ASSIGNMENT WRITING HELP ON IF YOU DO YOU THINK THAT CRISIS AFFECTS THE STOCK MARKET

[Do you think that crisis affects the stock market?]

Introduction to Stocks

            Stock refers to the shares of a company that represents its value. During the initiation of a company, sometimes it is impossible for the parties involved to raise enough money for capital. At that point, the proprietors have an option of either debt financing or equity financing. Debt financing involves taking loan a loan from the bank for use as capital. In as much as it is reliable and convenient, there is the aspect of paying it back with interest. The interest is usually high especially for a company that is in its beginning stage. Therefore, most companies prefer making an Initial Public Offer (IPO) for their shares. As long as investors can foresee great prospects for the company in the future, they buy the shares at a low price. In doing so, as the company is established and earning large profits, they earn dividends from its profits. They can also sell their shares at higher prices resulting to double or triple of the value they initially invested in the company as revenue.

            There are three advantages of equity financing over debt financing. First, there is neither payback nor interest to be paid. Secondly, companies receive profits accruing from their involvement in the stocks market. This profit is for expansion of shareholders wealth. Thirdly, equity financing enables a firm to distribute its risks over a wide portfolio. This way stockholders share the liabilities of the company in case the company liquidates or gets losses. The trading of stocks also gives companies a platform to invest any monies that lie idle. For instance, banks, insurance companies, pension schemes, housing finance institutions and development institutions invest monies in stocks among other investments in their portfolio. Stocks are therefore a fundamental aspect of every economy, both locally and internationally.

Stock Markets

            Stock markets, called stock exchanges in other instances, refer to the existing platforms where the buying and selling of shares occur. There are both physical locations and online sites for this exercise. Some of the commonly known stock exchanges are the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), London Stock Exchange, Hong Kong Stock Exchange, and National Association of Securities Dealers (NASDAQ), among others. There are two divisions of the stock market: primary and secondary markets. Primary markets are the IPOs while the secondary markets are the share trades that occur among existing shares of companies.

            Buying and selling of shares usually occurs through brokers. When one wants to buy some shares, they notify their broker who in turn liaises with the firm’s clerk at the stock exchanges. The clerk alerts the floor trader of the request to buy shares of the company. The floor trader goes to the spot where the company’s buyers and sellers are. He gets a seller and after agreeing on the price buys the shares and alerts the firm and the broker on the purchase. The broker then informs the individual or corporate buyer on the successful purchase. This is how the stocks markets work. It is important to note that the stock prices fluctuate from time to time due to several reasons. The supply demand theory which states, “high demand for goods leads to high pricing” applies in the stocks market. Whenever there are more people interested in buying shares of a particular company, say Samsung, then its share price goes up. However, when more people sell shares of a company, the share price decreases. The share price of a company is also dependent on its earnings and both local and international competition.

Factors that affect Stock Market Pricing

Growth expectations – Economies grow at different rates; while others grow faster like China, others grow steadily. It is important to realize that a high GDP does not necessary mean that the stocks are doing well in those economies. In fact, due to the rise of the inflation index, the stock markets would slump. As such, stock markets placed in steadily growing economies do much better. Therefore, expectations of growth affect stock prices.

Valuation – Studying the pattern of price per earnings of companies gives an investor a rough idea of how the future earnings of the company is likely to look like. Such information is good for making decisions on when best to either buy or sell share of the company. Anticipation for a higher value of earnings leads to share price increases as many people rush to buy shares while the price is still low.

Central Bank activity– Central banks are the financial controllers of the economies in every state. All the decisions that they make and all the actions taken by them directly affects the stock markets both locally and internationally. In case of extremely high economic growth, the stock prices markets are negatively affected. The central bank usually increases interest rates to minimize the effects of inflation.[1]

Overseas market– The results of stock exchange day in London will definitely affect the way NYSE’s trade will turn out. A bad stocks day in London translates to a bad day in the New York too. This is due to the complexities of the stock markets system that relies mostly on information.

Futures data– A positive futures data of a company attracts more investors to it. This is because the assurances of a handsome return in the long term.  

Midday trading lull– Trade at the stock exchanges become stagnant at noon as the media houses get involved in disseminating information to the public. If this period is not checked, it may result to a crisis.

The media and web-articles – Information is fundamental in the stock markets; even a rumor can cause such a huge effect on the stock prices of a company. This means that the information passed on to the public by the media houses is paramount. Positive news leads to positive effects, while negative news negatively affects the companies. If for instance in a news cast it is revealed that Microsoft is yet to launch a project worth trillions of dollars, then people will want to buy stocks from Microsoft at a low price. Then they will wait for the price to increase due to the earnings of the project and sell the shares at a high price.[2]

The effect of the stock markets on the ordinary persons

            The stock markets are not just a game of the rich. They have a direct link to the citizens of every nation and to nations worldwide. The risks and gains brought by the stock markets influence lives of ordinary persons. One of the ways it affects them is through pension funds. Whenever business is at its peak at the stocks market, pension funds invested therein earn high profits. However, when the stocks are low priced to due internal and external factors, the pensions’ earnings are low. Low earnings results to low pension pay to the people when they retire. Great earnings result to higher pension pays to the retirees.[3]

            Another effect of stocks is on the growth of businesses. Profitable businesses provide employment for suppliers, administrators, financiers, and many people. Although most businesses get funding from banks, the stock markets are also an avenue that provides additional revenue for their expansion. A robust stock exchange market results in higher earnings per share, hence higher business profits. Consequently, there are more job opportunities and higher dividends. This helps in assisting ordinary people to earn a living.

