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THE STOCK MARKET AND CRASHES
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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
Summary
LEARNING OBJECTIVES
LO1: Describe how stock prices are determined and what stock markets do.
LO2: Apply the concept of present value to the fundamental elements of stock prices and describe how prices can get
out of line with their fundamental value.
LO3: Explain that bankruptcy is an important feature in corporate business but that many of the bankruptcies of 2001
and 2002 involved a level of deception on the part of their accountants that was potentially quite damaging.
KEY TERMS
Fundamentals- Elements that determine stock prices that make long-term economic sense—profit expectations and
interest rates.
Initial Public Offering (IPO)- A company’s first sale of stock in the public in an attempt to raise money for
expansion.
Efficient market- All information is taken into account by participants in a market.
Stock index- A weighted average of stock prices in a particular group.
Bubble- The state of a market where the current price is far above its value determined by fundamentals.
Bankruptcy- A legal status entered into when a company or individual cannot pay its debt.
Creditors- The people or institutions to which a company or individual owes money.
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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.
DISCUSSION QUESTIONS
1. What determines stock values?
2. How can a stock market advance economic growth?
3. How does a stock market help new small companies?
4. If markets are “efficient” what happens when a company forecasts reduced profits?
5. How can a small investor with limited funds to invest participate in the stock market?
6. What is a bubble? How can bubbles cause a stock market to crash?
7. What are some of the reasons that the NASDAQ crashed?
8. What are the lessons from the NASDAQ crash?
9. Several major corporate bankruptcies took place in 2001-2002. Why are economists not very concerned about
such bankruptcies?
10. Why did the Enron case matter more to investors than the other cases? How did the government address these
issues?
11. What caused the stock market rebound of 2006-2007 and subsequent drop in 2008-2009?
The Stock Market and Crashes
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THE WEB-BASED QUESTIONS
Part I.
After the collapse of Enron Corporation and other major scandals that involved large companies, such as
WorldCom, Tyco and Global Crossing, the investor public was left shaken. The government responded by passing
the Corporate Responsibility Act of 2002, also known as the Sarbanes-Oxley Act.
What are some of the key provisions of this act?
Sources: www.rhoadssinon.com/updates-publications-142.html
Part III.
Some commentators consider the Sarbanes-Oxley act a success, and others feel that, because of the make-up of the
financial system, an Enron can occur again.
Can the Sarbanes-Oxley act prevent another Enron?
Sources: www.economist.com/business/displayStory.cfm?story_id=3984019
http://seattletimes.nwsource.com/html/businesstechnology/2002800032_corpfraud12.html
ANSWERS TO STUDY QUESTIONS
SUGGESTED ANSWERS TO THE DISCUSSION QUESTIONS
1. The value of a stock is usually judged on the present value of its expected dividend payments plus the present
value of its expected final sales price. Chapter 7 shows how the interest rate -- or the discount rate -- is the amount
by which future payments are discounted. When interest rates rise the present value of payments falls and vice
versa. Reduced profit expectations reduce dividend expectations and final sales price expectations. These, in turn,
will reduce the price of the stock. The reverse happens with improved profit expectations.
2. Stock markets help advance economic growth by transferring financial capital to investors who can make the best
use of that financial capital.
3. The stock market can help a small, new company through initial public offerings (IPOs), which enable the small
company to sell stock for the first time. The small, previously privately held firm that, prior to the IPO, only
borrowed or raised funds itself, now has access to an unlimited number of people or corporations who now invest
in the company. Additionally, as the stocks are re-issued, the market provides liquidity. IPOs only have value
when their owners know that they can sell them if they wish to turn their investments into cash.
4. A market is “efficient” if all information in the market is accounted for in the assets of that market. In the stock
market, professionals factor in new information in the market (e.g., on profits, risks, and interest rates) into the
price of the stock. Thus, when a company forecasts reduced profits, this market factors this information into the
price of the stock. The availability of information permits investors to invest with confidence.
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5. A small investor with limited funds to invest can participate in the stock market and maintain a diverse portfolio of
investment through index funds. These funds, which are managed by professionals, buy stocks in exact proportion
to their value in a commonly known stock index, such as the NASDAQ, Dow Jones Industrials, or Standard and
Poor’s. Since the stock index is a weighted average of stock prices in these groups it provides diversity to the small
investor.
6. A bubble is the state of a market in which the current price is far above its value that is determined by
fundamentals. The two fundamentals that go into the formula for the price of a stock are the flow of payments it
produces and the interest rate. If these change a lot, then the price of a stock will also “bubble.”
If the stock price falls abruptly and people think that it will be worth less next year, the value today is lessened,
causing a vicious cycle that spirals the value of the stock down. If this happens very fast, and to many stocks, the
market can crash.
7. The following are some of the reasons for the crash of the NASDAQ (National Association of Securities Dealers
Automated Quotations) in 2000:

