The Stock Market
I. Introduction
The stock market of a country can be divided into two large interrelated markets:
(1) the primary market, where newly issued shares are sold; and (2) the secondary
market, where outstanding shares are traded
In the primary market, a company needing funds can sell newly issued shares by
using an underwriter (usually a large brokerage firm). The primary market is a global
market; since newly issued shares can be sold anywhere the underwriter has a branch
office. The underwriter performs an important middleman service; since the issuing
company would generally not be able to sell its shares over such a large geographic
area. If the company is issuing a large amount of shares, then it may want to use a
large number of different security firms to underwrite these securities. Information
regarding the issuance will be contained in a prospectus, which can be obtained from
the underwriters.
Newly issued stock generally has a par or face value. However, when sold in the
primary market, it will have a price determined by supply and demand. Therefore,
except for some accounting relations, the par value is not of great importance. The
stock that is issued can be either common stock or preferred stock. Common stock
gives the owner voting rights in the stockholder meetings; however, it does not have a
fixed dividend like preferred stock. Moreover, preferred stock dividends must be paid
first before any common stock dividends can be paid.
The importance of corporate stock is that it carries limited liability. If the
company amasses debts, the personal assets of the stockholders cannot be taken to pay
these debts. The stockholder is liable only for the money he or she has invested in the
stock.
After the stock has been issued and bought by investors, it becomes stock
outstanding. If the company buys back some of its stock previously issued, then the
stock outstanding will decrease. However, the total number of shares issued will not
decrease. Shares repurchased in a stock buyback plan are called treasury stock. The
number of shares outstanding is very important in calculating certain financial ratios
(e.g., the P/E ratio).
Outstanding shares in corporations are often traded in organized secondary
markets. Such companies are what we call listed corporations. The secondary
markets mainly consist of various stock exchanges and the over-the-counter (OTC)
market. Listings on stock exchanges or the OTC are very important because they
increase the liquidity of the stock. Very few people would be willing to purchase
stock if they thought they could not sell it when necessary. Liquidity is a measure of
how quickly an asset can be sold for cash without a large reduction in its price. A
strong secondary market raises the liquidity of the stock and thus its value to
investors.
The largest and most famous secondary market for stock is the New York Stock
Exchange (NYSE). Secondary markets in stock have been going through substantial
consolidation over the last 10 years. In 2007 the NYSE was merged with the
electronic stock exchange Euronext, which is based in Amsterdam. In 2012 it was
announced that the NYSE Euronext would be merged with Intercontinental Exchange
a futures exchange located in Atlanta. To date, the merger is waiting on European
regulators to give the green light. The transaction will make the ICE-NYSE the third
largest exchange in the world, behind Hong Kong Exchanges and Clearing, and the
CME Group. Foreign companies can also sometimes obtain listings on these
exchanges. The American Stock Exchange was purchased by NYSE Euronext in
2008. Many regional stock exchanges in the US were purchased by the NYSE
Euronext or NASDAQ. NASDAQ stands for the National Association of Securities
Dealers and Automated Quotations. It is the largest over the counter market for stock
in the world. NASDAQ is controlled by NASDAQ OMX Group, which owns the
OMX stock exchange.
II. Important Concepts Regarding Stock
The starting point for understanding investment in stock is the stock-bond arbitrage
relation. This can be written as
Pt e1  Pt Dte1

 r    Nt
Pt
Pt
where Pt  the current stock price, Pt e1  next period’s expected stock price, Dte1 
expected dividends that will be paid in the next period, r  the interest rate on
government bonds,   a risk premium for holding risky stocks rather than less risky
government bonds, and N t  time period t news-shock specifically and positively
related to the stock (but not to its expected future dividends) and/or unrelated or
negatively related to the bond market. This last variable is very complex but is
generally treated as having a zero expected value and therefore is often ignored in
fundamental analysis. The equation above shows that stocks and bonds provide the
same risk-adjusted yields if there is equilibrium between the two markets.
