Chapter One: The Case of Equity

This chapter describes how investors, financial gurus, and scholars have viewed stocks and bonds over the years. It also takes into account how different economists predict that the value of investment stocks will increase over time. It also demonstrates the stock’s successes and shortcomings as well as how the media portrayed the trend in stock variations. The chapter provides examples of how the emergence of the stock markets and the Great Bull and Bear markets had an impact on the media and investors. According to John J. Raskob, people can create wealth if they are able to invest a small percentage of their cash which could appreciate into huge amounts in the course of time. Consequently, more investors out of excitement invested millions of their savings into the market, hoping for quicker profit. After the implementation of this plan, stocks rose high but crashed after seven months only. As a result, millions of investors’ funds were wiped out, and others forced into bankruptcy. There, the idea of Raskob was highly condemned in the preceding years. However, the failure of Rascob’s plan indicted how the Bull markets and Bear markets can lead to either unbelievable achievements or overwhelming losses.

During the nineteenth century, stocks were believed to be the main source of investment to speculators but not for conformist investors. A great U.S. economist Irving Fisher assumed that during inflation, bonds were less superior to stocks although, during deflation, common shares do not perform well as bonds. Nevertheless, Edgar Lawrence Smith, a fiscal psychoanalyst, investigated chronological portfolio prices and criticized Fisher’s plan. Smith pioneered the hypothesis that common stocks were better than bonds not only throughout inflation but also during devaluation. Consequently, Smith’s popularity and credibility were felt around the world. Smith’s investigation made the renowned Yale economist Irving Fisher change his mind by viewing Smith’s research as a substantiation of his conviction about the overvaluation of bonds as secure savings. Fisher later came up with the idea that stock market prices were at a permanent rise, and thus provoking more people to adopt his plan. Millions of investors adopted Fisher’s plan. However, stocks crashed making his research to be denounced, and his hypothesis was smashed despite his earlier good reputation. The fall of the stock market led to the condemnation of the common stock theory and the idea that stocks were safe reserves for wealth creation.

The media and investors cluttered both the market and the initiators of the hypothesis that stocks were the most excellent way to make wealth following the earlier crash. The steady depreciation of the interest toll led to the formation of a market that could make the stock prices appreciate. Few people deliberated that the Bull market would last despite the many warnings issued by the investors and analysts. However, the evolvement of the communication technology and the Internet added momentum to the already rolling market. The Internet allowed investors to be updated about the various trends in the market and investment information around the globe. Nonetheless, the pulling down of the technology expenditure caused the stock market to rupture leading to the emergence of the Great Bear Market. This led to the crashing of stock value, and thus many experts were doubtful about stocks and yet bonds were never considered a substitute.

Chapter Two: The Great Financial Crisis

This chapter explains the origin of the financial crisis and it holds the Chief Executive Officers of giant investment banks and the regulators responsible and accountable for the menace. Siegel (2014) outlined a series of lethal mistakes that led the Standard and Poor’s to give its desirable AAA rating to subprime mortgages, affirming them as secure as the U.S. Treasury bonds, and thus causing economic downfalls.

The financial conditions for the 2008 crisis were extremely long and preceded the Great Recession. The economic crisis was caused by the reduction in the cost of securities related to the real estate–related properties. Moreover, the risk quality on many economic tools declined in a noticeable way during the Great Moderation because investors thought that punctual Central Bank Act would neutralize any severe shock to the economy. However, the 2001 recession toughened the market’s outlook on the stability of the economy. The constancy of the crisis was attributed to the Federal Reserve by the economists who believed that lessening risk premiums and increasing monetary power was the major cause of financial fluctuation.

Hyman Minsky formulated the financial instability hypothesis, whereby he asserted that long periods of economic steadiness and increasing asset prices integrates the entrepreneurs, momentum investors, and fraudsters who came up with plots to ambush common investors wishing to spearhead the increasing market breaks. Unfortunately, Minsky’s hypothesis never added much prevalence to the conventional economics for the reason that he did not devise in a detailed form.

When the real estate marketers overturned their course, and the prices of these securities crashed, the firms that were operating on loans experienced a crisis that pushed some into bankruptcy. Survival options for other firm included mandatory amalgamation with stronger counterparts and seeking financial support from the government. The investment banks forced the rating organization to offer higher rating to the security investments to enable the banks to increase the pool of latent buyers. However, the rating techniques were ill-matched during scrutinizing of the defaulting likelihood in the housing market where real estate prices rose far above the fundamental price. The reasons for the increase in real estate prices to be higher than their historical in the early 2000s was accredited to substantial declines experienced in both nominal and real interest rates. In addition, there was the creation of new mortgage instruments, such as subprime and full-funding mortgages, which loaned up to or more than the price for purchasing a home. Furthermore, the housing finance institutions gave loans to borrowers who did not qualify for the loan and greatly lengthened housing orders.

