Stock Market: An Index of Economic Growth

STOCK MARKET: AN INDEX OF ECONOMIC GROWTH

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CONTENTS:

Introduction Stock Market Economy Relation between stock market and

economic growth Case Study Conclusion

STOCKS

A stock is a certificate that certifies ownership of a certain portion of a firm.

Stock represents a claim on the company's assets and earnings.

Stocks do not promise a fixed annual payment. Returns depend on company’s performance. If profits are high, the firm may pay dividends.

Stock markets are places where buyers and sellers of stock meet to trade

The NSE and BSE are the most important exchanges in the India.

BONDS

A bond is debt instrument which guarantees to repay the principal of the loan plus interest to the bondholder. Bonds are considered to be long-term debt and have to be paid back on their maturity date. Usually bonds have fixed interest rate, which is paid to the bondholder during the term of the bond. 

Bonds can be issued by both governments and corporations. When you buy bonds you are in effect lending money to the bond issuer, who agrees to repay the loan in the future and to pay interest during the life of the bond. 

DEBT VS. EQUITY

Stock is equity while bonds are debt. Bondholders are guaranteed a return

on their investment and have a higher claim than shareholders.

Stocks are considered riskier investments and require a higher rate of return.

STOCK MARKET

Stock market is an indicator of an economy financial health. It indicates the mood of investors in a country. As such, stock market development is an important ingredient for growth.

The growing importance of stock market around the world has reinforced the belief that finance is an important ingredient for growth.

In this we explore the relationship between stock market development and economic growth.

In principle, a well-developed stock market should increase saving and efficiently allocate capital to productive investments, which leads to an increase in the rate of economic growth. Stock markets contribute to the mobilisation of domestic savings by enhancing the set of financial instruments available to savers to diversify their portfolios.

JARGON OF EQUITY MARKET:

BOND

STOCK 1)COMMON STOCKS 2)PREFERRED STOCKS

SHARE

MUTUAL FUNDS.

PAR VALUE vs. MARKET VALUE

BULLISH vs. BEARISH

TERMS USED

Price/Earnings Ratio (P/E Ratio) Stop Loss Face Value Par Value Market Capitalization IPO

HOW DOES THE STOCK MARKET FUNCTION?

Stock exchanges Brokers Registrars Depositories and their participants Securities and Exchange Board of

India (SEBI)

THE NATIONAL STOCK EXCHANGE OF INDIA (NSE)

Located in India’s financial capital Mumbai, the National Stock Exchange (NSE) is the third largest stock exchange in the world. During 31 December 2005, NSE VSAT terminals, 2799 in total, were spanning across 320 cities of India. The NSE has been a podium for securities exchange for 14 years now! Thousand member strong, NSE provides dealing of different securities, some of them being equity, corporate debt, certificate of deposit, commercial paper, and central and state government securities. National Securities Clearing Corporation, India Index Services and Products, National Securities Depository, and NSE-IT (trading technology) are the associates of NSE. Owner of diverse financial and insurance establishments, NSE can be broadly divided into three segments:

Wholesale debt Capital market (automatic screen-based dealing system) Futures and options (derivatives)

GENESIS OF NSE

It all began 16 years back, in November 1992, when the NSE was integrated as a tax-paying company. In April 1993, NSE was given the status of a stock exchange under the Securities Contract (Regulations) Act of 1956. A year later, in June 1994, NSE began operations in the Wholesale Debt Market (WDM), and in November that year, the Capital Market (Equities) Segment of the NSE began operations. Two years hence, in 1996, NSE became the first exchange in India to trade derivatives specifically on an equity index. In the new millennium, NSE began Indian Internet Online trading system. Today the NSE deals in online examinations and award certification. Comprising branches all over India, NSE introduced India’s first clearing corporation (National Securities Clearing Corporation Ltd.) and India’s first depository (National Securities Depository Ltd.). NSE is India’s earliest national, anonymous, electronic limit order book (LOB) exchange that deals with securities.

