Stock Market

Capital markets in the United States provide the lifeblood of capitalism. Companies turn to them to raise funds needed to finance the building of factories, office buildings, airplanes, trains, ships, telephone lines, and other assets; to conduct research and development; and to support a host of other essential corporate activities. Much of the money comes from such major institutions as pension funds, insurance companies, banks, foundations, and colleges and universities. Increasingly, it comes from individuals as well. As noted in chapter 3, more than 40 percent of U.S. families owned common stock in the mid-1990s.
Very few investors would be willing to buy shares in a company unless they knew they could sell them later if they needed the funds for some other purpose. The stock market and other capital markets allow investors to buy and sell stocks continuously.
The markets play several other roles in the American economy as well. They are a source of income for investors. When stocks or other financial assets rise in value, investors become wealthier; often they spend some of this additional wealth, bolstering sales and promoting economic growth. Moreover, because investors buy and sell shares daily on the basis of their expectations for how profitable companies will be in the future, stock prices provide instant feedback to corporate executives about how investors judge their performance.
Stock values reflect investor reactions to government policy as well. If the government adopts policies that investors believe will hurt the economy and company profits, the market declines; if investors believe policies will help the economy, the market rises. Critics have sometimes suggested that American investors focus too much on short-term profits; often, these analysts say, companies or policy-makers are discouraged from taking steps that will prove beneficial in the long run because they may require short-term adjustments that will depress stock prices. Because the market reflects the sum of millions of decisions by millions of investors, there is no good way to test this theory.
In any event, Americans pride themselves on the efficiency of their stock market and other capital markets, which enable vast numbers of sellers and buyers to engage in millions of transactions each day. These markets owe their success in part to computers, but they also depend on tradition and trust -- the trust of one broker for another, and the trust of both in the good faith of the customers they represent to deliver securities after a sale or to pay for purchases. Occasionally, this trust is abused. But during the last half century, the federal government has played an increasingly important role in ensuring honest and equitable dealing. As a result, markets have thrived as continuing sources of investment funds that keep the economy growing and as devices for letting many Americans share in the nation's wealth.
To work effectively, markets require the free flow of information. Without it, investors cannot keep abreast of developments or gauge, to the best of their ability, the true value of stocks. Numerous sources of information enable investors to follow the fortunes of the market daily, hourly, or even minute-by-minute. Companies are required by law to issue quarterly earnings reports, more elaborate annual reports, and proxy statments to tell stockholders how they are doing. In addition, investors can read the market pages of daily newspapers to find out the price at which particular stocks were traded during the previous trading session. They can review a variety of indexes that measure the overall pace of market activity; the most notable of these is the Dow Jones Industrial Average (DJIA), which tracks 30 prominent stocks. Investors also can turn to magazines and newsletters devoted to analyzing particular stocks and markets. Certain cable television programs provide a constant flow of news about movements in stock prices. And now, investors can use the Internet to get up-to-the-minute information about individual stocks and even to arrange stock transactions.

There are thousands of stocks, but shares of the largest, best-known, and most actively traded corporations generally are listed on the New York Stock Exchange (NYSE). The exchange dates its origin back to 1792, when a group of stockbrokers gathered under a buttonwood tree on Wall Street in New York City to make some rules to govern stock buying and selling. By the late 1990s, the NYSE listed some 3,600 different stocks. The exchange has 1,366 members, or "seats," which are bought by brokerage houses at hefty prices and are used for buying and selling stocks for the public. Information travels electronically between brokerage offices and the exchange, which requires 200 miles (320 kilometers) of fiber-optic cable and 8,000 phone connections to handle quotes and orders.
How are stocks traded? Suppose a schoolteacher in California wants to take an ocean cruise. To finance the trip, she decides to sell 100 shares of stock she owns in General Motors Corporation. So she calls her broker and directs him to sell the shares at the best price he can get. At the same time, an engineer in Florida decides to use some of his savings to buy 100 GM shares, so he calls his broker and places a "buy" order for 100 shares at the market price. Both brokers wire their orders to the NYSE, where their representatives negotiate the transaction. All this can occur in less than a minute. In the end, the schoolteacher gets her cash and the engineer gets his stock, and both pay their brokers a commission. The transaction, like all others handled on the exchange, is carried out in public, and the results are sent electronically to every brokerage office in the nation.
Stock exchange "specialists" play a crucial role in the process, helping to keep an orderly market by deftly matching buy and sell orders. If necessary, specialists buy or sell stock themselves when there is a paucity of either buyers or sellers.
The smaller American Stock Exchange, which lists numerous energy industry-related stocks, operates in much the same way and is located in the same Wall Street area as the New York exchange. Other large U.S. cities host smaller, regional stock exchanges.
The largest number of different stocks and bonds traded are traded on the National Association of Securities Dealers Automated Quotation system, or Nasdaq. This so-called over-the-counter exchange, which handles trading in about 5,240 stocks, is not located in any one place; rather, it is an electronic communications network of stock and bond dealers. The National Association of Securities Dealers, which oversees the over-the-counter market, has the power to expel companies or dealers that it determines are dishonest or insolvent. Because many of the stocks traded in this market are from smaller and less stable companies, the Nasdaq is considered a riskier market than either of the major stock exchanges. But it offers many opportunities for investors. By the 1990s, many of the fastest growing high-technology stocks were traded on the Nasdaq.

