Stock Market
Definition and Overview
A stock market (equity market/stock exchange) is a place where ownership of both shares and derivatives changes at an agreed price. Both these legal entities are listed on the stock exchanges and traded privately.
In October 2008, the total size of the global stock market was estimated at approximately $36.6 trillion while the total size of the global derivative market was estimated at $791 trillion (nominal /face value)-which was 11 times higher than global GDP.
As derivatives market is represented by nominal value, it cannot be directly compared with the stock or fixed income securities that are stated in actual values.
Furthermore, a large number of derivatives offset each other. A derivative ‘bet’ over a probability of event happening is equalized by derivative ‘bet’ on the event not likely happening. As a result, many such comparatively illiquid securities are valued as marked to model rather than an actual market price.
Stocks are listed and traded on exchanges which are owned by corporations and mutual organizations. These legal entities are specialized in the business of converging buyers and sellers of the organizations for listing stocks and securities.
In terms of market capitalization, the New York Stock Exchange (NYSE) is the largest among all exchanges in the United States. In Canada, the Toronto Stock Exchange is the largest. In South America, Brazil’s BM&F BOVESPA is one the largest stock exchanges in the world, in terms of market capitalization and trading volume. In Europe, major stock exchanges are: the London Stock Exchange, Amsterdam Stock Exchange, Frankfurt Stock Exchange (Deutsche Bourse), Paris Bourse.
In Asia, prominent exchange include: The Hong Kong Stocks Exchange, the Tokyo Exchange, the Shanghai Stock Exchange, the Bombay Stock Exchange, and the Singapore Stock Exchange.
A stock market includes many parties, also called as market participants. Retail investors, corporations that trade in public by floating shares and large institutional investors such as mutual funds, hedge funds, bank, and insurance companies, are together called as market participants. Empirical studies have shown corporations that trade their own shares and large institutions tend to receive higher risk adjusted return than retail investors.
The Trading in Stock Exchanges
Market participants: be it small investors or large institutional investors, can trade shares and other securities from anywhere. The orders are received by professionals working in stock exchanges, who also execute these buying and selling orders on behalf of their clients.
Stock exchanges can be characterized in two ways: floor trading and virtual trading. Floor trading is where exchanges offer physical locations to carry out transactions, by a technique called as open cry, while the second kind of trading is executed virtually electronically with the help of network of computers.
Stock exchanges and commodity exchanges that use floor trading method are based on auction market model where traders may receive “verbal” bids from potential buyers and asks from potential sellers at the same time.
When bid and ask prices match up, a sale takes place based on first-come-first-serve basis if multiple bidders and sellers are ready to trade at given price. Exchanges help providing instant trading information on the listed securities, making it easier for market participants to discover stocks price.
The New York Stock Exchange is a physical exchange, also called as listed exchange- which means that only those stocks that are listed can be traded with a hybrid market for placing orders both electronically and manually on the trading floor.
Once the trading order is received on the trading floor by exchange members, it is passed on to a floor broker who drops on to the floor trading post specialist for that stock to trade the order. The specialist’s work is to match buy and sell orders via open outcry. If a spread is seen, no trade is executed immediately —in such cases the specialist should make use of his/her own resources (money or stock) to close the difference after his/her judged time.
After a trade occurs, the descriptions are made on the “tape” and sent back to the brokerage firm, which then informs the investor who placed the order. Even though there is a considerable amount of human involvement involved in this process, computers play the most important part, particularly for so-called “program trading”- highly sophisticated computer models.
On the other hand, NYSE’s rival, NASDAQ is a virtual listed exchange, where all the process pertaining to trading is executed over a computer network.
Although the method is akin to the New York Stock Exchange, buyers and sellers are matched by electronically means in NASDAQ.
Accordingly, one or more than one NASDAQ market makers will always offer a bid and ask price at which they will always purchase or sell ‘their’ stock.
The Paris Bourse which is now a part of the Euronext is an order-driven, fully mechanized stock exchange. It turned into fully equipped electronic exchange in the late 1980s. Earlier before 1980s, trading was executed under open outcry exchange.