The financial crisis emergency is linked to the failure of the management to warn the public of the escalating risks created by the extraordinary rise in housing prices. In fact, they did not supervise the coming up of risky mortgage-related securities in the balance sheet of important financial institutions. The plunge in the long-term interest rates was characterized by slowing financial growth, the change from equities to bonds in commercial pension funds, and the propagation of subprime and full-funding mortgages. In spite of the failures by the regulators to foresee the crisis, the Federal Reserve, however, acted quickly to ensure liquidity and barred the collapse from becoming more severe than it turned out.

Chapter Three: The Market, Economy, and Government Policy

This chapter analyzes the extraordinary impact of the financial crisis on the economic markets, disintegration of stock prices, and Treasury bill yields depreciating to zero or even less. The credit distress, harshly falling real estate prices, and falling stock markets have caused the deepest decline in the developed world economies since World War II. Though the crisis emerged in the United States, the GDP was not less than that in most of other parts of the developed world. The developing economies endured the economic downturn much better than the developed world.

Deflation deteriorates the business cycle, since a reduction in earnings and price boosts the debt burden which in turn rises in real cost as prices decline. The stabilization of the price level was a main concern for the Federal Reserve. The Fed was able to shun deflation by lessening the money supply. The stipulation of liquidity rate was meant to stabilize the economy and to eradicate the crisis.

Despite the actions taken by the Federal Reserve to restrain the financial breakdowns, the unpredictability of stock prices increased steadily, as it does in Bear markets. The decline in the up-and-coming stock markets was indistinguishable to the one witnessed during the Asian financial crisis in 1997–1998. However, the emerging market remained well above the 2009 crisis and this was dissimilarity with the United States and most other developed markets.

The variation in real estate prices had a significant impact on the economy. It was estimated that consumers spent between 25 and 30percent of the equity borrowings during the crisis period. The reduction in consumption was caused by the slow recovery from the Great Recession.

During the crisis, the Federal Reserve not only gave liquidity access to the markets but also lowered the Fed’s funds rate significantly. However, the Federal Reserve assurance on bank deposits and money market funds stopped up the liquidity strain. Consequently, Fed could not manage the shock waves that echoed through the credit markets. In the long run, Treasury rates fell considerably while interest rate rose.

In the early stages of the subprime crisis, the prices of commodities appreciated rapidly due to the increasing strength of the economy. Investors who thought that financial commodities offered them an evasion against a strict decline in market stock prices were wrong. The dollar depreciated progressively against other currencies of the major developed countries at the early stages of the economic crisis. However, as the financial crisis worsened, the dollar recovered its status, and foreign investors reversed to dollar securities. On the contrary, as the crisis fastened and the equity markets began to recuperate, the dollar lost its worth and its prices depreciated.

The financial crisis of 2008 made legislators design laws to mitigate a repeat of the potential future financial crisis. For instance, the Dodd-Frank Wall Street Reform and Consumer Protection Act were signed by President Obama into action in July 2010. The three most significant parts of this act that have impact on the economy include: the Volcker rule which restricts the proprietary operation of commercial banks; the Title II grants for the liquidation of huge monetary firms not under the purview of the Federal Deposit Insurance Corporation; and the Title XI which places new boundaries on the Federal Reserve. However, most of the details have not been formulated and implemented.

Chapter 20: Technical Analysis

Technical analysis is the anticipation of the future proceeds by referring at the past flow of prices. Stock profits are predicted by the use of surplus wages and the rates recorded in financial books. However, these values are overlooked by chartists, who uphold that the information for foreseeing the future price movements can be collected by looking at the past price patterns. In addition, they believe that it can be caused by knowledgeable investors who have a sufficient understanding of the value of the firm. If these patterns are understood keenly, chartists assert that investors can use them to surpass the market.

Charles Dow, the ancient scientific analyst and the founder of the Dow Jones Industrial Average, did not scrutinize graphic representation with bare information. However, Dow focused on market schedules by comparing the surging of stock prices to the effects of the waves in an ocean. He declared that general trend was established first and then followed by a minor heaving. Additionally, one may perhaps discover which movement the market stock price will take by studying the Dow Jones Industrial Average Chart.

