Everything about Equity Market totally explained
A
stock market, generally referred to as (equity market) is a private or public
market for the
trading of
company stock and
derivatives of company stock at an agreed price; these are
securities listed on a
stock exchange as well as those only traded privately.
The Definition
The expression 'stock market' refers to the market that enables the trading of company stocks (collective shares), other
securities, and
derivatives. Bonds are still traditionally traded in an informal,
over-the-counter market known as the
bond market. Commodities are traded in
commodities markets, and derivatives are traded in a variety of markets (but, like bonds, mostly 'over-the-counter').
The size of the worldwide 'bond market' is estimated at $45 trillion. The size of the 'stock market' is estimated at about $51 trillion. The world derivatives market has been estimated at about $480 trillion 'face' or
nominal value, 30 times the size of the U.S. economy…and 12 times the size of the entire world economy. It must be noted though that the value of the derivatives market, because it's stated in terms of
notional values, can't be directly compared to a stock or a fixed income security, which traditionally refers to an
actual value. (Many such relatively
illiquid securities are valued as
marked to model, rather than an actual
market price.)
The stocks are listed and traded on
stock exchanges which are entities (a
corporation or
mutual organization) specialized in the business of bringing buyers and sellers of stocks and securities together. The stock market in the United States includes the trading of all securities listed on the
NYSE, the
NASDAQ, the
Amex, as well as on the many regional exchanges, for example
OTCBB and
Pink Sheets. European examples of stock exchanges include the
Paris Bourse (now part of
Euronext), the
London Stock Exchange and the
Deutsche Borse.
Trading
Participants in the stock market range from small individual
stock investors to large
hedge fund traders, who can be based anywhere. Their orders usually end up with a professional at a stock exchange, who executes the order.
Some exchanges are physical locations where transactions are carried out on a trading floor, by a method known as
open outcry. This type of auction is used in stock exchanges and
commodity exchanges where traders may enter "verbal" bids and offers simultaneously. The other type of exchange is a virtual kind, composed of a network of computers where trades are made electronically via traders.
Actual trades are based on an
auction market paradigm where a potential buyer
bids a specific price for a stock and a potential seller
asks a specific price for the stock. (Buying or selling
at market means you'll accept
any ask price or bid price for the stock, respectively.) When the bid and ask prices match, a sale takes place on a first come first served basis if there are multiple bidders or askers at a given price.
The purpose of a stock exchange is to facilitate the exchange of securities between buyers and sellers, thus providing a
marketplace (virtual or real). The exchanges provide real-time trading information on the listed securities, facilitating price discovery.
The
New York Stock Exchange is a physical exchange, also referred to as a
listed exchange — only stocks listed with the exchange may be traded. Orders enter by way of exchange members and flow down to a
specialist, who goes to the floor trading post to trade stock. The specialist's job is to match buy and sell orders using open outcry. If a
spread exists, no trade immediately takes place--in this case the specialist should use his/her own resources (money or stock) to close the difference after his/her judged time. Once a trade has been made the details are reported on the "
tape" and sent back to the brokerage firm, which then notifies the investor who placed the order. Although there's a significant amount of human contact in this process, computers play an important role, especially for so-called "
program trading".
The
NASDAQ is a virtual listed exchange, where all of the trading is done over a computer network. The process is similar to the New York Stock Exchange. However, buyers and sellers are electronically matched. One or more NASDAQ
market makers will always provide a bid and ask price at which that'll always purchase or sell 'their' stock.
(External Link
).
The
Paris Bourse, now part of
Euronext, is an order-driven, electronic stock exchange. It was automated in the late 1980s. Prior to the 1980s, it consisted of an open outcry exchange.
Stockbrokers met on the trading floor or the Palais Brongniart. In 1986, the
CATS trading system was introduced, and the order matching process was fully automated.
From time to time, active trading (especially in large blocks of securities) have moved away from the 'active' exchanges.
Securities firms, led by UBS AG, Goldman Sachs Group Inc. and Credit Suisse Group, already steer 12 percent of U.S. security trades away from the exchanges to their internal systems. That share probably will increase to 18 percent by 2010 as more investment banks bypass the NYSE and NASDAQ and pair buyers and sellers of securities themselves, according to data compiled by Boston-based Aite Group LLC, a brokerage-industry consultant [citationneeded].
