Investments Analysis and Behavior Chapter 2 Equity Markets

Learning Objectives n n 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. 2 -2

Equity Markets n New York Stock Exchange ¨ An n www. nyse. com Agency Auction Market in which brokers represent buyers and sellers and prices are determined by supply and demand. ¨ Trading n n 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. 2005 NYSE Average Daily Stock Volume (millions) 1, 604 NYSE Average Trade Size per Sale (in shares) 334 Number of NYSE Non-US Stocks 453 NYSE Dollar Value of Trading Activity (billions of dollars) $56. 1 Programs as % of Total NYSE 56. 9% Companies Listed on the NYSE 2, 779 2 -3

The NYSE is the most prestigious stock exchange in the world n General Electric, Citigroup, Wal-Mart, Time Warner, IBM, Coca Cola n Some listing standards: Round-lot Holders (holders of at least 100 shares) or Total U. S. shareholders with monthly trading of 100, 000 shares Or Total shareholders with monthly trading of 1, 000 shares Shares Outstanding Market Value $100, 000 Aggregate pretax earnings over the last three years of 2, 000 2, 200 500 1, 100, 000 $6, 500, 000 2 -4

American Stock Exchange n n n 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 n www. amex. com 2 -5

Nasdaq n n Electronic market Negotiated market ¨ Market makers are dealers ¨ Price determination through bargaining n 3, 600+ issues ¨ more technology firms ¨ Dell, Microsoft, Intel www. nasdaq. com 2 -6

Other U. S. stock markets n Nasdaq Small. Cap Market ¨ 800 small firms seeking Nasdaq market maker sponsorship ¨ No penny stocks (price < $1) n Over-the-Counter Bulletin Board ¨ 3, 000+ securities offered by 300+ market makers ¨ Penny stocks traded here n Electronic Communication Networks (ECNs) ¨ Electronic market for institutional investors to trade with each other 2 -7

Tracking the market n 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? n Prices increases are larger than price decreases? n Should the size of the companies changing price matter? n Is stock price or capitalization important? n 2 -8

Dow Averages n Charles Dow and Edward Davis Jones ¨ Credited with inventing the stock index ¨ First stock index created in 1884 n n n 11 firms Mostly railroad companies Added up the stock prices and divided by 11. (price average index) ¨ DJIA n was started in 1896 with 12 stocks DJUA, DJTA 2 -9

Dow Jones Industrial Average n 30 companies ¨ Most important and largest firms ¨ Selected by the editors of the Wall n 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) 2 -10

3 M Co. Alcoa Inc. Altria Group Inc. American Express Co. American International Group Inc. Problems with price-weighted averages Boeing Co. Caterpillar Inc. n Citigroup Inc. Coca-Cola Co. E. I. Du. Pont de Nemours & Co. Exxon Mobil Corp. n General Electric Co. General Motors Corp. Hewlett-Packard Co. Home Depot Inc. ¨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. Honeywell International Inc. Intel Corp. International Business Machines Corp. Johnson & Johnson JPMorgan Chase & Co. Mc. Donald's Corp. Merck & Co. Inc. Microsoft Corp. Pfizer Inc. Stock splits require changes in the divisor Larger priced stocks move the index more than smaller priced stocks for the same % price move. n Difficult to index to a price-weighted average. Procter & Gamble Co. SBC Communications Inc. United Technologies Corp. Verizon Communications Inc. Wal-Mart Stores Inc. Walt Disney Co. 2 -11

Standard & Poor’s 500 Index n The 500 -firm index started in 1957 ¨ Value weighted index n Determine market capitalization of each firm (stock price × shares outstanding) n Add up the market capitalization for all 500 firms n Scale (Index Base set to 10) ¨ Generally the largest 500 firms in the U. S. n However, it is designed to match the sectors weights of the overall market composition. 2 -12

Index Example n 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. n Consider two indices ¨ Price-weighted average, divisor=2. 5 ¨ Value-weighted average Base index value = 100 n The stock originally sold for $30, $50, and $60 with outstanding shares of 300, 100, and 100, respectively n 2 -13