Stockbrokers used to meet on the trading floor or the “Palais Brongniart”. In 1986, the CATS trading system was launched, and the order matching process was fully programmed.
Once in a while, active trading (especially in large blocks of securities) looks for some other avenues other than the ‘active’ exchanges.
A data compiled by Boston-based Aite Group LLC, a brokerage-industry consultant shows that Securities firms, such as UBS AG, Goldman Sachs Group Inc. and Credit Suisse Group, already moved 12 percent of U.S. security trades away from the exchanges to their internal systems by 2008. That share was expected to climb at 18 percent by 2010 as more investment banks bypassed the NYSE and NASDAQ and bring buyers and sellers of securities themselves.
Thanks to computers and new “design systems”, the balance of power is shifting away from human interference. Computers have practically eliminated the requirement of trading floors like the big boards.
Amid rapid development in technology which has helped bringing more orders in-house, the cost of operations have also fallen down considerably as it enabled clients to move big blocks of stock anonymously.
Market Participants
Earlier (few decades back), globally, buyers and sellers used to be individual investors, such as rich businessmen, generally with big families having strong ties with particular corporations.
Gradually, market dynamics changed and it became more “institutionalized”; both buyers and sellers are largely institutions such as hedge funds, mutual funds, insurance companies, pension funds, index funds, exchange trade funds (ETFs), investor groups, banks and several other financial institutions.
With growth in institutional investing, some improvements have also been seen in market operations.
Over the course of the time, “fixed” and exorbitant fees have reduced for all investors- big institutions or retail investor- mainly due to reduction in administration costs. Besides, large institutions have also helped challenging brokers’ oligopolistic business approach, resulting into standardized fees.
Stock Markets: Earlier Period
Back in the 12th century France, the “courretiers de change” were responsible with handling and regulating the debts of agricultural communities on behalf of the banks.
Since, these men also dealt with debts, they could be also regarded as the first brokers. A common story goes that in late 13th century Bruges commodity traders assembled inside the house of a man called Van der Beurze, and in 1309 they turned into the “Brugse Beurse”, institutionalizing the meeting, which earlier used to be an informal meetings.
However, the actual fact was the family Van der Beurze had a building in Antwerp where those gatherings occurred;the Van der Beurze had Antwerp, as most of the merchants of that period, as their main place for trading.
The idea rapidly reached around Flanders and some other neighboring counties and “Beurzen” soon started in Ghent and Amsterdam
Then, In the middle of the 13th century, Venetian bankers started to trade in government securities. In 1351 the Venetian government banned dispersing rumors, meant for lowering the price of government funds.
Subsequently in the 14th century, bankers in Pisa, Verona, Genoa and Florence also started trading in government securities. Trading was only possible because these were autonomous city states not ruled by a duke but a committee of influential citizens.
The first ever shares introduced by Italian companies. Later in the 16th century, companies in England and the Low Countries also started issuing shares.
The Dutch East India Company, established in 1602, was the first joint-stock company to get a fixed capital stock and Amsterdam Exchange started to operate due to continuous trade in company stock. Soon after that, an active trading in various derivatives emerged even as options and repos started trading on the Amsterdam market. Dutch traders also pioneered in short selling – a practice which was prohibited by the Dutch authorities as early as 1610.
Stock markets are practically everywhere. Both developed and developing markets have seen rapid rise in investments through exchanges over the years.
Some of the world’s largest stock markets are in the United States, United Kingdom, Japan, Germany, France, China, Brazil, India, South Korea, and Netherlands.
Why stock Market matters?
Stock market not only helps companies to tap money from the public but it also increases the liquidity in the system.
Liquidity provided by exchanges enables investors to quickly and easily sell securities. This is why; investing in stocks is more popular than other investment vehicles like real estate- which is highly illiquid. Some companies also actively trade in their own shares to increase the liquidity.
Besides, history has also shown that the price of shares and other assets is an imperative part of the dynamics of economic activity, and can influence or be an accurate gauge of social mood.
