Section 7

Equity Markets

In this section we will cover the basics of equity markets. We will begin with a short history of a few well-known financial bubbles, take a look at fundamental techniques for stock valuation and conclude with portfolio theory.

Building Castles-in-the-Air

You are regularly shocked by the fact that people pay outrageous prices for dresses worn only once to some ghastly social function by Jackie Kennedy or Princess Diana. Prices of a guitar once strummed by Elvis, including his chewed up guitar pick, or John Kennedy's golf clubs rise to levels beyond ordinary rationality during a frenzied auction.

When analyzing the behavior of financial markets, we can not ignore the historical tendency for frenzied, irrational behavior. Greed and panic are two closely related emotions and extended periods of greed may give way to immediate panic. A market bubble forms when even rational investors follow others whom they think are better informed. If the consensus is mistaken, the bubble may end in a large crash.

A description for financial bubbles is known as building castles-in-the-air, or creating something that lacks a foundation. Assets that see enormous increases in prices due to bubbles have no intrinsic value, but only a market value where valuation is based on trends.

Aside from being a well-known economist, John Keynes was a very successful investor. Among other practices, Keynes advocated trying to outperform the market by predicting what investments are most susceptible to castle-building and then buying before the rest of the crowd. For many of his investment choices, Keynes applied psychological principals rather than financial evaluation of individual corporations.

The Holland Tulip Bulb Craze

The first well-known bubble took place in Holland during the 17th century. The mania started in 1593 when tulip bulbs were first introduced from Turkey. Over the next decades, the popularity of tulips in Holland grew enormously. The city of Amsterdam became the home of a significant market for tulip bulbs as tulip-mania began to explode.

During the tulip craze, different varieties of tulip came in and out of fashion, just as we see with designer clothing today. By 1636, people started to speculate on the popularity of a bulb during a given year. Bulbs became an investment opportunity, as everyone speculated: nobles, farmers, mechanics, maids, chimney sweeps, etc.

Prices of bulbs rose to seemingly unbounded heights. Rare bulbs sold for up to $50,000 in today's money. Call options were developed that allowed a person the right to buy tulip bulbs at a fixed price (usually near the market price) during a specified period. Options allowed the trader to pay only a portion of total cost of the bulb when purchasing the option. If price of the bulb increased, the person would exercise option, and buy at lower guaranteed price and simultaneously sell at higher market price. Options allowed speculators to gamble on future bulb prices without putting up-front large sums of guilders.

During the month of January 1637, bulb prices were driven up by over twenty-times as bulbs were purchased indiscriminately. By the end of the month, some speculators started to sell, quickly followed by the herd of investors. As bulb prices took a free-fall in February of that year, a panic ensued. With the collapse of the tulip bulb market, bulb speculators were wiped out financially and Holland fell into an economic depression as financial losses spread throughout the Dutch economy.

The South Sea Bubble - South Sea Trading Company

The South Sea Bubble is the name given to the first great stock market crash in England in 1720. The South Sea Bubble is a collection of stories of mass hysteria, political corruption, and public upheaval. The bubble involves the personal fortunes of countless individuals who rode the wave of stock speculation for a furious six months in 1720. The "Bubble year" as it is referred to, actually involves several individual "bubbles" as all kinds of fraudulent companies sought to take advantage of the mania for speculation.

The South Sea Bubble originated in 1711 when the South Sea Company lent ten million pounds to the British government. In return, the company was given a monopoly of all trade to the south seas, an area located around the Caribbean and further south. Although the South Sea Company had maintained the focus of its business in trade with the Bengal region of India, the potential financial prize was the anticipated trade that would open up with the rich Spanish colonies in South America.

In return for this monopoly, the South Sea Company assumed a portion of the national debt that England had incurred during a war with Spain. At first, the company had little financial success in South Sea trade. Some slave-trade voyages were made but these produced little profits. When Britain and Spain officially went to war again in 1718, the immediate prospects for any benefits from trade to South America disappeared. However, the South Sea Company was also a financial institution that used its monopoly primarily as a means of attracting investors.What mattered to speculators were future prospects, and it was argued that incredible prosperity lay ahead and would be realized when the war with Spain came to an end.

The South Sea Company was envious of the success that Scot John Law had achieved in France with the Mississippi Company, which was given a monopoly of French trade to North America. Using this trade monopoly, Law had driven the price of his company's stock up, and the South Sea directors hoped to follow this model to tremendous financial wealth.

