Equity Markets and Total Wealth

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Equity Markets and Total Wealth

• Chris Wise
• Conrad Culbertson
• Sam Ullrich
• Ryan Turner
• Richard Berry

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What are Equity Markets?

• A Market for the trading of company stock, also
  known as the Stock Market
• How companies gain capital?

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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.

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Total Wealth

• In general, total wealth is how much a persons
  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.

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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.

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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
• SP 500-The Standard and Poors ranking of the
  top 500 companies with regard to net worth

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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.

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Brief History of DJIA

• During the late 1800s, 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  companies have been replaced by thirty of the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.

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How to Compute the DJIA

• DJIA (1/d)SP
• Price-weighted average
• Supporters of the market valuation or market
  capitalization weighting average (NASDAQ and SP
  500) believe the Dow is flawed.
• Based on this data collection, the DJIA in recent
  years follows this trend.

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Dow Jones Industrial Average 1980-2006
Closing Price
Year
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Federal Funds Rate 2001-2007
Interest Rate
Year
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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.

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NASDAQ

• - The worlds 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

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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
•  

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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
•  
•  

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NASDAQ Percentage Change (Quarterly 2004-2006)
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SP 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 SP 500 is used largely as an indicator of
  the broader market
• includes both "growth" stocks and generally less
  volatile "value" stocks.

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SP 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 indexs of
  only 90 companies
• On March 4, 1957, a broad, real-time stock market
  index, the SP 500 was introduced

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SP 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).

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SP 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 SP have become.

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Historical Highs for SP 500
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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 rateconsidered a looser
  monetary policy

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Federal Reserve and Stock Market

• The FOMC sets monetary policy.
• Stock portfolios respond significantly to changes
  in monetary policy an easier monetary policy
  raises stock prices.
• Increase in Stocks will increase Wealth.

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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

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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.

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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

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Multiple Choice Questions

• The Wealth effect is the relationship between
  Stock Prices and what?
• Inflation
• Consumer Spending
• Business Spending
• None of the above

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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

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Multiple Choice Questions

• The SP 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.