The technology sector in general, was operating with staggering losses, while being touted as the “new
economy,” and making profits was considered “stagnant thinking.” Expectations were that these
companies would more than make up for losses with massive profits later. One explanation is that
interest rates rose, thereby reducing the present value of these stocks.

A second explanation is that diminished profit expectations had a big effect on reducing stock prices.

Stocks got out of line of their fundamental value fueled by a buying frenzy as people did not want to be
left out of the “next Microsoft” or the “next Intel”, and bought stocks without regard to the
fundamentals, creating a bubble. When the fundamentals were reexamined, the bubble burst.
8. The lessons of the NASDAQ crash are that stock prices cannot be judged on poor fundamentals. For example, new
companies cannot perform in the future if they are not making any profits. When a bubble is created, bubbles can
burst.
9. K-Mart went bankrupt because it could not compete effectively with WalMart and Target; and Global Crossing
borrowed billions to string fiber-optic cable under the oceans, connecting Europe, Asia and North America, and
could not repay its debt. Bankruptcies like these do not disturb economists because they hold that when companies
get out-competed, they should lose money, and if this keeps up for a long time, they should go out of business.
This does not seem to be the thinking of the press, bankers, and shareholders.
10. The Enron case matters to investors because Enron’s stockholders were simply lied to. Investors rely on
information to make decisions, and they take calculated risks based on that information. They seek to avoid
uncertainly over the truth of financial reports by requiring independent audits. When an independent auditor also
lies, there is additional uncertainty. This raises the required rate of return on stocks, and inhibits some profitable
business avenues.
Companies such as Xerox and WorldCom began to reveal their own “overstatements” of profits and investors
continued to lose confidence through 2002 and stock values dropped considerably. Congress and President Bush
addressed these issues in the Sarbanes-Oxley Act of 2002.
The Stock Market and Crashes
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SUGGESTED ANSWER TO THE WEB-BASED QUESTION
Part I.
President Bush signed into law the Sarbanes-Oxley Act of 2002 on July 30, 2002. It was the most significant
change to federal securities laws in the Unites States since the New Deal in the early 1920s. The law was designed
to restore public confidence in the capital markets of the United States after the accounting scandals that resulted in
the dissolution of major companies, such as Enron, WorldCom and Arthur Andersen.
Some of the main provisions of the act are:

Auditor independence.

Auditing standards, which include seven-year retention for audit work papers, and description of both
material weaknesses in internal controls and of material noncompliance.

Fines or imprisonment (up to 25 years) for any person defrauding shareholders of publicly-traded
companies.

White collar crime penalty enhancements.

Increased disclosure regarding executive compensation.

Protection of whistleblowers who provide information of violations of securities or antifraud laws in
their companies
Part II.
It is too early to tell whether the Sarbanes-Oxley act will prevent another Enron. Some of the reasons are:

The law addresses the symptoms of fraud more than the causes.

Perhaps the failures were not accounting regularities, as such, but other failures – kinds of corporategovernance failure.

Companies are under tremendous pressure to meet short-term financial goals, thereby making
accounting fraud a strong motive.

The environment remains rife with incentives for taking risks, business, as well as ethical that can lead to
fraudulent practices.

Once the Enron trial is over, regulatory budgets may be squeezed, thereby limiting government auditing
and regulation.
The post-Sarbanes-Oxley period is short: only two accounting years, 2003 and 2004. Time will tell whether the
act has had an impact on attitudes of corporate executives.