Stock market explained

The stock market is a place where traders buy and sell shares, government bonds and other assets. The stock market shows the price of shares and facilitates companies to raise revenue from issuing shares. Investors buy shares for both dividends and the prospect of capital gains. the US stock exchange based in NY (NYSE) has a market value of US $30.1 trillion as of February 2018.

How the stock market affects the global economy

Movements in share prices can have an impact on the global economy. Most famously the Wall Street Crash of 1929 was an important factor in precipitating bank closures and the great depression of the 1930s. Whilst this was the most dramatic example, movements in share prices can have an influence over the rest of the economy.

If the economy goes into recession or if there is a period of financial uncertainty then stock markets will generally fall reflecting the negative economic news.

In turn, a falling stock market can impact the economy in a negative way.

Falling share prices will:

  • Reduce consumer wealth for those who own shares. Therefore, they may spend less, leading to lower economic growth
  • Reduce the value of pension funds and reduce private pension income (if it is a prolonged fall in share prices) another factor that could cut consumer spending
  • Falling share prices make it more difficult for companies to raise finance on the stock markets, leading to lower private sector investment.
  • Falling share prices tend to reduce consumer confidence.

However in evaluation

  • Not everyone owns shares.
  • People who own shares tend to be rich and can ‘afford to lose money’ on the stock market. Therefore, their consumption levels will not be affected at all.
  • Stock market crashes don’t always affect levels of economic growth. e.g. the 1987 stock market crash didn’t reduce growth at all. (Partly because interest rates were cut sharply)

Leading stock market indexes like the FTSE-100 and Dow Jones are important in the sense that it gives an indication of the health of the biggest economies. Rising shares are a good sign, falling shares a bad sign, but in the short term, a lot of price movements can be due to speculation.


How Share Prices Affect Companies

Readers Question: A company issues stock and sells it in a primary market at a fixed price. In that case, do fluctuations in the stock market affect specific companies? In other words, when the stock value of company crashes, is that company affected at all?

If the company sells 10,000 shares at £1, then it receives £10,000 which it can use for investment. If the share price then fluctuates, it doesn’t change the initial sum the firm gained. For example, if the share price fell to 60p, the firm would still have the initial investment of £10,000. However, if the share price collapsed it would affect the company in some ways:

  • It would be harder to issue a share rights issue to raise future capital (many banks are trying to do this at the moment)
  • The firm may become subject to a takeover, especially if the collapsing share price is due to bad management and other people think they can run the company better.
  • Also, it is worth bearing in mind that a collapsing share price is often a reflection of a badly performing firm – a firm which is making a loss. It is not the other way around ie. it is not that a fall in share prices will cause a firm to become unprofitable and inefficient.

The Role of the Stock Market for Investors

Readers Question: As well, how does the stock market affect the economy? I understand the purpose it serves in raising funds for companies but not the role it plays for the investors? Anything to do with saving?

The importance of the stock market includes:

1. Raising funds for companies

Barclays recently announced a share issue to raise just under $9billion. This is to try and help the company survive the credit crunch and so it is important for the banking system, which currently needs more liquidity.

2. A place for investment

Pension funds and investment trusts look for a variety of investment options. They will try to get a balanced portfolio to provide income and capital gains for their members. The stock market can traditionally offer a mix of interest (dividends) and capital growth over the longer term. Of course, the stock market is riskier, but, if investment trusts get it right they can offer an excellent return for their trust fund. People often forget how much dividends you can get from shares. For example, Barclays currently offer a dividend equal to 11% of the share value – making it excellent value (assuming they don’t have to write off billions of bad debt in the near future)

3. Share prices and affects on the economy

Movements in the stock market can also affect the macroeconomy in the long run through wealth and confidence effects.


Volatility of the stock market

“There is a saying: stock markets have predicted 10 out of the last 3 recessions.”

Readers Question: That does not make sense – how can you predict 10 out of 3? Did you not mean 3 out of 10?

The rationale behind the statement “stock markets have predicted 10 out of the last 3 recessions.” is that stock market volatility does not necessarily reflect economic conditions. If share prices fall 15% we may think that indicates a coming recession, but often share prices fall 15% – there is no recession, and then share prices recover.

Sometimes stock market investors panic; they think share prices are overvalued or some bad piece of economic news makes them fearful about future economic conditions. These small signals can, in some circumstances, can cause a rapid fall in share prices. The fall can then precipitate panic selling and share prices suddenly lose a large % of their value. However, later it is realised that the stock market has overreacted to a piece of bad news and actually conditions are not as dire as they feel.

Example:

Stock Market Crash of October 1987

On October 1987, stock markets around the world fell by about 25% in the space of a week. Many at the time felt this was due to an impending recession. However, economies continued to grow and the recession never materialised. Therefore, the stock market crash was not based on economic fundamentals, but, a chain of situations making people nervous and wanting to sell.

If a recession is coming, share prices will fall because a recession will mean lower profits and possibility of bankruptcy. However, just because share prices fall doesn’t mean the economy is going to do badly.

Also, I think the statement is a bit ‘tongue in cheek’ but, it is trying to emphasise the point that share price volatility is often divorced from economic reality.

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