To make a huge financial splash, in 1720 the South Sea company assumed the entire public debt of the British government of £31 million. Along the way the trading company bribed a number of important politicians, other influential people, and even the royal mistresses Madam von Platen and the Duchess of Kendal. The bribes were paid in stock shares of the South Sea Trading Company in order to expand the influential group of South Sea shareholders.

Having taken notice of South Sea's growing political and business importance, people demanded South Sea stock shares, causing prices to rise even though company was losing money - almost overnight, the value of South Sea's stock rose from £55 per share to £100 per share. The Company immediately aided the stock price run up through artificial means; these largely take the form of new subscriptions combined with the circulation of pro-trade-with-Spain stories designed to give the impression that the stock could only go higher. The potential for growth seemed limitless, many Dutch investors bought South Sea stock, thus fueling the rise in share prices.

Quickly, share prices rose from £130 to £300. The South Sea company issued new shares priced at £300. Buyers could acquire shares using an easy installment plan of £60 down. King George I buys £100,000 worth of South Sea's stock.

Within a month, share prices reached £400. Seeing a financial windfall, the South Sea company made another offering of newly issued shares, and share prices rose immediately to £550. Another new issue of shares required only 10% of the share price as a cash down payment for purchase, helped to fuel the runaway demand and share prices reached £800, and soon climbed skyward to £1000. All of this share appreciation took place in the short span of January through June.

Success soon attracted imitators. All kinds of companies suddenly appear, hoping to cash in on the speculation mania. Some of these companies are legitimate but the bulk were bogus schemes designed to take advantage of the credulity of the people. Several of the bubbles, both large and small, had some overseas trade or "New World" aspect. In addition to the South Sea and Mississippi ventures, there was a project for improving the Greenland fishery, another for importing walnut trees from Virginia. Other projects promised to produce less in the way of tangible goods, and were rather vague on details. People created investment schemes to satisfy people’s desire for stocks. One proposed to covert salt water to fresh (even though England had plenty of fresh water already). Another to create wood out of sawdust, although there was an abundance of forests worldwide at the time. One sold out in a matter of hours had a prospectus for "a company for popular new share offering that carrying on an undertaking of great advantage, but nobody to know what it is."

[the prospectus stated] that the required capital was half a million, in five thousand shares of 100 pounds each, deposit 2 pounds per share. Each subscriber, paying his [or her] deposit, was entitled to 100 pounds per annum per share. How this immense profit was to be obtained, [the proposer] did not condescend to inform [the buyers] at that time, but promised that in a month full particulars should be duly announced, and a call made for the remaining 98 pounds of the subscription. Next morning, at nine o'clock, this great man opened an office in Cornhill. Crowds of people beset his door, and when he shut up at three o'cock, he found that no less than one thousand shares had been subscribed for, and the deposits paid. He was thus, in five hours, the winner of 2000 pounds. He was philosophical enough to be contented with his venture, and set off the same evening for the Continent. He was never heard of again.

As South Sea shares peaked at a value of £1,000, rumors abounded of insider selling by South Sea directors. The bubble begins to deflate - at first gradually but then with increasing velocity. By mid August the bankruptcy listings in the London Gazette reach an all-time high, as people who purchased shares on credit or margin near the peak are crushed by falling share prices. As thousands of fortunes are lost, both large and small, the full collapse comes by the end of September as the stock has fallen from £1,000 to £135 a share.

Investors who lost their savings and more screamed foul against the South Sea directors. Parliament is recalled and George I hastens back to London. Mobs crowd into Westminster. In 1721, a committee investigating the South Sea Company uncovers widespread corruption and fraud among the directors, company officials and their friends at Westminster. By then, many of the corporate principles have fled to the continent, profits in hand. Those who remain are investigated and some estates are confiscated.

Many prospectors believed in the greater fool theory - the intrinsic value of company may be low, but buy the stock anyway, since other buyers could be found when they resell at a higher price. A big loser was Issac Newton who lamented that "I can calculate the motions of heavenly bodies, but not the madness of people."

The 1929 Stock Market Crash

During the 1920s, stocks and bonds were frequently sold to investors on the basis of glittering promises of fantastic profits. In the 1920s, many investors purchased stocks on margin, putting down only a small fraction of the stock's purchase price to acquire shares. In this way, an investor could leverage large sums of money in the market without raising much in the way of actual money for the purchase. Banks could take in saver deposits and use the money to purchase stock shares.