Now that computers have eliminated the need for trading floors like the
Big Board's, the balance of power in equity markets is shifting. By bringing more orders in-house, where clients can move big blocks of stock
anonymously,
brokers pay the exchanges less in fees and capture a bigger share of the $11 billion a year that institutional investors pay in trading commissions .
Market participants
Many years ago, worldwide, buyers and sellers were individual investors, such as wealthy businessmen, with long family histories (and emotional ties) to particular corporations. Over time, markets have become more "institutionalized"; buyers and sellers are largely institutions (for example,
pension funds,
insurance companies,
mutual funds,
hedge funds, investor groups, and
banks). The rise of the
institutional investor has brought with it some improvements in market operations. Thus, the government was responsible for "fixed" (and exorbitant) fees being markedly reduced for the 'small' investor, but only after the large institutions had managed to break the brokers' solid front on fees (they then went to 'negotiated' fees, but only for large institutions).
However,
corporate governance (at least in the West) has been very much adversely affected by the rise of (largely 'absentee') institutional 'owners'.
History
Historian
Fernand Braudel suggests that in
Cairo in the
11th century Muslim and
Jewish merchants had already set up every form of
trade association and had knowledge of many methods of credit and payment, disproving the belief that these were invented later by Italians. In 12th century
France the
courratiers de change were concerned with managing and regulating the debts of agricultural communities on behalf of the banks. Because these men also traded with debts, they could be called the first
brokers. In late 13th century
Bruges commodity traders gathered inside the house of a man called
Van der Beurse, and in 1309 they became the "Brugse Beurse", institutionalizing what had been, until then, an informal meeting. The idea quickly spread around
Flanders and neighboring counties and "Beurzen" soon opened in
Ghent and
Amsterdam.
In the middle of the 13th century
Venetian bankers began to trade in government securities. In 1351 the Venetian government outlawed spreading rumors intended to lower the price of government funds. Bankers in
Pisa,
Verona,
Genoa and
Florence also began trading in government securities during the
14th century. This was only possible because these were independent city states not ruled by a duke but a council of influential citizens. The Dutch later started
joint stock companies, which let
shareholders invest in business ventures and get a share of their profits - or losses. In 1602, the
Dutch East India Company issued the first shares on the
Amsterdam Stock Exchange. It was the first company to issue stocks and bonds.
The
Amsterdam Stock Exchange (or Amsterdam Beurs) is also said to have been the first stock exchange to introduce continuous trade in the early
17th century. The Dutch "pioneered
short selling,
option trading, debt-equity swaps,
merchant banking, unit
trusts and other
speculative instruments, much as we know them" (Murray Sayle, "Japan Goes Dutch",
London Review of Books XXIII.7,
April 5,
2001). There are now stock markets in virtually every developed and most developing economies, with the world's biggest markets being in the
United States,
Canada, China (
Hongkong),
India,
UK,
Germany,
France and
Japan.
Importance of stock market
Function and purpose
The
stock market is one of the most important sources for
companies to raise
money. This allows businesses to be publicly traded, or raise additional capital for expansion by selling shares of ownership of the company in a public market. The
liquidity that an exchange provides affords investors the ability to quickly and easily sell securities. This is an attractive feature of investing in stocks, compared to other less liquid investments such as
real estate.
History has shown that the price of
shares and other assets is an important part of the dynamics of economic activity, and can influence or be an indicator of social mood. Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the wealth of households and their consumption. Therefore,
central banks tend to keep an eye on the control and behavior of the stock market and, in general, on the smooth operation of
financial system functions. Financial stability is the
raison d'être of central banks.
Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an individual buyer or seller that the
counterparty could default on the transaction.
The smooth functioning of all these activities facilitates
economic growth in that lower costs and enterprise risks promote the production of goods and services as well as employment. In this way the financial system contributes to increased prosperity.