Technical analysts operate under the scheme that major market trends can be established by contracting with the Bull Markets while evading the Bear Markets. When a trend is recognized, technical analysts illustrate the channels consisting of corresponding high and lesser limits inside the operation of the market. The minor hurdle of a channel is normally called a support level while the latter forms the resistance level. A huge market shift follows when the bounds of the channel split. Dealers take advantage of prices by trading their stock at the higher end of the channel and make purchases when they attain the lower end. For this case, they utilize the benefit of the evident instability of net worth of stock within the channel. However, the wreckage of the trend will cause many of these traders to quash their position and to do an overturn. These actions often speed up the movement of stock prices. Accordingly, the trend following also reinforces how market timers will behave either during inflation or deflation.

Buying individual stocks are also another use of technical analysis, also referred to as momentum investing. Momentum approach unlike fundamental strategies relies on past returns regardless of earnings, dividends, or other valuation elements. Momentum investors buy stocks that have recently appreciated in price and sell stocks that have depreciated with the expectation that the stock value will proceed with the same trend. However, these momentum strategies are only short-term and not a long-term strategy. The success of momentum investing cannot be explained within an efficient market framework. Regrettably, momentum investing does not guarantee warranty accomplishment as the recent evidence suggests that expert investors gain excess returns with a momentum strategy. On the other hand, individual investors are likely not to perform well the market.

Advocates maintain that technical analysis can use their knowledge to categorize the key trends in the market through verifying where a shift is expected. Nonetheless, a substantial debate arises on whether such drift subsists or whether they present dashes of superior and dire proceeds which result from casual price change. For instance, analyzing how the investors’ intention to gain from precedent times can transform future incomes requires full attention of the investor so as to better analyze the trends.

Chapter 22: Behavioral Finance

This chapter is documented as a narrative to ease the understanding of the fundamental studies and the relationship between behavior and finance. The economics profession is increasingly alert to the fact that mental factors can ruin rational analysis and put off investors from achieving best results. The study of these psychological factors has proliferated into the field of behavioral finance.

Dave is a financier who cascades into a psychological ambush that averts him from being an effective investor. He then visits an investment counselor, who advices him on how to become a more triumphant investor. Investment counselors use behavioral psychology to help investors understand why they do not perform well. This narrative begins in the fall of the stock market in 1999, several months before the peak in the great technology and Internet bubble that conquered the stock markets at the turn of the century.

Dave was doubtful and thought that the knowledge of stocks required an understanding of economics, accounting, and mathematics. Dave, however, never heard the word psychology used in any of those subjects. The investment psychologists started by giving Dave various examples of how psychologists in the ancient times linked behavior and finance. He asserts that any of the beliefs of behavioral finance are founded on the psychological notion that has hardly ever been practically applied to the stock market and collection management. He gives him some background when money was dictated by the assumption that presumed shareholders to be maximizing their expected well-being, and at all times to be operating realistically. This was an expansion of the rational theory of consumer choice. This theory, however, was developed in the 1970s theory by two psychologists, Daniel Kahneman and Amos Tversk, who noticed that many people did not act as per the hypothesis. Therefore, they came up with the prospect theory that stated how individuals conducted themselves and made verdicts when faced with hesitation. Due to this model they were termed the pioneers of behavioral finance, and their knowledge has received a higher rating in the finance career.

The psychologist realized that Dave’s stocks were depreciating. However, after a discussion, he realized that Dave was pressured by his friends who were investing in the Internet and technology and making lump sums. The psychologist advised Dave to be vigilant when everyone is excited about the stock market. According to the psychologist, stock prices are not being dependent on economic worth only but also on the psychological aspect that affects the market. He notes how the crowd influenced Dave’s decision against his better opinion. He asserts that the technology bubble is a perfect example of how the public pressures affect stock prices. This has been a trend since the early years, but often most of the people who follow the crowd end up losing. However; he states that sometimes the crowd is right.

Dave is blamed for being overconfident as the result of his failure in the stock market. The psychologist links this to self-attribution bias which is giving credit where there is no outstanding. In addition, it erupts from representative bias, which is the predisposition to see too many equivalents amid the actions that appear identical but not legitimate. He concludes that representative bias is liable for some enormously erroneous moves in the stock market, even when the situations are indistinguishable.

Chapter 10: Sources of Shareholder Value

Asset values are derived from the predictable cash flows that can be acquired from owning the asset. Stock prices are dependent on the rate at which these future cash flows will be economical. Prospect cash flows are economical since the money got from the future is not treasured higher as cash received at hand. The main rationale why investors discount the future value is the extension of the risk-free rate which offers investors the capability to exchange a dollar endowed today into a superior sum tomorrow. Besides, price rises condenses the influence of purchasing of cash to be acknowledged in future. Lastly, if the risk is related to the scale of anticipated cash flows of risky assets, investors aim at stipulating a premium on the secure securities. These three factors determine the discount rate for equities.