An economy where the stock market is climbing up consistently is considered to be a potentially strong and growing economy.
Soaring share prices, for example, is likely to be linked with increased business investment and vice versa.
Furthermore, share prices also have an effect on the wealth of households and their consumption. Therefore, central banks tend to keep an eye on the control and conduct of the stock market and, in general, on the smooth operation of financial system functions. Financial stability is the underlying principle of central banks.
Exchanges also provide services like a clearinghouse for each transaction, which is collecting and delivering the shares, and guaranteeing payment to the seller of a security.
This system negates the risk faced by an individual buyer or seller that the other party could fail on payments related to the transaction.
The smooth implementation of all stock market activities enable economy to grow faster as lower operational costs and risks management promote the production of goods and services in additional to creating employment. Moreover, once listed, companies also tend to run more professionally, as any mismanagement would hit its price of the stock.
A highly developed financial market tends to increase the prosperity of a country.
Stock Market and Modern Financial System
Over the course of the time, the financial system in western economies has seen considerable transformation. One of the features behind this expansion is disintermediation. A large part of funds from saving and financing, is channeled directly towards the financial markets instead of flowing towards the traditional bank lending and deposit operations.
The increasing public interest in investing in the stock market, either directly or through mutual funds has been a significant factor of this process.
According to Statistics, shares’ proportion in household’s total financial assets has risen significantly in past few decades around the world. Take for instance: Sweden in the 1970s, had bank deposits and other low risk assets made up 60% of the total household’s wealth, while in 2000’s this share dropped as low as 20%.
The major reason behind this is that large part of public savings and funds are channeled towards shares; however, investments have also risen in many other investing instruments like ETFs, mutual funds, hedge funds.
Stock Market Movements
Past experiences have shown that investors’ risk taking appetite, speculation and greed may momentarily move financial prices away from their long term cumulative price ‘trends’. (In stock market jargon, positive or up trends are termed to as bull markets while negative or down trends are termed to as bear markets.
Over-reactions over economic reports, central banks’ monetary policies, corporate results, and specific sector’s upturn could easily lead to excessive optimism, driving prices excessively high. Similarly, excessive pessimism may pull down prices to a level which is unjustifiably low. For this very reason, economists continue to argue whether financial markets are in general, “efficient”.
One of the interpretations of efficient-market hypothesis (EMH) is that only changes in fundamental factors, such as long term and short look on the margins, profits or dividends, are likely to affect share prices.
Nevertheless, this heavy theoretic academic point of view—also known as ‘hard’ EMH—also predicts that slight or no trading should happen, since prices are at or near equilibrium, having priced in all public knowledge.
The ‘hard’ efficient-market hypothesis proved completely wrong by events such as the stock market crash in 1987- a time when the Dow Jones index plunged 22.6 percent—the biggest-ever one-day slide in the United States.
This event confirmed that share prices can fall considerably. Even to this day, it is impossible to come over a conclusion behind the cause that resulted in crash generally. A detailed search failed to spot any ‘reasonable’ development that might have accounted for the crash.
Nevertheless, a ‘soft’ EMH has emerged which does not necessitate that prices remain at or near equilibrium, but only that market participants not be able to analytically profit from any temporary market ‘inefficiencies
Moreover, while EMH says that all price movement in the absence of change in fundamental information is arbitrary i.e., non-trending, many studies have shown a noticeable inclination for the stock market to trend over time periods of weeks or longer.
Different explanations for such large and in fact non-random price movements have been propagated. For example, few researches have shown that changes in expected risk and the use of specific strategies, such as stop-loss limits and Value at Risk limits, in theory could cause financial markets to react abnormally. But the best justification seems to be that the distribution of stock market prices is “non-Gaussian” (in which case EMH, in any of its present forms, would not be relevant).
Further research has revealed that “psychological factors” may cause lots of exaggeration in stock price movements (opposing to EMH which presume such behaviors ‘cancel out’). Psychological research has confirmed that people are inclined to ‘seeing’ trends, and often will distinguish a pattern in what is, in fact, just “noise”.
