The stock market is in the news every weekday. Some days it’s up, some days it’s down. But what is the stock market?
The stock market is more informal name for the equity market. Equity is an ownership claim in a firm. A stockholder (or shareholder) has a legal claim on the firm’s profits and on its equity. Limited liability shields stockholders from losses beyond their investment. A dividend is a cash payment to stockholders.
The stock of a company has a price and there are a set number of shares available in the market. Market capitalization is the total market value of a firm’s common and preferred stock.
The stock market is simply a market for buying and selling stocks. It is a primary market, because companies can provide an initial public offering (IPO) on the stock market. It is a secondary market, because traders can trade existing stocks on the stock market.
A stock exchange is a market for trading shares in publicly-traded companies. An example is the New York Stock Exchange (NYSE). Companies with stocks on a stock exchange are referred to as “listed” or “publicly-traded.”
Most developed (and even developing) countries have their own stock exchange. Other examples of stock exchanges are the London Stock Exchange (LSE) and Toronto Stock Exchange (TSE).
There are still regional stock exchanges in the U.S. For instance, the Chicago Stock Exchange (CHX) still exists, although its trading volume is quite small.
A stock index is an index for measuring the overall performance of a large group of stocks. Stock indexes are used to track the stock market. The three most important stock indexes in the U.S. are the
- Dow Jones Industrial Average (the “Dow”)
- S&P 500
- Nasdaq
These three U.S. stock indexes are often reported together in the news.
The Dow is the most well-known U.S. stock index. It is an index for 30 U.S. publicly-traded components. In other words, the index tracks 30 components.
The U.S. stock market is near all-time highs as of the beginning of 2021. Some people are worried that these prices are not sustainable given the current economy. Is this a bubble? If so, when will the bubble pop?
Stock valuation can be measured using the price-to-earnings (PE) ratio.
Just as there are international stock exchanges, there are also international stock indexes. Stoxx 600 is an index for European stocks. Nikkei is an index for Japanese stocks.
Stock indexes are cyclical, meaning that they rise in an economic expansion and fall in an economic recession. The three U.S. stock indexes are different, but highly correlated.
Prior to 2020 and the COVID-19 crisis, the U.S. stock market was in the longest bull run in history. The bull run began on March 9, 2009 after the global financial crisis. This bull run ended in 2020 after more than 10 years. The S&P500 has nearly quadrupled in value following March 2009. The prior longest bull run was in the 1980s.
Stocks are valued based on expected future dividends. A basic one-period valuation model is the following:
Note that this model is a “buy and sell” model. The model assumes that the stock is going to be sold in one period.
The required return on equity is a combination of the risk-free rate and the risk premium. The Federal Reserve can influence stock prices by changing the risk-free rate. Lowering interest rates reduces the required return on equity and increases stock prices.
A longer-term valuation model can be based on an assumption about a constant dividend growth rate. This is called a Gordon Growth model. This model can be viewed as the following:
Asset prices reflect expectations of future cash flow. This is of all financial securities, including stocks. This means that prices react to new information that is different than expectations. In the quarterly earnings seasons, stock prices rise when a company beats analyst consensus and stock prices fall when a company misses analyst consensus.
Technical analysis focuses on price trends. Fundamental analysis focuses on earnings.
Value stocks have low price to earnings. Growth stocks have high price to earnings.
One debate in stock markets is around the issue of efficient valuation. This can be viewed as a debate between efficient markets and behavioral finance.
Efficient markets assume rational expectations. This implies that prices reflect all available information. A book on this topic is “A Random Walk down Wall Street.” This is the philosophy behind index investing, which is also known as passive investing. Eugene Fama won the Nobel prize in this area. Index investing has grown dramatically in recent decades. One way to think of the efficient markets view is that Price = Fundamental Value. There are no “undervalued securities,” so activist investing does not discover any such hidden opportunities.
Behavioral finance does not assume rational expectations. It acknowledges that market prices can be driven by greed and fear. This perspective also results in a belief that some stocks are overpriced and some stocks are underpriced. Analysts use technical analysis (and pricing anomalies) to value stocks based on price patterns. Analysts also use fundamental analysis of financial statements for the same goal of identifying deviations of values from prices. Either approach can lead to stock picking. This is the key rationale behind active investment management and trying to “beat the market.” Robert Shiller won the Nobel prize in this area for his work on bubbles.
There are many different ways to invest in the stock market. Online brokerages like Charles Schwab are becoming increasingly popular. Robin Hood is a free app for trading stocks.
There are many books on investing that are available. Peter Lynch is an interesting author in this area.
Glossary
Dividend. A cash payment to stockholders
Equity. An ownership claim in a firm
Market capitalization. The total market value of a firm’s common and preferred stock
Stock exchange. A market for trading shares in publicly-traded companies
Stock index. An index for measuring the overall performance of a large group of stocks