Relation of the stock market to the modern financial system
The financial system in most western countries has undergone a remarkable transformation. One feature of this development is
disintermediation. A portion of the funds involved in saving and financing flows directly to the financial markets instead of being routed via banks' traditional lending and deposit operations. The general public's heightened interest in investing in the stock market, either directly or through
mutual funds, has been an important component of this process.
Statistics show that in recent decades shares have made up an increasingly large proportion of households' financial assets in many countries. In the 1970s, in
Sweden,
deposit accounts and other very liquid assets with little risk made up almost 60 per cent of households' financial wealth, compared to less than 20 per cent in the 2000s. The major part of this adjustment in
financial portfolios has gone directly to shares but a good deal now takes the form of various kinds of institutional investment for groups of individuals, for example, pension funds, mutual funds, hedge funds, insurance investment of premiums, etc. The trend towards forms of saving with a higher risk has been accentuated by new rules for most funds and insurance, permitting a higher proportion of shares to bonds. Similar tendencies are to be found in other
industrialized countries. In all developed economic systems, such as the
European Union, the
United States,
Japan and other developed nations, the trend has been the same: saving has moved away from traditional (government insured) bank deposits to more risky securities of one sort or another.
The stock market, individual investors, and financial risk
Riskier long-term saving requires that an individual possess the ability to manage the associated increased risks. Stock prices fluctuate widely, in marked contrast to the stability of (government insured) bank deposits or bonds. This is something that could affect not only the individual investor or household, but also the economy on a large scale. The following deals with some of the risks of the financial sector in general and the stock market in particular. This is certainly more important now that so many newcomers have entered the stock market, or have acquired other 'risky' investments (such as 'investment' property, for example, real estate and
collectables).
With each passing year, the noise level in the stock market rises. Television commentators, financial writers, analysts, and market strategists are all overtalking each other to get investors' attention. At the same time, individual investors, immersed in chat rooms and message boards, are exchanging questionable and often misleading tips. Yet, despite all this available information, investors find it increasingly difficult to profit. Stock prices skyrocket with little reason, then plummet just as quickly, and people who have turned to investing for their children's education and their own retirement become frightened. Sometimes there appears to be no rhyme or reason to the market, only folly.
This is a quote from the preface to a published biography about the long-term value-oriented
stock investor Warren Buffett. Buffett began his career with $100, and $105,000 from seven limited partners consisting of Buffett's family and friends. Over the years he's built himself a multi-billion-dollar fortune. The quote illustrates some of what has been happening in the stock market during the end of the 20th century and the beginning of the 21st.
The behavior of the stock market
From experience we know that investors may temporarily pull financial prices away from their long term trend level. Over-reactions may occur—so that excessive optimism (euphoria) may drive prices unduly high or excessive pessimism may drive prices unduly low. New theoretical and empirical arguments have been put forward against the notion that financial markets are efficient.
According to the
efficient market hypothesis (EMH), only changes in fundamental factors, such as profits or dividends, ought to affect share prices. (But this largely theoretic academic viewpoint also predicts that little or no trading should take place—contrary to fact—since prices are already at or near equilibrium,
having priced in all public knowledge.) But the efficient-market hypothesis is sorely tested by such events as the
stock market crash in 1987, when the
Dow Jones index plummeted 22.6 percent—the largest-ever one-day fall in the United States. This event demonstrated that share prices can fall dramatically even though, to this day, it's impossible to fix a definite cause: a thorough search failed to detect
any specific or unexpected development that might account for the crash. It also seems to be the case more generally that many price movements are not occasioned by new information; a study of the fifty largest one-day share price movements in the United States in the post-war period confirms this. Moreover, while the EMH predicts that all price movement (in the absence of change in fundamental information) is random (for example, non-trending), many studies have shown a marked tendency for the stock market to trend over time periods of weeks or longer.
Various explanations for large price movements have been promulgated. For instance, some research has shown that changes in estimated risk, and the use of certain strategies, such as stop-loss limits and
Value at Risk limits, theoretically could cause financial markets to overreact.
Other research has shown that
psychological factors may result in exaggerated stock price movements. Psychological research has demonstrated that people are predisposed to 'seeing' patterns, and often will perceive a pattern in what is, in fact, just
noise. (Something like seeing familiar shapes in
clouds or
ink blots.) In the present context this means that a succession of good news items about a company may lead investors to overreact positively (unjustifiably driving the price up). A period of good returns also boosts the investor's self-confidence, reducing his (psychological) risk threshold.