In the present situation this means that a sequence of good news items about a company may lead investors to overreact, unjustifiably driving up the price. A series of good returns also perk up the investor’s self-confidence, shrinking his/her psychological) risk threshold.
Another observable fact—related to human psychology—that works against an objective judgment is group thinking. Humans being social animals, it is not easy to form an opinion that differs specifically from that of a majority of the group.
For example, consider this: we are reluctant to enter a restaurant that is empty; people in general favor to have their judgment validated by those of others in the group.
In one research finding, authors show a similarity with gambling. In normal times the market behaves like a game of roulette; the probabilities are known and largely independent of the investment decisions of the different players.
In times of market anxiety, though, the game alters to more like poker where herding behavior takes over. The players now must give more emphasis to the psychology of other investors and how they are likely to react psychologically.
The stock market, just like any other business, is quite ruthless for amateurs. Inexperienced investors hardly ever get the help and support they want.
Before the stock market crash of 1987, less than 1 percent of the analyst’s advice had been to sell and even during the 2000–2002 bear market, the average did not rise above 5 %.
Amid dotcom bubble of late 1990s and 2000, the media gave boost to the euphoria surrounding the market, with reports of quickly rising share prices and the idea that large sums of money could be quickly earned in the so-called “new economy” stock market.
However, when the dotcom bubble went burst, the media now augmented the gloominess which was the reason behind the 2000–2002 bear market. During the summer of 2002, predictions of a DOW average below 5000 level were very common.
Human’s irrational Behavior
Sometimes, the market tends to react unreasonably to economic or financial news, even if that news is likely to have no actual effect on the fundamental value of securities itself.
The stock market can fluctuate wildly in either direction due to press release rumors, excitement and mass panic; but normally it exists for a brief time with more experienced investors, especially the hedge funds quickly try to take advantage of even the slightest, temporary hysteria.
Over the short-term, stocks and other securities can fall sharply or buoyed by any number of fast market-changing events, making the stock market behavior difficult to predict.
Human emotions can move prices up and down, people are usually not as rational as they think, and the reasons for buying and selling are in general, unclear. Behaviorists say that investors often act ‘irrationally’ when making investment decisions thereby inaccurately pricing securities, which causes market inefficiencies, which, in turn, are opportunities to make money. Nevertheless, the whole idea of EMH is that these non-rational reactions to information cancel out, leaving the prices of stocks reasonably determined.
The Dow Jones Industrial Average biggest gain in one day was 936.42 points or 11 percent, this occurred on October 13, 2008.
World’s Stock Market Crashes
A stock market crash is often described as a sharp plunge in share prices of equities listed on the stock exchanges. Not only economic events, stock market crashes are also caused due to fear and investing public’s loss of confidence. Very often, stock market crashes end speculative economic bubbles.
The history of stock market has seen many stock market crashes where investors have lost billions of dollars. The history of stock market has been filled with great bull runs; where people have made fortunes but it has also witnessed severe bear runs where even the most experienced investors have lost huge amount of money. Even though with the passage of time, the functioning of stock market has become highly regulated; unprincipled traders, bankers, brokers always find some loopholes in the financial system which may cause systemic financial market failures.
With passage of time, more and more people are involved in the stock market, especially since the social security and retirement plans are being increasingly privatized and linked to stocks and bonds and other elements of the market.
Some of the most famous stock market crashes include: the Wall Street Crash of 1929, the stock market crash of 1973–4, the Black Monday of 1987, the Dot-com bubble of 2000, and the Stock Market Crash of 2008.
One of the biggest market meltdown started in October 24, 1929 on a “Black Thursday”. The Dow Jones Industrial was hammered by during this stock market crash.
The plunge was the beginning of the Great Depression. History’s biggest economic depression saw a massive erosion of stock market wealth. Between the period of September 1929 and October 1929 the US stock market saw a whopping 40% of the market capitalization being destroyed. And at the end of June 1932 when the stock market bottomed out 90% of the market capitalization was wiped out.
Cause:
During this period, industrialization was at its peak in America and people were experiencing luxuries which were not seen before in American history. The victory in the First World War made American feel that now investing in stock market is guaranteed way to become rich.
