The Common Stock Market

    Types of markets Trading mechanics Stock market indexes Pricing efficiency

Common stock
 equity security
 ownership  entitled to distributed earnings  entitled to share of assets

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I. Type of Markets
 exchanges  OTC trading of  unlisted stocks & listed stocks  direct trading

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Exchanges
 physical location for trading  trading by members
 own a seat on the exchange

 stock traded on exchange are listed stocks

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NYSE
 the Big Board  about 2800 listed U.S. companies
 & 450 non-U.S. companies

 $18 trillion market value (2/04)  1366 seats (fixed)

 seat price $2 million 2002  10/2003 $1.35 million
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 stocks trade at post on the trading floor

 20 posts, trading about 100 stocks

 each stock has one specialist

 10 specialist firms, 470 specialists  each specialist has 5-10 stocks  process trades from floor brokers (5%) and electronically (95%)

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role of the specialist

 MUST maintain a fair and orderly market for stock  act as buyer or seller as needed (10% of trades)  match buyers and sellers  maintain order priority

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the future of the specialist

 may be phased on with next 5-10 years  recent SEC fines for improper trading for several major firms

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AMEX
 merged w/ Nasdaq 1998  specializes in equity derivative securities and closed-end funds

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Regional exchanges
 stocks may be listed on both NYSE and regional exchange  5 regional exchanges  cheaper seat prices

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OTC markets
 electronic network of dealers all over the world  ECNs
 electronic communication networks

 more than one dealer per stock

 not obligated to make a market

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Nasdaq
 not the only OTC system, but the largest  over 4000 companies listed
 mkt. value $2 trillion (2/28/03)

 leader in daily share volume  over 500 dealers  listing requirements

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II. Trading Mechanics

    types of orders short selling buying on the margin institutional trading

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Types of orders
 instructions from investors to brokers  market order
 buy/sell order to be executed at best price -- get lowest price for buy order -- get highest price for sell order

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 market order (cont.)

 market orders given priority in trading  no guarantee of execution price -- price could rise/fall from time order is placed to time it is executed

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 limit order
    buy/sell order where investor specifies price range buy at $50 or less sell at $52 or more specialist records orders in limit order book

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 investor sets reservation price BUT  no guarantee that limit order will be executed

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 stop order
 order lies dormant  turns into market order when certain price (the stop) is reached  buy if price rises to $60  sell if price falls to $58 -- stop loss order

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 investor does not have to watch market

 but in a volatile market stop could be triggered prematurely -- end up trading unnecessarily

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 stop limit order

 turns into limit order when stop is reached  buy if price rises to $60, but only is executed at $65 or less

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 market if touched order

 turns into market order if certain price is reached  buy if price falls to $55  sell if price rises to $62

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how long is an order good?

 fill or kill order
 executed when reaches trading floor, or canceled

 good until canceled/open order

 is good indefinitely

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order size
 round lots
 lots of 100 shares

 odd lots
 less than 100 shares  more difficult to trade

 block trades
 10,000 shares or $200,000 value

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short selling
 sale of borrowed stock  profit from belief that stock price is too high will fall soon  how?
 borrow stock through broker  sell stock  buy and return later

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 short selling could further destabilize falling prices

 tick test rules on exchange

 short sales allowed if

   
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uptick or zero uptick in price for previous trades: $20.75, $21 (uptick) $20.75, $20.75 (zero upick) $20.75, $20 (downtick)
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 so short sellers
 believe price will fall and SOON  but price not currently falling  face unlimited losses if price rises

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Buying on the margin

 buyer borrows part of purchase price of stock, using stock as collateral
 borrow at call money rate

 Fed sets initial margin requirement

 minimum cash payment  50% since 1975

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 if stock price falls

 collateral worth less  if collateral worth only 125% of loan (maintenance margin) -- margin call -- owner must put up more cash or sell stock  margin calls can worsen stock crash

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example
 1000 shares, $20 per share
 $20,000 cost  $10,000 cash, borrow $10,000

 leverage
 gains/losses on $20,000 capital  but tied up only $10,000 capital

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 if prices falls to $12,

 value of stock $12,000  below 125% of $10,000 loan  get a margin call

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Institutional trading
 vs. retail trades
 institutional trades are larger  special execution  over 50% of NYSE share volume

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block trades
 large # shares in one stock  executed in upstairs market
 other firms directly take other side of trade

 remainder executed on trading floor or Nasdaq (downstairs)

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program trades
 large # shares, different stocks  used by mutual funds for asset allocation  want
 low commissions  prevent frontrunning

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what is frontrunning?
 brokers trade ahead of program trade
 to benefit from anticipated price movements  due to large trade

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example
 broker buys ahead of large buy order
 broker buys first  large buy order pushes up price  brokers holdings increase in value

 result
 frontrunning starts to push up price, so firm does not get best price

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agency basis
 brokers bid for trade by commission  low commission, but  frontrunning likely

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agency incentive agreement

 set benchmark value for trade
 based on last days prices

 if broker does better

 gets commission + bonus

 higher commission, but  frontrunning less likely

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III. Stock market indicators

 measure average performance of a group of stocks  different indexes are highly correlated:
 DJIA & S&P 500 .991 (1990s)  DJIA & NYSE .95

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indexes differ due to

 stocks included in the index  weighting of stocks
 equal, price, value

 average
 arithmetic  geometric

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stock exchange index

    includes all stocks listed on exchange NYSE Composite Nasdaq Composite (both value weighted)

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subjectively selected index

 organization picks group of stocks to measure  Dow Jones Industrial average  S&P 500

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DJIA
 price weighted  30 large blue chip companies
 cross section of industries  leaders

 large movements in DJIA may halt trading on NYSE

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S&P 500
 500 large blue chip companies  value weighted  most popular benchmark for index funds

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objectively selected index

 inclusion of stock based on objective criteria  market value  Wilshire 5000  all publicly traded stocks  Russell 2000  largest 3000 companies, then take smallest 2000 of those
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IV. Pricing Efficiency of the Stock Market

 what information is reflected in current stock prices?
 what implications does this have for active vs. passive investment strategies?

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3 levels of price efficiency

 what are they?  implication?  evidence for U.S. stock markets?

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Weak form efficiency

 current stock prices reflect
 information about past prices  and trading history

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implication
 if markets are weak-form efficient
 using past price/trading pattern to predict future stock prices will not work  so, technical analysis will fail to beat the market

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evidence
 U.S. stock market is weak-form efficient  technical analysts do not beat the market
 especially after trading costs

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Semi strong form efficiency

 current stock prices reflect
 all publicly available information relevant to stock -- economic data -- financial statements

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implication
 using public info to predict future stock prices will not work
 fundamental analysis will fail to beat market

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evidence
 mixed  Yes
 most actively managed portfolios do not outperform randomly selected portfolios

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 No.
 certain pricing anomalies persist for long periods of time  January effect  size effect

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Strong form efficiency

 current stock prices reflect all information
 public and private

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implication
 impossible to predict future stock prices
 stock prices are a random walk

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evidence
 U.S. stock market is not strong form efficient  why?
 corporate insiders consistently outperform market  & they have access to private info

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active strategy
 using fundamental or technical analysis to select stocks to buy/sell  growth, sector, value funds  trading on this info increases
 trading costs  tax consequences

 odds of working are low

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passive strategy
 believe market is efficient, just capture longrun returns of market  buy-and-hold diversified portfolio
 index funds

 lower expenses, defer taxes  index funds outperform most actively managed funds
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