Another phenomenon—also from psychology—that works against an objective assessment is
group thinking. As social animals, it isn't easy to stick to an opinion that differs markedly from that of a majority of the group. An example with which one may be familiar is the reluctance to enter a restaurant that's empty; people generally prefer to have their opinion validated by those of others in the group.
In one paper the authors draw an analogy 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 stress, however, the game becomes more like poker (herding behavior takes over). The players now must give heavy weight to the psychology of other investors and how they're likely to react psychologically.
The stock market, as any other business, is quite unforgiving of amateurs. Inexperienced investors rarely get the assistance and support they need. In the period running up to the recent
Nasdaq crash, less than 1 per cent of the analyst's recommendations had been to sell (and even during the 2000 - 2002 crash, the average didn't rise above 5%). The media amplified the general euphoria, with reports of rapidly rising share prices and the notion that large sums of money could be quickly earned in the so-called
new economy stock market. (And later amplified the gloom which descended during the 2000 - 2002 crash, so that by summer of 2002, predictions of a DOW average below 5000 were quite common.)
Irrational behavior
Sometimes the market tends to react irrationally to economic news, even if that news has no real effect on the technical value of securities itself. Therefore, the stock market can be swayed tremendously in either direction by press releases, rumors,
euphoria and
mass panic.
Over the short-term, stocks and other securities can be battered or buoyed by any number of fast market-changing events, making the stock market difficult to predict.
Crashes
A stock market crash is often defined as a sharp dip in
share prices of
equities listed on the
stock exchanges. In parallel with various
economic factors, a reason for stock market crashes is also due to panic. Often, stock market crashes end up with speculative economic bubbles.
There have been famous
stock market crashes that have ended in the loss of billions of dollars and wealth destruction on a massive scale. An increasing number of 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. There have been a number of famous stock market crashes like the
Wall Street Crash of 1929, the
stock market crash of 1973–4, the
Black Monday of 1987, the
Dot-com bubble of 2000. But those stock market crashes didn't begin in 1929, or 1987. They actually started years or months before the crash really hit hard.
One of the most famous stock market crashes started October 24, 1929 on Black Thursday. The
Dow Jones Industrial lost 50% during this stock market crash. It was the beginning of the
Great Depression. Another famous crash took place on October 19, 1987 – Black Monday. On Black Monday itself, the Dow Jones fell by 22.6% after completing a 5 year continuous rise in share prices. This event not only shook the USA, but quickly spread across the world. Thus, by the end of October, stock exchanges in Australia lost 41.8%, Canada lost 22.5%, Hong Kong lost 45.8% and Great Britain lost 26.4%. Names “Black Monday” and “Black Tuesday” are also used for October 28-29,1929, which followed Terrible Thursday – starting day of the stock market crash in 1929. The crash in 1987 raised some mysticism – main news or events didn't predict the catastrophe and visible reasons for the collapse were not identified. This event had put many important assumptions, of modern
economics, under uncertainty, namely, the
theory of rational conduct of human being, the
theory of market equilibrium and the
hypothesis of market efficiency. For some time after the crash, trading in stock exchanges worldwide was halted, since the exchange's computers didn't perform well owing to enormous quantity of trades being received at one time. This halt in trading allowed the
Federal Reserve system and central banks of other countries to take measures to control the spreading of worldwide financial crisis. In the United States the SEC introduced several new measures of control into the stock market in an attempt to prevent a re-occurrence of the events of Black Monday. Computer systems were upgraded in the stock exchanges to handle larger trading volumes in a more accurate and controlled manner. The SEC modified the margin requirements in an attempt to lower the volatility of common stocks, stock options and the futures market. The New York Stock Exchange and the Chicago Mercantile Exchange introduced the concept of a circuit breaker. The circuit breaker halts trading if the Dow declines a prescribed number of points for a prescribed amount of time.