MARKET INDICES

NSE established an index services firm called IISL – India Index Services and products Ltd. – and opened numerous stock indices, including:

S&P CNX Nifty CNX Nifty Junior CNX 100 (this is the total of S&P CNX Nifty and CNX Nifty Junior) S&P CNX 500 (this is equal to CNX 100 plus 400 major players

across 72 industries) CNX Midcap (this replaced CNX Midcap 200 on 18 July 2005)  The other NSE Indices are: S&P CNX Defty CNX IT Bank IT

BOMBAY STOCK EXCHANGE (BSE) Having its headquarters in Mumbai, the BSE

SENSEX is the stock index or SENSitive indEX of the BSE. The oldest stock exchange of Asia, the BSE SENSEX, also known as BSE 30, is the focal stock index of India. There are 4800 companies listed with the BSE. As of July 2007, the total equity market capitalization of the Bombay Stock Exchange was US$ 1.005 trillion. The Singapore Exchange has become an alliance of BSE by acquiring a strategic investment in the BSE

GENESIS OF BSE

Way back in 1986, the BSE introduced the stock index that eventually became the most important stock index of the country. The SENSEX was based on market-capitalisation-weighted method and included stocks of some of the top financial houses. Noted financial analyst and columnist, Mr. Deepak Mohoni in the year 1990, introduced the term “BSE SENSEX” which is an acronym for BombayStock Exchange SENSitive indEX. Since September 2003, the SENSEX is measured on the method of free-float capitalisation.

The BSE gives information on the price, charting, announcements, company contact, shareholding pattern and results of the companies that are enlisted in the exchange. The Board of Directors, encompassing eminent financial professionals, Managing Director of the exchange, and the representatives of the Trading Members, maintain the overall functionality of the exchange.

BSE also gives the Beta value of the SENSEX Scrips, Beta being calculated by the formula: Beta = Co-Variance (SENSEX, Stock)/Variance (SENSEX)

MARKET INDICES

Apart from maintaining the BSE SENSEX, the Bombay Stock Exchange also maintains stock indices like:

SENSEX MIDCAP SMLCAP BSE-100 BSE-200 BSE-500

WHAT ARE THE EXPENSES DURING ATRANSACTION?

Capital gains tax Securities transaction tax Brokerage Depository fees

ECONOMIC GROWTH

GDP(GROSS DOMESTIC PRODUCT)

GDP

• A measure of a country's overall official economic output.• Market value of all final goods and services officially made within the borders of a country in a year. •

GDP = private consumption + gross investment + government spending + (exports − imports)

GNI

Gross national income (GNI) comprises the total value produced within a country (i.e. its gross domestic product), together with its income received from other countries (notably interest and dividends), less similar payments made to other countries.

GDP per capita is not a measurement of the standard of living in an economy. However, it is often used as such an indicator, on the rationale that all citizens would benefit from their country's increased economic production.

LIMITATIONS OF GDP TO JUDGE THE HEALTH OF AN ECONOMY

Wealth distribution Non-market transactions Underground economy

THE TWO-WAY RELATIONSHIP BETWEEN THE STOCK MARKET AND THE ECONOMY

Stock Market Economy

THE WEALTH EFFECT

To understand how market affects economy, let’s run through following mental experiment Suppose that, for some reason stock prices rise When stock prices rise, so does household wealth

What do households do when their wealth increases? Typically, they increase their spending

Link between stock prices and consumer spending is an important one, so economists have given it a name Wealth effect

Tells us that autonomous consumption spending tends to move in same direction as stock prices

When stock prices rise (fall), autonomous consumption spending rises (falls)

THE WEALTH EFFECT AND EQUILIBRIUM GDP

Autonomous consumption is a component of total spending

Can summarize logic of the wealth effect

Changes in stock prices—through the wealth effect—cause both equilibrium GDP.

An increase in stock prices will raise equilibrium GDP and price level

While a decrease in stock prices will decrease both equilibrium GDP .

THE WEALTH EFFECT AND EQUILIBRIUM GDP How important is wealth effect?

Economic research shows that marginal propensity to consume out of wealth is between 0.03 and 0.05

Change in consumption spending for each one-dollar rise in wealth

As a rule of thumb, a 100-point rise in DJIA—which generally means a rise in stock prices in general—causes household wealth to rise by about $100 billion

This rise in household wealth will increase autonomous consumption spending by between $3 billion and $5 billion—we’ll say $4 billion

FIGURE 4: THE EFFECT OF HIGHER STOCK PRICES ON THE ECONOMY

Y1 Y2Real GDP

Ag

gre

gat

e E

xpen

dit

ure

AEhigher stock prices

45°

AElower stock prices

HOW THE ECONOMY AFFECTS THE STOCK MARKET Let’s look at the other side of the two-way

relationship How economy affects stock prices

Many different types of changes in the overall economy can affect the stock market

Let’s start by looking at the typical expansion Real GDP rises rapidly over several years

In typical expansion (recession), higher (lower) profits and stockholder optimism (pessimism) cause stock prices to rise (fall)

Theoretically, a growing literature argues that stock market development boost economic growth. Large stock markets can decrease the cost of mobilizing savings, thus facilitating investment in most productive technologies.

