally associated with falling prices, investor pessimism, economic slowdown, and government restraint • Where did the terms bull market and bear market come from? Bear Skin Jobbers: “Don’t sell the bear skin before the bear is caught.”
Types of Stock Transactions • Market Order • “Buy/sell at the current price” • Limit Order • “Buy/sell only at the price you specify” • Stop-loss Order (a.k.a. Stop Order) • “Buy/sell at the current price once a trigger point is reached” • Stop-limit Order • “Buy/sell only at the price you specify once a trigger point is reached” Although you can use limit orders to buy or sell at the price you want, and stop-loss and stop-limit orders to “lock-in” profits or protect against losses, remember that they trigger automatically. If for some reason, you change your mind, it is often too late to cancel the order.
Types of Stock Transactions (continued) I normally use and recommend market orders. Short-term traders tell me they prefer limit orders or stop orders on all their trades.
Types of Stock Transactions (continued) • Buying on Margin • Borrowing money from your broker to enhance your return • You can borrow up to 50% of the purchase price of a stock • Selling Short • Borrowing stock and selling it in the hopes that the price will go down (Sell stock you do not own! Huh?) • You must buy it back at some time in the future The book spends much time discussing margin accounts and selling short in chapter 2. We will discuss these in detail late in the semester. My advice to you is never sell short. It is simply too risky. Using a margin account can be useful once you have built a substantial portfolio. It allows you to borrow from your portfolio without selling your stocks.
Transaction Costs • Traditionally, transaction costs were in the 1% to 5% range • Sometimes higher • The largest percentage of the cost was the brokerage’s commission • Deep-discount Internet brokers have driven the commissions down to as low as $5 per trade • A few firms used to offer free trades (?) • But have transaction costs really gone down? • Yes, but more and more of the cost is hidden from the investor Especially the “Internet garbage” brokers. (Those aren’t my words!)
Transaction Costs (continued) • Example: • A deep-discount Internet broker offers trades for $7 • In the fine print of the client-broker agreement is included a provision for allowing the broker to solely utilize exclusive stock dealers and market makers • The quoted price is simply the best price available but at any one time, there are dozens of prices quoted as dealers and market-makers compete for buy and sell orders • The chosen dealer doesn’t necessarily have the best price • Instead of paying $20, the investor might pay $20.05 The investor sees the $7 commission on their confirmation. The investor does not see the extra $5 they paid on a 100 share purchase because of the dealer’s markup.
Transaction Costs (continued) • The following disclaimer is included in each trade confirmation e-mail from Scottrade SCOTTRADE INC. RECEIVES REMUNERATION FOR DIRECTING ORDERS TO PARTICULAR BROKER/DEALERS OR MARKET CENTERS FOR EXECUTION. SUCH REMUNERATION IS CONSIDERED COMPENSATION TO THE FIRM AND THE SOURCE AND AMOUNT OF ANY COMPENSATION RECEIVED BY THE FIRM IN CONNECTION WITH YOUR TRANSACTION WILL BE DISCLOSED UPON REQUEST In Scottrade’s defense, at least they prominently disclose this relationship. Many others hide it in their customer agreement fine print and the customers are never aware of the relationship.
Transaction Costs (continued) • The SEC says that “your broker has a duty to seek the best execution that is reasonably available for its customers' orders” • But it is not a guarantee • “… the SEC requires broker/dealers to notify their customers if their orders are not routed for best execution. Typically, this disclosure is on the trade confirmation slip you receive … after placing your order”– Investopediahttp://investopedia.com/articles/01/022801.asp • And determining whether or not a customer got “best execution” can be very difficult Here is an example of the SEC trying to enforce the rules: http://lawprofessors.typepad.com/securities/2008/06/scottrade-settl.html
Transaction Costs (continued) • The SEC was looking into making the costs more transparent • Possibly showing the customer the difference between the dealer’s price and the best price available at the time of the transaction • Maybe even – gasp! – showing the total cost of the transaction from the markup/markdown • Needless to say, the deep-discount brokers cried that it would drive up the cost of commissions and ultimately hurt the consumer and the proposal died • So it is up to you to check if you are getting the “best execution” But how can you, a lone investor, determine if you are getting the best price if even the SEC has trouble watching over the brokerage companies?