Stock market index
The movements of the prices in a market or section of a market are captured in price indices called
stock market indices, of which there are many, for example, the
S&P, the
FTSE and the
Euronext indices. Such indices are usually
market capitalization (the total market value of
floating capital of the company) weighted, with the weights reflecting the contribution of the stock to the index. The constituents of the index are reviewed frequently to include/exclude stocks in order to reflect the changing business environment.
Derivative instruments
Financial innovation has brought many new financial instruments whose pay-offs or values depend on the prices of stocks. Some examples are
exchange-traded funds (ETFs),
stock index and
stock options,
equity swaps,
single-stock futures, and stock index
futures. These last two may be traded on
futures exchanges (which are distinct from stock exchanges—their history traces back to
commodities futures exchanges), or traded
over-the-counter. As all of these products are only
derived from stocks, they're sometimes considered to be traded in a (hypothetical)
derivatives market, rather than the (hypothetical) stock market.
Leveraged Strategies
Stock that a trader doesn't actually own may be traded using
short selling;
margin buying may be used to purchase stock with borrowed funds; or,
derivatives may be used to control large blocks of stocks for a much smaller amount of money than would be required by outright purchase or sale.
Short selling
In short selling, the trader borrows stock (usually 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, hoping for the price to fall. The trader eventually buys back the stock, making money if the price fell in the meantime or losing money if it rose. Exiting a short position by buying back the stock is called "covering a short position." This strategy may also be used by unscrupulous traders to artificially lower the price of a stock. Hence most markets either prevent short selling or place restrictions on when and how a short sale can occur. The practice of
naked shorting is illegal in most (but not all) stock markets.
Margin buying
» Main article: margin buying
In margin buying, the trader borrows money (at interest) to buy a stock and hopes for it to rise. Most industrialized countries have regulations that require that if the borrowing is based on collateral from other stocks the trader owns outright, it can be a maximum of a certain percentage of those other stocks' value. In the United States, the margin requirements have been 50% for many years (that is, if you want to make a $1000 investment, you need to put up $500, and there's often a maintenance margin below the $500). A margin call is made if the total value of the investor's account can't support the loss of the trade. (Upon a decline in the value of the margined securities additional funds may be required 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 protect its loan position. The investor is responsible for any shortfall following such forced sales.) Regulation of margin requirements (by the
Federal Reserve) was implemented after the
Crash of 1929. Before that, speculators typically only needed to put up as little as 10 percent (or even less) of the total investment represented by the stocks purchased. Other rules may include the prohibition of
free-riding: putting in an order to buy stocks without paying initially (there is normally 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 hasn't declined in the interim).
New issuance
Global issuance of equity and equity-related instruments totaled $505 billion in 2004, a 29.8% increase over the $389 billion raised in 2003.
Initial public offerings (IPOs) by US issuers increased 221% with 233 offerings that raised $45 billion, and IPOs in
Europe, Middle East and Africa (EMEA) increased by 333%, from $ 9 billion to $39 billion.
Investment strategies
One of the many things people always want to know about the stock market is, "How do I make money investing?" There are many different approaches; two basic methods are classified as either
fundamental analysis or
technical analysis.
Fundamental analysis refers to analyzing companies by their
financial statements found in
SEC Filings, business trends, general economic conditions, etc.
Technical analysis studies price actions in markets through the use of charts and quantitative techniques to attempt to forecast price trends regardless of the company's financial prospects. One example of a technical strategy is the
Trend following method, used by
John W. Henry and
Ed Seykota, which uses price patterns, utilizes strict money management and is also rooted in
risk control and
diversification.
Additionally, many choose to invest via the
index method. In this method, one holds a weighted or unweighted 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 aim of this strategy is to maximize diversification, minimize taxes from too frequent trading, and ride the general trend of the stock market (which, in the U.S., has averaged nearly 10%/year, compounded annually, since World War II).
Taxation
According to each national or state legislation, a large array of fiscal obligations must be respected regarding
capital gains, and taxes are charged by the state over the transactions, dividends and
capital gains on the stock market, in particular in the
stock exchanges. However, these fiscal obligations may vary from jurisdiction to jurisdiction because, among other reasons, it could be assumed that
taxation is already incorporated 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.
Further Information
Get more info on 'Equity Market'.
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