Moreover, stock markets play a key role in allocating capital to the corporate sector, which will have a real effect on the economy on aggregate. Debt finance is likely to be unavailable in many countries, particularly in developing countries, where bank loans may be limited to a selected group of companies and individual investors.

STOCK MARKET BUBBLE

In financial markets, a stock market bubble is a self-perpetuating rise or boom in the share prices of stocks of a particular industry. The term may be used with certainty only in retrospect when share prices have since crashed. A bubble occurs when speculators note the fast increase in value and decide to buy in anticipation of further rises, rather than because the shares are undervalued. Typically many companies thus become grossly overvalued. When the bubble "bursts", the share prices fall dramatically, and many companies go out of business

CASE STUDY

Dow Jones Industrial Average Index: An index based on the stock prices of 30

actively traded large companies. The oldest and most widely followed index of stock market performance.

NASDAQ Composite Index: An index based on the stock prices of over

5,000 companies traded on the NASDAQ stock market. The NASDAQ market takes is name from the National Association of Securities Dealers Automated Quotation System.

Standard and Poors 500 (S&P 500) Index: An index based on the stock prices of the

largest 500 firms traded on the New York Stock Exchange, the NASDAQ stock market, and the American Stock Exchange.

Between 1995 and 2000, the S&P 500 index rose 226 percent, an annual rate of 25 percent!

This is by far the largest stock market boom in U.S. history. This boom added $14 trillion to household wealth, about $2.5 trillion per year.

The stock market boom cannot be explained by a large fall in interest rates, higher profits, or a fall in the perceived riskiness of stocks. This led many people to the view that it was simply a bubble.

Millions of lives were affected by the euphoria of the boom and the “correction” that followed.

THE CRASH OF OCTOBER 1987

The value of stocks in the United States fell by about a trillion dollars between August 1987 and the end of October 1987.

If the multiplier is 1.4, the $1 trillion decrease in wealth in 1987 implies a $40 billion lower level of spending in 1988, or about 1.4 percent of GDP.

THE CRASH OF OCTOBER 1987

• However, as the life-cycle theory of consumption predicts, households smooth their consumption over time, which means that the decrease in wealth would not have reduced consumption in the current year by the full amount of the decrease in wealth, but by cutting consumption a little each year.

THE CRASH OF OCTOBER 1987

The stock market crash of 1987 did not result in a recession in 1988 because households and business firms did not lower their expectations drastically.

Since the initial decrease in wealth turned out to be temporary, the negative wealth effect was not as large as anticipated.

THE BOOM OF 1995-2000

The boom in the economy between 1995 and 2000 was fueled by the stock market boom.

Estimates show that had there been no stock market boom the economy would not have looked historically unusual in the last half of the 1990s.

THE BOOM OF 1995-2000

The value of stocks increased by about $2.5 trillion per year during the boom. Assuming that a $1 increase in stock prices

leads to a $0.04 increase in consumption and investment, and a multiplier of 1.4, then:0.04 x $2.5 trillion x 1.4 = $140 billion increase in GDP, or 1.5% of GDP.

The growth rate of GDP would have been around 2.8% instead of 4.5%

PERSONAL SAVING RATE,1995 I – 2002 III

Had there been no boom: The personal

saving rate would have been higher.

INVESTMENT OUTPUT RATIO,1995 I – 2002 III

Had there been no boom: Firms would have

invested less in plant and equipment.

RATIO OF FEDERAL GOVERNMENT BUDGET SURPLUS TO GDP, 1995 I – 2002 III

Had there been no boom: The federal

government surplus would not have been as high, since taxable income and profits would have been less.

THE UNEMPLOYMENT RATE,1995 I – 2002 III

Had there been no boom: The

unemployment rate would have remained at about 5.5 percent. It was 4% during the boom.

INFLATION RATE, 1995 I – 2002 III

Had there been no boom: Inflation would

have been lower due to less demand pressure.

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Ishan-10703041Mangal-10703056Nitish-100883003

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