Transaction Costs (continued) • High Frequency Trading (a.k.a. HFT) • Uses computers to transact large numbers of orders at very fast speeds • Detailed in the book Flash Boys by Michael Lewis • There is little doubt that High Frequency Trading has reduced transaction costs • However, at the same time, HFT firms have been accused of using their ability to transact at the microsecond level to “front run” investors • Essentially stealing tiny amounts of money from the average retail investor and even large players like mutual funds • One firm, IEX, is fighting back and has the backing of some very large market players IEX has created what they call a “speed bump” so the HFT firms can not “jump” in front of you and “front run” your transaction. In June 2016, the SEC approved IEX’s bid to become an exchange. Stay tuned! http://www.latimes.com/business/la-fi-capital-group-iex-20160815-snap-story.html
Round Lot versus Odd Lot • Round Lot • 100 shares or multiples of 100 shares • Odd Lot • Less than 100 shares • Mixed Lot • Lots over 100 shares but not evenly divisible by 100 • Odd-lot Differential • Extra cost of trading an odd lot • Traditionally, the odd-lot differential was 12½¢ - 25¢ • It is now typically 5¢or less Some people recommend against odd-lot purchases because of the higher cost. On 10 shares, an odd-lot differential might be $1. On 80 shares, it might be $4. Big deal.
Reading Stock Quotes • Current price during trading hours • The bid and the ask • Open, High, Low, Close (a.k.a. Last) • 52-Week High and Low • Dividend Yield • P/E Ratio • Volume • Net Change • Year-to-Date Change Different sources will contain some, all or more of these statistics. But always remember that the quoted prices are not the only prices available. At any one time, there are many prices available from many different dealers/market-makers. The quoted prices are the best prices available. Plus, usually you are seeing the current prices 15 to 20 minutes ago.
Reading Stock Quotes (continued) Wall Street Journal Example “Omigod! You mean you actually wait until the next day to find out how much your stock is worth?! How Twentieth Century!”
Reading Stock Quotes (continued) • On-line Examples • ca.finance.yahoo.com • bloomberg.com • marketwatch.com (owned by Wall Street Journal) • morningstar.com • Any others you want to check out? Yahoo! used to be my favorite web site but just recently, they have literally destroyed the Finance home page (after destroying the Yahoo! home page several months earlier). I now use the Canadian Yahoo! Finance page to research individual stocks. (Note to online students: Please see the accompanying presentation on how to use the Canadian Yahoo! Finance to do your research.)
Market Averages and Indexes • How can we say that “stocks have returned approximately 10% over the past 70 years?” • The industry uses market averages and indexes • “Benchmarks” used to measure the general behavior of securities prices by reflecting either the average price behavior (market average) or relational price behavior (market index) of representative groups of securities at a given point in time • You can not help but hear about these every day in the news • “The Dow went down! The NASDAQ went up!” The differences between a market average and market index are subtle. Most people do not even know there are differences.
Market Averages and Indexes (continued) • Share price calculation (Market Average) • Looks solely at the price of the stock without regard to the market value • Example: Dow Jones Industry Average • Market-weighted calculation (Market Index) • Stock price times number of shares outstanding • Takes into account the market value of the stock in the index • The larger the market share, the more influence the security will have in the index • Example: Standard & Poor’s 500 Stock Index Market-weighted calculations were generally regarded as a better measure until the bubble of the late 1990’s.
The Dow Jones Industrial Average • Stock market average made up of 30 high-quality stocks selected for total market value and broad public ownership and believed to reflect overall market activity • Share price calculation • Most famous of the stock market measures • a.k.a. the Dow, the Dow Average, the DJIA • Changes from time to time as companies and industries evolve • As such, it now has more non-industrial stocks than industrial stocks Dow Jones is the company that publishes the Wall Street Journal. In 2007, it was purchased by Rupert Murdoch of Fox News fame. It appears that they sold the DJIA and all their other indices to S&P.