Deliberate manipulation and falsification of information was rampant during this period. Investment pools often formed that were comprised of several large traders and company officers that grouped together to manipulate the price of a chosen stock. Since most of the reporters on the Wall Street Journal could be bribed, the pool would pay Journal reporters to write false, but complementary news items about a company. Simultaneously, over the course of several weeks, the members of the pool would buy large blocks of the share.

Average investors would be tricked by the news, see the increase in share prices and volume of trades, and think that the company was a good buy. The wider population of investors would pile on, accumulating shares of the company in their own portfolio. The investment pool members would wait until the general public had bid up share prices significantly and then abruptly dump their shares, cashing out for a nice profit. Seeing the rapid selling, other shareholders would try to bail, but usually too late to avoid a substantial loss. Over time, greed prevailed and many duped investors would soon return to the soaring market hoping to recoup their losses.

After a decade-long run of rising shares prices in the Dow Jones, during the summer of 1929, the U.S. economy reached the peak of economic growth and a business downturn began. On September 3, 1929, the stock market took a sharp downward move. September 5 is known as the Babson break, named after an economist who warned of a crash. On Monday, October 21 rapid declines in stock prices led brokers to require more cash from margin buyers, who in turn had to sell shares to raise money. October 24 is known as Black Thursday, where many issues lost 40 to 50 points in value. Finally, on Tuesday, October 29, catastrophe hit as stock prices took a free fall.

By 1932 most ‘blue-chip’ stocks had lost 95% or more of their value from the market peak on September 3, 1929.

Security	Price Sept. 3, 1929	Low for 1932
AT&T	$304	$70 1/4
Bethlehem Steel	$140 3/8	$7 1/4
General Electric	$396 1/4	$8 1/2
Montgomery Ward	$137 7/8	$3 1/2
RCA	$101	$2 1/2

The securities laws of the United States were developed by Congress in the early 1930s as a direct response to these market abuses, which were blamed in large part for the disastrous Stock Market Crash of 1929, and the ensuing Great Depression. The Securities Act of 1933 and the Securities Exchange Act of 1934 created the Securities and Exchange Commission, cleaning up trading practices and cracking down on the falsifying of information.

Fundamental Analysis

Fundamental analysis bases the valuation of a stock on the intrinsic quality and the future outlook of a corporation. Fundamental analysts tend to ignore the past performance of a stock since all relevant and known information about a company is included in its current stock price. Analysts focus on the future outlook for a company and the effect of future developments on the earning of a company. In addition, fundamental analysis looks at the current price of a stock to determine if it is fairly valued.

Using fundamental analysis, the price of a stock is based on four main criteria:

1. The growth rate of earnings. Stocks with strong present and expected future growth rates are valued more highly. But be aware of the high flying growth stock that misses its earning estimates as the market will immediately deflate its price.
   
   
2. The magnitude of dividends. When a corporation earns profits it can divide the money up in several different ways. Profits can be used to pay bonuses to high ranking corporate officers (and sometimes to the employees down the line). A portion of the profits can be distributed to stock shareholders in the form of dividends. The general rule is that the greater the dividend pay out, the higher the valuation of a company's stock.

   It should be emphasized that the absence of dividend payoffs is not a negative. Rather than paying dividends, the corporation can use the money for research and development. If done wisely, future earnings growth rates will rise.
   
   

3. Market interest rates. Actual or anticipated increases in market interest rates will lead to lower stock valuations as the dividend yield on stocks becomes less attractive in comparison to other assets such as bonds or money market funds.
   
   
4. Risk.

The risk associated with owning a stock can be separated into two components:

Systematic risk is also known as market risk. Systematic risk captures the reaction of stocks or portfolios to changes in the stock market as a whole. Different stocks vary in their reaction to market movements. In relation to overall movements in the market, a stock may show a historical tendency to move by a smaller magnitude, a roughly equal amount or show greater volatility.

A stock's beta (ß) measures the historical change in share price relative to the market as a whole. Using the value of 1 as a benchmark (e.g. changes in the S&P 500) a stock with a value for ß >1 will on average change in price by a greater magnitude that the market as a whole. For example, if a stock's estimated ß equals 2.0, then for every 1% change in the S&P 500, the stock's price will on average move by 2% or twice the amount of the overall market. Or, a conservative stock may have a ß of 0.5, and exhibit behavior that is significantly less volatile that the market as a whole.

Since risk is often related to return, stock's with higher betas offer the potential for greater returns during bull markets and more painful losses during market downturns.

