Equity Markets and Total Wealth

Chris WiseConrad Culbertson

Sam UllrichRyan Turner

Richard Berry

What are Equity Markets?

A Market for the trading of company stock, also known as the Stock Market

How companies gain capital?

How markets can be affected by Interest Rates

Increasing the interest rates hurts the equity markets.

Investors have less disposable income to invest.

Companies would have less money to seek growth opportunities.

Both leading to a market slow down.

Total Wealth

In general, total wealth is how much a person’s assets are worth. Houses, stocks, baseball cards, anything you own counts toward your total wealth

An increase in your belongings leads to an increase in your total wealth.

Wealth Effect

Relationship between rising stock prices and higher consumer spending.

Economists’ main concern with the wealth effect is that as the value of stocks increase people will become in a sense too rich, causing higher spending, which in turn would put upward pressure on productive capacity and cause inflation.

The Big 3

Dow-Jones Industrial Average (DOW)- measure the industrial output of the United States

NASDAQ- mostly comprised of newer tech and service companies

S&P 500-The Standard and Poor’s ranking of the top 500 companies with regard to net worth

Dow Jones Industrial Average

Also known as the Dow, Dow Jones, and the Dow 30.

Charles Dow created the index in order to measure the performance of the thirty largest industrial companies in the American stock market.

DJIA Sector Weights

25%

14%

16%

14%

9%

8%

8%3% 3%

Industrials

Consumer Cyclicals

Consumer Non-Cyclicals

Technology

Health Care

Basic Materials

Financials

Telecom

Energy

Brief History of DJIA

During the late 1800’s, investors on Wall Street found it difficult to determine whether stocks were generally rising, falling, or remaining the same.

Charles Dow developed his average to put an end to the confusion and encourage people to invest in stocks, which were not as appealing as bonds at the time.

Since May of 1896 when the industrial average was created, the original railroad and utilities companies have been replaced by thirty of the most well-know and established companies of our time.

Examples include: Boeing Co., McDonalds, Disney (Walt), Exxon Mobil, and Microsoft.

How to Compute the DJIA

DJIA= (1/d)ΣP Price-weighted average Supporters of the market valuation or market

capitalization weighting average (NASDAQ and S&P 500) believe the Dow is flawed.

Based on this data collection, the DJIA in recent years follows this trend….

Dow Jones Industrial Average 1980-2006

Clo

sing

Pric

e

Year

Federal Funds Rate 2001-2007

Year

Inte

rest

Rat

e

Comparing the DJIA with the Federal Funds Rate

DJIA has been volatile and increased exponentially for the past twenty years.

DJIA has recently climbed up to an all-time high on January 11th, 2007 with a closing price of 12,514.98.

The federal funds rate drops at about the same time as the DJIA during the September 11th attacks, however instead of recovering in between the Iraq war, the federal funds rate continues to decrease and stay near or below 1%.

Consider how increasingly high the DJIA has been in the past year compared to the stable federal funds rate of 5.25% the Federal Reserve has maintained since June of 2006.

Some positive correlation.

NASDAQ

- The world’s 1st electronic stock market

- NASDAQ began trading on Feb. 8, 1971- Comprised of more than 3,200 companies- Trades more shares per day than any other

U.S. stock market

NASDAQ

 - Played a large role in lowering the spread

*Spread= difference between the bid price of the stock and the total price paid for the stock

- Made NASDAQ unpopular with brokerages

 

Business Investment

- Goldman, Sachs & Co. looked at the correlation between B.I. and the stock market

- Concluded that a rise in the stock market will lower the cost of equity capital for companies

- This in turns causes the companies to increase their business investment

- From 1995-1998 the real cost of declined 24%

- Consequently this decrease led to a 12% increase in business investment

  

NASDAQ Percentage Change (Quarterly 2004-2006)

S&P 500

Includes the stock indexes of the 500 major companies traded on the New York Stock Exchange(NYSE)

The most widely watched index of large-cap US stocks

The S&P 500 is used largely as an indicator of the broader market

– includes both "growth" stocks and generally less volatile "value" stocks.

S&P 500 Breakdown

4%

11%

10%

10%

21%

12%

11%

14%

4% 3%

Utilities

Cons Disc

Cons Staples

Energy

Financials

Healh Care

Industrials

Info Tech

Telecom Svc

Materials

S&P 500 History

Used as a “Benchmark” when comparing to all stocks

The Dow was used previously, but its lack of depth eliminated it as a Benchmark

Created in 1923 and only consisted the index’s of only 90 companies

On March 4, 1957, a broad, real-time stock market index, the S&P 500 was introduced

S&P 500 History Cont.

Standard & Poor's introduced to the financial world a new methodology for evaluating stock performance called the "base-weighted" aggregative technique.