The main source of cash flow to shareholders is earnings which are the difference between the revenues generated and the costs of production. Retained earnings are profits that are not used to pay dividends but kept aside for re-investment. They create worthiness of the enterprise by raising future cash flows through retirement of arrears, investment in other assets, and savings in principal projects intended to boost future profits and procurement of the firm’s shares. These earnings can be used to increase the capital of the firm to produce higher profits in the future. Indeed, investors who sell their shares to the company obtain ready money for their stock from retained earnings. However, those who do not sell their stocks will obtain larger per share earnings and per share dividends in the future as the firm’s earnings are alienated to a smaller number of shares.

The distinction between the operating earnings that an enterprise reports and what shareholders expect compels the stock prices during the earnings season. The published consensus estimates do not always equalize the prospect built into the price of the stock at the time the statements are made. This is a result of analysts and traders coming up with estimates that differ from the agreement referred to as the whisper estimates which are not extensively distributed. The whisper estimates are higher than the consensus estimates because of a firm’s earnings regulation and according to the analysts it is often skewed to the distrustful side. Earnings are not the only financial information that stockholders act on in the quarterly reports though being important.

The most significant indicator of a firm’s prediction is revenue. The combination of the revenue data and earnings data can be used to figure out the profit margin on sales which is a critical information. Investors are inclined to any earnings direction that firms give over the next quarter or year. In the past, the management would often give a tip to analysts when unpredicted good or bad news affected the firm. However, after stipulation and adoption of tough new fair discovery laws by the SEC in 2000, such selected leaking is no longer permitted.

The primary determinant of stock values is the future expected cash flows to shareholders. These cash flows are referred to as dividends and are the derivative of earnings. There are many earnings perception. For instance, companies’ operating earnings are what is deliberated and predicted by analysts and are the most central information in the quarterly reports. They are always more highly preferred than the account earnings.

Chapter 15: Stocks and Business Cycle

The rising and falling of stocks in the market have been experienced nearly every day, thus lowering down the surplus output to depreciation and increasing the income proportion. The market and the financial system are not always connected. Many investors are interested in identifying if the financial environments will be capable of performing better to sustain the rising prices. The business cycle is defined as the variation and fluctuation in the economic growth over a given period. Expansion, peak, contraction, and trough make up the three stages of the business cycle. The recession is a turn down in the economic activities spread across the fiscal system and stops after a shorter time like few months at the trough and peak. However, it sets in again when the economy hits the highest point of action.

The expansion is the usual condition of the financial system in the economy when all business operations are normal and experiencing a steady growth. It is vital when inspecting the stock market and thus, should not be dismissed when analyzing the market range of stock prices. The comeback of the stock market due to the shifts in trade and industrial activities is always positive. However, in the preceding recession stock prices depreciate and ascend ahead of financial recuperation.

Several shareholders in the preparation of their market strategy seem to neglect financial prediction. In such cases, the modification in the monetary bustle is countered for in the market. Nevertheless, in predicting the series of economic expansion and contraction, the peaks and trenches of economic activity should be considered before their occurrence. Normally, it is the hardest process for most investors. Estimation of the business cycle is common in Wall Street since the rewards are high because discovering the turning points of stock prices and the ability to make successful predictions lead to higher returns to investors. Forecasting when the recession will turn in can be of great benefit and thus, an investor can gain substantial growth.

National Bureau of Economic Research (NBER) is concerned with the business cycle dating. In addition, it is involved in the preparation of public revenue accounts. The dating of the business cycle is vital as the dates entail supporting the proposition that shapes the economic and financial decisions. The staffs’ assembles broad sequential accounts relating to the shifts in the financial state of affairs in the developed nations. The key reason for the necessitating of a dating committee is that it reinforces and gauges the changing nature of information base in the economy.

The stock market slows down in advance to depression and rises before the economic improvement. Mutual earnings are supported by the stock values and determined by the business cycle. Furthermore, the stock market is also used to fake cautions and these increase mostly during the postwar period.

The time amid the crest of the market and the peak of the economy also has revealed much superior unpredictability than the time between the trough of the market and that of the economy. The stock market rises at the time the economy has reached the trend of the recession. Therefore, an investor waiting for concrete proof that the business cycle has hit bottom and has already missed a very substantial rise in the market. Following the existing trend in the market can be the worst path to be followed by a shareholder. Consequently, it can lead to purchasing stock at soaring values during the peak season of the year when investors are hopeful and in turn selling at low prices at the deflation period.

References

Siegel, J. J. (2014). Stocks for the long run (5th ed.). New York: McGraw Hill Education.