Unsystematic risk relates to factors peculiar to a given company. Stock prices may move independent of market trends, responding to changes in corporate fortunes and earnings.

Creating a diversified portfolio of multiple stocks allows the investor to significantly reduce the unsystematic risk present in a portfolio. A portfolio's systematic risk depends on the overall ß of the combined stocks.

The general formula for pricing of a stock is:

P_t = D^e_t+1 + P^e_t+1 / (1 + i_e)

where:

D^e_t+1 = expected periodic dividend

P^e_t+1 = expected future price (factors in expected earnings growth)

The formula discounts future dividends and earnings growth into a present value for today's stock price. The greater the expected dividend pay out and/or the higher the expected earnings growth rate, the more the stock is worth in today's price, and the higher the expected interest rate, the less should be paid for a stock today.

Stock Basics

The following two tables provide some basic information about stocks. The upper table is for Intel with a symbol of INTC and is traded on the NASDAQ exchange. The second table is for General Electric, symbol GE and traded on the New York Stock Exchange.

Generally, any company that has a stock symbol with four letters is traded on the NASDAQ. Companies with symbols comprising one, two or three letters are traded on either the New York Stock Exchange or American York Stock Exchange.

Stocks with five letter symbols are for foreign corporations that trade on either of the three exchanges. Foreign companies that trade in U.S. stock markets are known as American Depository Receipts (ADRs). These companies can also be purchased in their home country stock markets, but in that currency, requiring U.S. investors to covert dollars to the foreign currency. This implies that the U.S. saver faces some exchange rate risk when saving abroad. ADRs are foreign companies that trade on U.S. markets and their shares are denominated in dollars. U.S. investors who purchase ADRs can buy shares in a foreign company but can avoid the risk of depreciating foreign currencies that lower the return on foreign investments.

Here is some useful information from the following tables:

• Last Trade refers to the price at which shares were last traded. A good indicator of the stocks current price to both buyers and sellers. For example, Intel was last traded at a price of $93.62 per share.

• Change is the amount the share price has moved since trading began that same day. For example, Intel's shares have moved up by $1.81 during the day shown here.

• 52-week Range shows the low and high price at which shares have closed during the past 52-weeks. As you can see, both Intel and GE have had a good year since both are near their 52-week highs and both have current prices that are substantially greater than the lowest closing price seen during the 52-week period.

• Earn/Shr stands for earning per share. This is calculated by taking total corporate earnings during the past reported quarter and dividing by the total number of stock shares present.

• P/E stands for the price-earnings ratio. The P/E is calculated by taking the stock's current price and dividing by the earnings per share. Taking 93 ⁵/₈ and dividing by 3.83 gives the rounded value of 24.45. It is important to note that a company's P/E is based on past earnings, not estimated future earnings. The P/E gives an indication of how highly the stock is valued compared to the market as a whole. Companies that are reporting and projecting rapid earnings growth will usually command higher P/Es than moderately or slow growing companies. However, sometimes certain sectors command higher P/Es simply because they happen to be popular with institutional investors (look at GE's high P/E/ shown here). If a company has shown an operating loss in its last earnings report, then its P/E is not applicable.

• Div/Shr implies dividends per share. For example, for every share of GE a person owns, GE pays a $1.04 in annual dividends - that are paid in quarterly increments.

• Ex-Div refers to the last date when a dividend was paid.

• Yield is the dividend-only rate of return is shares are purchased at the current trading price. For example, taking GE's dividend, $1.04 and dividing by its share price 69 ¹/₈ , gives a yield of 1.50%.

A final useful bit of information is known as the PEG (price-to-earnings growth) ratio. The PEG ratio is especially useful in calculating the valuation of stocks for companies that are expecting rapid rates of earning growth in the upcoming year. The PEG ratio is calculated by taking a stock's P/E ratio and dividing by estimates of the next twelve months earnings growth.

A rule of thumb for stock traders is growth stocks with PEG ratios below a value of 1.0 are good buys - the lower the ratio, the better. As the PEG ratio for a stock climbs past 1.0, the more overvalued the company may be and the greater the potential for a rude correction if the company does not report actual earnings above expectations - just meeting expectations is often not satisfactory for companies with high PEG ratios. Reporting actual earnings below estimates is disastrous, as share prices may fall anywhere from 10% to 50% and even more, within a matter of minutes as institutional traders dump their shares in the company.

Readings

Financial Legends - The Economist

Potential Zero Inflation Effects on Equity and Debt Markets - Barrons

Hubbard Chapter 5