This was possible thanks to advances in computers, which could now calculate and publicize the index in real-time (one-minute intervals).

S&P 500 History Cont.

• Uses a market capitalization weighted average price to earnings ratio

• Stocks are traded at a multiple of 55

It is hard to describe how crazy these current valuation levels in the S&P have become.

S&P 500 Quarterly Closings

11441133

1114

1211

11801191

12281248

1294

1270

1335

1418

1000

1050

1100

1150

1200

1250

1300

1350

1400

1450

2004

I

   20

04 II

   20

04 III

   20

04 IV

   20

05 I

   20

05 II

   20

05 III

   20

05 IV

   20

06 I

   20

06 II

   20

06 III

   20

06 IV

Year

Ind

ex a

t C

lose

Series1

Personal Consumption Expenditures

7,000,000

7,500,000

8,000,000

8,500,000

9,000,000

9,500,000

10,000,000

2004

I

   20

04 II

   20

04 III

   20

04 IV

   20

05 I

   20

05 II

   20

05 III

   20

05 IV

   20

06 I

   20

06 II

   20

06 III

   20

06 IV

Year

Dollars

(In

Million

s)

2004 I

   2004 II

   2004 III

   2004 IV

   2005 I

   2005 II

   2005 III

   2005 IV

   2006 I

   2006 II

   2006 III

   2006 IV

Percent Change in Personal Consumption Expenditures

4.7

2.9

3.9

4.3

2.7

4.2

3.9

0.8

4.8

2.62.8

4.2

0

1

2

3

4

5

6

2004

I

   20

04 II

   20

04 III

   20

04 IV

   20

05 I

   20

05 II

   20

05 III

   20

05 IV

   20

06 I

   20

06 II

   20

06 III

   20

06 IV

Year

Perc

en

t C

han

ge

Series1

S&P 500 Quarterly Percentage Change

3.25

-0.96

-1.6

8.7

-2.6

0.9

3.1

1.6

3.7

-1.8

5.1

6.2

-4

-2

0

2

4

6

8

10

2004

I

   20

04 II

   20

04 III

   20

04 IV

   20

05 I

   20

05 II

   20

05 III

   20

05 IV

   20

06 I

   20

06 II

   20

06 III

   20

06 IV

Year

Perc

en

t C

han

ge

Series1

Historical Highs for S&P 500

Milestones Closing Level Date 100 100.38 June 4,1968 200 201.41 November 21, 1985 300 301.16 March 23, 1987 400 404.84 December 26, 1991 500 500.97 March 24, 1995 600 600.07 November 17, 1995 700 700.66 October 11, 1996 800 802.77 February 12, 1997 900 904.03 July 2, 1997 1000 1,001.27 February 2, 1998 1100 1,105.65 March 24, 1998 1200 1,202.84 December 21, 1998 1300 1,307.26 March 15, 1999 1400 1,403.28 July 9, 1999 1500 1500.64 March 22, 2006

Monetary Policy

The FOMC implements its decisions about monetary policy by changing its target for a particular federal funds rate

The higher the targeted rated=> the tighter the monetary policy will be creating a higher federal funds rate

A lower targeted rate=>considered a looser monetary policy

Federal Reserve and Stock Market

1. The FOMC sets monetary policy.

2. Stock portfolios respond significantly to changes in monetary policy=> an easier monetary policy raises stock prices.

3. Increase in Stocks will increase Wealth.

Wealth and Consumer Spending

Easier monetary policy, for example, raises stock prices. Higher stock prices increase the wealth of households,

prompting consumers to spend more--a result known as the wealth effect.

Moreover, high stock prices effectively reduce the cost of capital for firms, stimulating increased capital investment.

Increases in both types of spending--consumer spending and business spending--tend to stimulate the economy

Policy Recommendation

Even though interest rates do not directly affect the equity markets, there is enough indirect correlation for us to recommend to decrease the federal funds rate.

Why? If companies and consumers are spending less or making less profit then the future cash flows of the companies will decrease lower stock prices.

Multiple Choice Questions

The Dow Jones Industrial Average is computed using a formula based on:

A. Market Capitalization

B. Stock Prices

C. Both A and B

D. None of the above

Multiple Choice Questions

The Wealth effect is the relationship between Stock Prices and what?

A) Inflation

B) Consumer Spending

C) Business Spending

D) None of the above

Multiple Choice Questions

The Goldman, Sachs & Co. concluded that higher stock prices have _______ with business investments:

A. a Negative Relationship

B. a Positive Relationship

C. No Relationship

Multiple Choice Questions

The S&P 500 is used largely as an indicator of the broader market, asit includes _____:

A. Bubble Stocks B. "growth" stocks C. less volatile "value" stocks D. Both A. and C. E. Both B. and C.