Note however that a rise in N t will immediately raise the current price, Pt , and may
affect the expected price, Pt e1 . An important assumption is that this shock will have a
stronger effect on Pt than on Pt e1 . This says that N t will jump wildly up and down for
many different reasons and that the stock price will move along a path determined by
the interest rate, the risk premium, and the growth of dividends or profits. Note also
that a rise in r or  will cause an immediate fall in Pt . An increase in Dte1 will raise
the current price Pt . Many people try to guess the movements in N t but there are
strong reasons to believe that such news cannot be predicted. Naturally, if one knew
about N t at time (t-1) then one could make money. This is what is meant by inside
information.
III. Balance Sheets and Income Statements
To clearly understand the financial condition of a corporation, one needs to study
both the balance sheets and income statements of the company.
An annual balance sheet lists the assets, liabilities and owners' equity of a
corporation. By definition, owners' equity is equal to all assets minus all liabilities.
The basic assets of a company include such things as cash, accounts receivable,
inventory, and plant and equipment. These assets are used to produce revenue for the
company. Total liabilities consist of mainly bank loans, accounts payable, and
corporate bonds outstanding. Each of these will require future payments of money by
the company. Owners' equity (or net worth) is composed of stock outstanding and
retained earnings. It is important to note that the balance sheet shows the above
information for one point in time, usually the last day of the year.
By contrast, the quarterly income statement shows the revenues and expenditures
made by the corporation during the past three months, usually compared with the
same period in the previous year. The income statement gives a concise picture of
how profits were made, income taxes were paid, and typically shows the earnings per
share of common stock. Often it is important to understand how net earnings were
made and not just how large they were.
Careful analysis of the balance sheets and income statements can help one
determine such things as whether a stock is currently undervalued, whether it may
become the target of a hostile takeover, or even whether current earnings have been
manipulated through clever accounting tricks.
IV. Stock Indexes and Selling Short
The NYSE has thousands of listed stocks, so it can often be difficult to judge the
overall direction of the market. To judge general movements in the market, we must
rely on a stock index. The most popular indexes are the three Dow Jones indexes: one
each for industrials, transportation companies, and utilities. There is also a very broad
based index called the NYSE Composite Index which considers the whole market. In
addition, there is the S&P 500 index which covers the top 500 corporations. The
NASDAQ index gives an average of a particular set of stocks trading OTC.
Over a period of a year, the stock index will be affected by the health of the
economy. Over shorter periods of time, there are many factors which affect the index,
such as changes in interest rates, money supply, earnings reports, trade and budget
deficits, and important political developments.
When the index rises steadily, we call it a bull market. By contrast, when most
stockholders and investors want to sell their stock, we call it a bear market. 1
Sometimes, the market will rise too far and then suddenly drop. This is called a
market correction since the index was unrealistically high. We often say that the
market fell because of profit-taking.
Sometimes an investor feels that the market is going lower. He may choose to
short a particular stock. Selling stock short means that the investor borrows stock
from a broker and sells it now, with the intention of buying the same stock back at a
lower price. The investor must maintain a margin account with the broker. If the
stock the investor is shorting rises in price, he is required to increase the deposit in his
margin account. Shorting stock creates a risk of unlimited losses for the investor,
since the stock he is shorting can theoretically experience an unlimited rise in price.
Short sellers can limit this risk by hedging with call options, which we will discuss
later.
1
As Investopedia puts it “a market condition in which the prices of securities are falling, and
widespread pessimism causes the negative sentiment to be self-sustaining. As investors anticipate losses
in a bear market and selling continues, pessimism only grows. Although figures can vary, for many, a
downturn of 20% or more in multiple broad market indexes, such as the Dow Jones Industrial Average
(DJIA) or Standard & Poor's 500 Index (S&P 500), over at least a two-month period, is considered an
entry into a bear market. “http://www.investopedia.com/terms/b/bearmarket.asp
Discussion Questions:
#1. What is the difference between the primary and secondary market for stock?
#2. Who are underwriters and why are they important?
#3. What is meant by limited liability?
#4. What is the definition of liquidity?
#5. What is the difference between common and preferred stock?
#6. What factors are considered important in determining a stock’s price?
#7. What are balance sheets and income statements?
#8. What are some US stock indexes?
#9. What is meant by bull and bear markets?
#10. What does it mean to sell stock short?