Back then, people thought that stock market is a riskless medium to make fortunes. Investors did not apply any logic or brains behind stock market strong rally. People flooded the stock market with their savings without challenging or verifying the system or the promise of the underlying companies. As investors were not educated, unprincipled traders, bankers, brokers, and sometimes even companies’ executives manipulated the stock market together to fool investors. They used to buy large chunks of stocks and then sell those stocks among each other at higher price tempting investors to buy those stocks. This kind of stock market manipulation resulted in huge profits for all these people. The unabated cycle of manipulation went on and one where layman kept on buying overpriced stocks without looking at the rationale behind this stock market rally. Perhaps, this could also be result of “herd mentality”. As we have already learned under behavioral finance, people sometimes react irrationally. The “herd mentality” prompts humans to join the bandwagon without challenging the rationale thinking that if he/she do not join then they will miss out the opportunity.
Another massive stock market crash took place on October 19, 1987 – Black Monday. It first started in Hong Kong and quickly the bearish sentiment spread throughout the world.
By the end of the October, stock markets in Hong Kong saw 45.5 % of their market capitalization wiped out, Australia’s markets plunged 41.8 %%, Spain shrank 31 %%, the United Kingdom lost 26.4 %%, the United States sank 22.68 %%, and Canada fell 22.5 %%.
In stock market history, the Black Monday saw the biggest percentage decline in one day. The Dow Jones dropped 22.6 %% in a day. The names “Black Monday” and “Black Tuesday” are also referred for October 28–29, 1929, which trail Terrible Thursday—the first day of the stock market crash in 1929.
The crash in 1987 threw up some questions. Main news and events did not forecast the catastrophe and discernible reasons for the fall down were not identified. This incident threw up questions about many significant assumptions of modern economics, namely, the theory of rational human conduct the theory of market equilibrium and the hypothesis of market efficiency.
For some period after the crash, trading in stock exchanges globally was stopped, since the exchange computers could work properly due to enormous quantity of trades being received at one time.
The stoppage in trading allowed the Federal Reserve system and central banks of other countries to take corrective measures to control the spreading of worldwide financial crisis. In the United States the SEC introduced quite a few new measures of control into the stock market in an effort to avert a re-occurrence of the events of Black Monday.
Post early 1990’s, many of the major exchanges have employed electronic ‘matching engines’ to bring together buyers and sellers, substituting for open outcry system. In developed markets, electronic trading now accounts majority of trading.
Computer systems were improved, overall infrastructure was enhanced in the stock exchanges to handle larger trading volumes in a more precise and controlled manner.
The SEC changed the margin requirements in an effort to reduce the amount of volatility of common stocks, stock options and the futures market.
The New York Stock Exchange and the Chicago Mercantile Exchange started the concept of a “circuit breaker”. The circuit breaker will stop trading if the Dow plunges a stipulated number of points for a stipulated amount of time. Early in February 2012, the Investment Industry Regulatory Organization of Canada (IIROC) set up single-stock circuit breakers.
Stock Market Index
The swings in the prices of stocks are captured in price indices called stock market indices. Some of the indices are S&P 500, FTSE, The Euronext, The Hang Seng.
All these indices usually show the weighted market capitalization, with the weights indicating the contribution of the stock to the index. The components of the index are reviewed often to include or exclude stocks in order to indicate the changing business environment.
Derivatives
Financial innovation has resulted in the invention of many new financial instruments whose price relies on the prices of stocks. Example: exchange-traded funds (ETFs), stock index and stock options equity swaps single-stock futures and stock index futures.
Stock futures and Stock index futures may be traded on futures exchanges which are different from stock exchanges—their history goes back to commodities futures exchanges, or traded over-the-counter.
As all of these investing instruments are only derivative from stocks, they are sometimes said to be traded in a (hypothetical) derivatives market, rather than the (hypothetical) stock market.