What is the value of each index? n Price-weighed average (40 + 60 + 80) / 2. 5 = 72. 00 n Value-weighted index {($40 X 300 + $60 X 200 + $80 X 100) / ($30 X 300 + $50 X 100 + $60 X 100)} × 100 = {32, 000 / 25, 000} × 100 = 128. 00 2 -14

What is the value of each index after the $40 stock changes to $45? n Price-weighed average (45 + 60 + 80) / 2. 5 = 74. 00 a 2. 78% change n Value-weighted index {($45 X 300 + $60 X 200 + $80 X 100) / ($30 X 300 + $50 X 100 + $60 X 100)} × 100 = {33, 500 / 25, 000} × 100 = 134. 00 a 4. 69% change 2 -15

More Popular Indices n Russell Indexes ¨ Russell 3000 uses the 3, 000 largest U. S. companies n Represents 98% of the investable US equity ¨ Russell 1000 uses the 1, 000 largest U. S. companies n Represents 92% of the investable US equity ¨ Russell 2000 uses the 2, 000 smallest companies n the Russell 3000 n Considered a small cap index. 2 -16

Dow Jones Wilshire 5000 (Full Cap) Price Dow Jones Wilshire 4500 (Full Cap) Price Dow Jones Wilshire 2500 Price Dow Jones Wilshire U. S. Large-Cap Price Dow Jones Wilshire U. S. Mid-Cap Price Dow Jones Wilshire U. S. Small-Cap Price Dow Jones Wilshire U. S. Micro-Cap Price Dow Jones Wilshire U. S. Large-Cap Growth Price n Dow Jones Wilshire U. S. Large-Cap Value Price 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 U. S. Mid-Cap Growth Price Dow Jones Wilshire U. S. Mid-Cap Value Price Dow Jones Wilshire U. S. Small-Cap Growth Price Dow Jones Wilshire U. S. Small-Cap Value Price Wilshire Large Cap 750 Wilshire Mid Cap 500 Wilshire Small Cap 1750 Wilshire Micro Cap Wilshire All Growth Wilshire All Value Wilshire Large Growth Wilshire Large Value Wilshire Mid Growth Wilshire Mid Value n Dow Jones Wilshire 4500 Contains the Wilshire 5000 firms less the S&P 500 firms ¨ Considered a mid-cap index ¨ Wilshire Small Growth Wilshire Small Value Wilshire Small Cap 250 Price 2 -17

Nasdaq Indexes n Nasdaq Composite Index ¨ All common stocks listed on the Nasdaq Stock Market ¨ 3, 175 firms ¨ Market value-weighted n Nasdaq 100 Index ¨ Largest 100 firms on the Nasdaq Stock Market ¨ Large stock index, but technology oriented 2 -18

Standard & Poor’s S&P 500 n S&P Mid. Cap 400 Index n ¨ 400 firms ¨ Stocks with market caps of $1. 5 to $10 billion n S&P Small. Cap 600 Index ¨ 600 firms ¨ Average market cap of $600 million 2 -19

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Global Stock Indexes n Major Local Stock Market Index ¨ Nikkei, n Dax, FTSE Morgan Stanley Capital International Indexes ¨ Global, regional, and local indexes ¨ Emerging and developed markets 2 -21

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Securities Market Regulation Legislation 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 ¨ 2 -23

Self-Regulatory Organizations (SROs) n n SEC delegates regulatory authority National Association of Securities Dealers (NASD) ¨ ¨ n n n 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 2 -24

Market Surveillance n NYSE’s Stock Watch ¨ Flags unusual volume or price changes ¨ Investigates n questionable trades Intermarket Surveillance Group ¨ Shares information and coordinates efforts to detect manipulation n Securities Arbitration 2 -25

Circuit Breakers and Trading Limits n n n 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 2 nd breaker halts trading for 2 hours and the third breaker stops trading for the day. ¨ n Collars: restricts index arbitrage when DJIA moves 200 points. ¨ “Curbs” are in 2 -26

Investment Associations n 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 ¨ n 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 ¨ 2 -27