During most of the 20th century, investors could earn more by investing in stocks than in other types of financial investments -- provided they were willing to hold stocks for the long term.
In the short term, stock prices can be quite volatile, and impatient investors who sell during periods of market decline easily can suffer losses. Peter Lynch, a renowned former manager of one of America's largest stock mutual funds, noted in 1998, for instance, that U.S. stocks had lost value in 20 of the previous 72 years. According to Lynch, investors had to wait 15 years after the stock market crash of 1929 to see their holdings regain their lost value. But people who held their stock 20 years or more never lost money. In an analysis prepared for the U.S. Congress, the federal government's General Accounting Office said that in the worst 20-year period since 1926, stock prices increased 3 percent. In the best two decades, they rose 17 percent. By contrast, 20-year bond returns, a common investment alternative to stocks, ranged between 1 percent and 10 percent.
Economists conclude from analyses like these that small investors fare best if they can put their money into a diversified portfolio of stocks and hold them for the long term. But some investors are willing to take risks in hopes of realizing bigger gains in the short term. And they have devised a number of strategies for doing this.
Buying on Margin. Americans buy many things on credit, and stocks are no exception. Investors who qualify can buy "on margin," making a stock purchase by paying 50 percent down and getting a loan from their brokers for the remainder. If the price of stock bought on margin rises, these investors can sell the stock, repay their brokers the borrowed amount plus interest and commissions, and still make a profit. If the price goes down, however, brokers issue "margin calls," forcing the investors to pay additional money into their accounts so that their loans still equal no more than half of the value of the stock. If an owner cannot produce cash, the broker can sell some of the stock -- at the investor's loss -- to cover the debt.
Buying stock on margin is one kind of leveraged trading. It gives speculators -- traders willing to gamble on high-risk situations -- a chance to buy more shares. If their investment decisions are correct, speculators can make a greater profit, but if they are misjudge the market, they can suffer bigger losses.
The Federal Reserve Board (frequently called"the Fed"), the U.S. government's central bank, sets the minimum margin requirements specifying how much cash investors must put down when they buy stock. The Fed can vary margins. If it wishes to stimulate the market, it can set low margins. If it sees a need to curb speculative enthusiasm, it sets high margins. In some years, the Fed has required a full 100 percent payment, but for much of the time during the last decades of the 20th century, it left the margin rate at 50 percent.
Selling Short. Another group of speculators are known as "short sellers." They expect the price of a particular stock to fall, so they sell shares borrowed from their broker, hoping to profit by replacing the stocks later with shares purchased on the open market at a lower price. While this approach offers an opportunity for gains in a bear market, it is one of the riskiest ways to trade stocks. If a short seller guesses wrong, the price of stock he or she has sold short may rise sharply, hitting the investor with large losses.
Options. Another way to leverage a relatively small outlay of cash is to buy "call" options to purchase a particular stock later at close to its current price. If the market price rises, the trader can exercise the option, making a big profit by then selling the shares at the higher market price (alternatively, the trader can sell the option itself, which will have risen in value as the price of the underlying stock has gone up). An option to sell stock, called a "put" option, works in the opposite direction, committing the trader to sell a particular stock later at close to its current price. Much like short selling, put options enable traders to profit from a declining market. But investors also can lose a lot of money if stock prices do not move as they hope.