Leveraged Strategies
Stock that a trader does not really own may be traded using short selling; margin buying may be used to buy stock with borrowed funds; or, derivatives may be used to manage large blocks of stocks for a much smaller amount of money than would be required by outright purchase or sales.
Short Selling
In short selling technique, the trader borrows stock generally from his brokerage which holds its clients’ shares or its own shares on account to lend to short sellers then sells it on the market, expecting for the price to fall. The trader ultimately buys back the stock, making money if the price drops in the period in-between and losing money if it rose.
Leaving a short position through buying back the stock is called “covering a short position.” This strategy may also be employed by unprincipled traders in illiquid or thinly traded markets to falsely lower the price of a stock. Hence most markets either put a complete ban on short selling or put restrictions on when and how a short sale can occur. The practice of naked shorting is illegitimate in most, although not all stock exchanges.
Margin Buying
In margin buying, the trader borrows money at an interest, to buy a stock and hopes for it to increase. Most developed countries have set of laws that need the borrowing is based on collateral from other stocks the trader owns outright; it can be a maximum of a specific percentage of those other stocks’ value. In the United States, the margin requirements stands at 50 % for many years, that is, if an investor wants put in $1000 as investment, he or she will need to put up $500, and there is often a maintenance margin below the $500.
A margin call is given if the total value of the investor’s account cannot hold the loss of the trade. (Upon a fall in the value of the margined securities additional funds may be needed to maintain the account’s equity, and with or without notice the margined security or any others within the account may be sold by the brokerage to guard its loan position. The investor is accountable for any shortfall following such forced sales.)
Regulation of margin requirements by the Federal Reserve was employed after the Crash of 1929. Before that, speculators usually required to put up as little as 10 percent (or even less) of the total investment represent by the stocks purchased. Other rules may consist of the prohibition of free-riding: placing in an order to buy stocks without paying at the start (there is generally a three-day grace period for delivery of the stock), but then selling them (before the three-days are up) and using part of the proceeds to make the original payment (assuming that the value of the stocks has not declined in the interim).
Investment Strategies and Taxation
Investors are always edgy on stock market investing. People always have a one question in their mind which is, “How do I make money investing?”
There are many different approaches; but two basic methods are distinguished by either fundamental analysis or technical analysis. In Fundamental analysis, investors try analyzing companies by their financial statements as shown by in SEC Filings, business trends, general economic conditions, etc. Technical analysis is looking at price actions in markets through the use of charts and quantitative techniques. Experts try to forecast possible price movements regardless of the company’s financial prospects.
John W. Henry and Ed Seykota, employed technical strategy known as the Trend Following which uses price patterns, utilizes strict money management and is also rooted in risk control and diversification.
Moreover, many opt to invest via the index method. In this method, investor holds a weighted or un-weighted portfolio consisting of the entire stock market or some segment of the stock market (such as the S&P 500 or Wilshire 5000. The principal objective of this strategy is to take full advantage of diversification, minimize taxes from too frequent trading, and move with the general “tide” (trend) of the stock market. Since the Second World War, the U.S., has averaged nearly 10 % per year, compounded annually.
Taxation
In most state and national legislations, a large collection of fiscal obligations are taxed for capital gains. Taxes are levied by the state over the transactions, dividends and capital gains on the stock market, especially in the stock exchanges. However, these fiscal compulsions may alter from jurisdictions to jurisdictions because, among other reasons, it could be assumed that taxation is already included into the stock price through the different taxes companies pay to the state, or that tax free stock market operations are useful to boost economic growth
Stock Market and Returns
We all like to make money in the stock markets; but not all investors are always successful. Investing in stock market needs sound financial market knowledge, business acumen, and analytical skills, lots of patience and of course luck. Our aim is always to build a portfolio that can beat the market rate of returns. And if we are lucky and knowledgeable we can do that but most of the times investors are always in search of that magic combination of portfolio which can deliver more than average market return. Historically, average market return has been solid 12%. But markets have also seen some great investors like Warren Buffet, Bill Gross, and Philip Fisher beating this rate of return and earned more-consistently. These great investors always outperformed stock market through their innovative and new ways to analyze investments potential.