Chapter 40 The Stock Market Crashes McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc All rights reserved 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-2 1-2 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-3 1-3 Stock Prices: How they are Determined • Fundamentals • Earnings projections • Interest rates • Non-fundamental • The expected price of the share in the future McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-4 1-4 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-5 1-5 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 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-6 1-6 The Function of Trading • Regular trading of stock serves to equate the risk-adjusted return to investors across assets McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-7 1-7 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-8 1-8 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-9 1-9 Dow Jones Industrials McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-10 1-10 S&P 500 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-11 1-11 NASDAQ McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-12 1-12 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-13 1-13 Bubbles • A bubble is the state of a market where the current price is far above its value determined by fundamentals Prices rise which creates the expectation that prices will rise further which Repeat steps and McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-14 1-14 Examples of Bubbles • The Asian Financial Crisis of 19981999 • 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-15 1-15 NASDAQ 1999-2003 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-16 1-16 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-17 1-17 Accounting Scandals of 2001 and 2002 • K-Mart-poor performance • Global Crossing-fraud and very high risk • Enron-fraud McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-18 1-18 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-19 1-19 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-20 1-20 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 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-21 1-21 ... the projected earnings at an expected interest rate • An increase in earnings increases stock values • A decrease in the interest rate increases stock value McGraw-Hill/Irwin ©2012 The McGraw-Hill... 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... concern to investors because it introduced a new variety of risk McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 40-20 1-20 Rebound in 2006-2007 & Drop in 2008-2009 • All international