Equity Markets, Valuation, and Analysis. H. Kent Baker
services purchased by or on the behalf of U.S. residents.
Source: U.S. Bureau of Economic Analysis (2019b).
FIGURE 3.4 Corporate Profits versus Standard & Poor's 500 Index
This figure shows the relation between aggregate corporate profits and stock market as shown by S&P 500 Index level between 2010 and 2019.
Source: U.S. Bureau of Economic Analysis (2019a).
Economic improvement or trouble is accompanied by corporate securities issues increasing in good economic periods and decreasing when the economy faces a downturn. Business firms turn to the economy and the market for an indication as to whether they should increase production and require additional capital funding. Figure 3.6 provides insight into the relation between stock market capitalization and the economy, as evidenced by gross domestic product (GDP). Between 2012 and 2019, capitalization or firm value improved in line with the related improvements in the economic conditions in the United States, as shown in GDP.
FIGURE 3.5 Government Revenues
This figure shows aggregate government revenues between 2011 and 2019.
Source: International Monetary Fund (2019).
FIGURE 3.6 Stock Market Capitalization to GDP
This figure shows the ratio of stock market capitalization to GDP between 2009 and 2017.
Note: Data are defined as the total value of all listed shares in a stock market as a percentage of GDP.
Source: World Bank, Stock Market Capitalization to GDP for United States [DDDM01USA156NWDB] (2019).
MARKET INDICATORS
Many market indicators for the economy, including market indices, are available. A market index is a hypothetical portfolio of investment holdings representing a segment of the stock market. The change in the value of this portfolio can serve as an indicator of market movement. Calculating the index return involves summing the products of individual index component returns and weights.
Different index-weighting schemes are based on factors such as market capitalization (market-cap) and price. Two popular stock indices for tracking the performance of the U.S. market are the Dow Jones Industrial Average (DJIA) and the Standard & Poor's 500 Index (S&P 500).
FIGURE 3.7 Dow Jones Industrial Average
This figure shows the Dow Jones Industrial Average index level between 2010 and 2019.
Source: S&P Dow Jones Indices LLC (2019b).
DJIA. The DJIA is one of the oldest, most famous, and most frequently used indices in the world. It measures the stock performance of 30 large companies listed on U.S. stock exchanges. These companies are mature companies traditionally paying dividends over time. The DJIA represents about 25 percent of the total value of the U.S. stock market. Figure 3.7 shows the trendline of the DJIA between the first quarter (Q1) of 2010 and Q1 of 2019.
S&P 500 Index. Another market indicator is the S&P 500 Index, which is an index of 500 of the largest companies in the U.S. market. Stocks are selected for this index mainly based on company size, which is measured by market capitalization, along with other factors such as public float (i.e., the number of a firm's shares available for trading in the market), financial stability, and the firm's historical record. The S&P 500 Index represents about 80 percent of the total value of the U.S. stock market, so it widely serves as an indication of the stock market and economy as a whole. Figure 3.8 illustrates the S&P 500's movement between Q1 2010 and Q1 2019.
GOOD MARKETS – LIQUIDITY
Liquidity and marketability are often used interchangeably. Although related, the two market characteristics differ. Liquidity refers to the speed with which an asset can be converted into cash without a loss of value. Marketability refers to the level of ease or the ability of buyers or sellers of a security to create and complete a transaction.
Generally speaking, securities with better marketability are more liquid than those with poor marketability. As a result, they trade more often. This high level of trading activity implies that the change in value from trade to trade is generally minimal relative to the changes in value for illiquid securities. This feature is important to investors: Illiquidity essentially measures one type of cost related to stock trading and investing and is, therefore, a vital consideration for investors. Pastor and Stambaugh (2002a) show that stocks with higher sensitivity to liquidity have a higher required rate of return.
FIGURE 3.8 S&P 500 Index
This figure shows the S&P 500 Index level between 2010 and 2019.
Note: The S&P 500 is a gauge of the large-cap U.S. equities market. Since the S&P 500 is a price index and not a total return index, it does not contain dividends.
Source: S&P Dow Jones Indices (2019a).
Market participants can easily buy and sell marketable securities, but nonmarketable securities are more challenging to trade. The shares of a privately held company, for example, are more difficult to sell and thus less marketable than shares in a publicly held company because they do not trade in the public secondary market. The presence of an actively traded secondary market improves a security's marketability. In summary, securities with poor marketability are less liquid (illiquid) than those with better marketability because they trade less often, implying that changes in their values from trade to trade are generally larger relative to the changes in value for liquid securities.
GOOD MARKETS – EFFICIENCY
One characteristic of a good market is market efficiency, which is an important component of a capitalist system. For efficient capital markets to function smoothly in allocating financial resources, the prices of company stocks must be reasonable, if not perfect, indicators of firm value.
The root market efficiency question hinges on both the type and amount of information available. Specifically, the type of information defines the three forms of the hypothesis: weak, semi-strong, and strong. Studies identify various anomalies in efficient markets.
Weak Form Efficiency