The Efficient Market Hypothesis

            In as much as there are so many factors that influence the price of shares, the stock markets have a very efficient system. The stock prices have a way of incorporation all these factors such that there are no issues such as undervalued or overvalued stocks. This theory has its explanation in efficient Market Hypothesis Model. The random and unpredictable nature of the stock markets determines its efficiency. The proposers of this model argue that information reaches all investors at the same time. Therefore, no one can take advantage of the other in the market. They say no one can “beat the market” and that the riskier an investment, the more earnings one receives. In as much as this is mostly true, it is not a hundred percent true. There have been instances such as the Wall Street Crash that occurred in 1929 that revealed the inefficiency of the stock markets. Furthermore, information reaches some people before it reaches the others. It is also impractical that people will make rational decisions always. Sometimes human errors occur which may be detrimental to the whole system.

Crisis

A crisis is an “unstable condition, in political, social, economic, or military affairs, which involves an impending abrupt change” (The Merriam Webster Dictionary). A crisis may range from a simple water crisis to an international aircraft crash. Some of the events that have occurred recently and could have had an impact on the stock market are the Malaysian Airline crash, flight Air Asia saga, the extreme fluctuation of the value of the euro and terrorist attacks among others. The ISIS operations in Asia could also have an impact in their stocks. See appendix for a table that shows other crises that have occurred in the past.

All these events had negative effects on the stock markets, except the Cuban missile crisis, Iraq war, Lehmann brothers collapse, and Taper tantrum. The table shows us that on one hand, the stock markets can survive in the midst of crisis. On the other hand, the table indicates that in most instances, crisis negatively affects the stock markets. The Wall Street Market crash is still one of the worst disasters that have ever occurred in history.

            The table shows that very clearly, as the effect is a loss of 43.7%. Based on these statistics and on the Efficient Market Hypothesis, a strong support for the argument that crisis affects the performance of stocks on the trading floors will be developed in this paper. A report of an air crash for instance leads to a worldwide shock and uncertainty. Airlines like Malaysia end up collapsing due to lack of investors. Few people would want to invest in such a business because of immense uncertainty looming. In demonstrating the effects of crisis on the stock market, the Wall Street Market Crash case study will be assessed.

The Wall Street Market Crash (1929)

            One of the most destructive crises that ever occurred in the world was the Wall Street Market crash. It happened on the October 29, 1929, a Tuesday that was nick named “Black Tuesday” as it was the fateful day that the stock market crashed. In the figure below, a graph shows how the Dow Jones Average kept rising steadily until the day when there was a fall because of the crash. The crash may have partly caused the Great Depression that occurred the following year: 1930.

Several scholars, economists, and analysts came up with different causes of the market crash. Some of them were as listed hereafter:-

  1. The increase in loan offers by banks and other credit facilities – Since the economy was booming with business, and firms were making huge profits, people believed it was the best time to invest in shares. Share prices steadily rose and investors decided that they did not have more time to spare. They rushed into banks and other credit facilities to take loans to invest in shares. More and more people invested in shares and the credit value piled up to a point when it even exceeded the money supply in the economy. It is at this point that warnings started on the possibility of a market crash.
  2. Purchasing share on debt

The norm in purchasing shares was through cash and not credit. However, during this period of escalation of economic activity, share traders began selling shares on credit. They only required the investors to pay only a fifth of the total value of shares bought. This act increased the large amount of credit that already existed.

  • Over speculation

It is agreeable that the economy was doing well, however the people should have allowed the market to direct share prices. However, firms showed signs of making more profits that would lead to higher values of their shares. Therefore, people rushed to buy more shares to secure more earnings in the future.

  • A huge disconnect between production and consumption. Another cause of the crash was the large gap that existed between the levels of production and the consumption levels. The consumption levels dropped due to a drop in the level of income of the people. Companies lay off and yet others received less income than usual due to the crisis. The net effect of this is that the income levels became much lower.
  • Agricultural recession – At the time that the crash happened, the agricultural sector was already facing recession. The sector’s businesses earned low profits that were not even enough to expand the businesses. Investors neglected the agricultural sector and instead shifted their attention to the stock markets resulting to the investors to losses in both agriculture and the stocks market.
  • Weaknesses in the banking system – At the time when the crisis happened, the banking system was still unstable. As much as they were giving loans, they should have also had a reserve for the normal bank operations. Unfortunately, because they lacked a central system to hold them accountable, banks lent out most of its money leading to about 5,000 banks going bankrupt.

            The effect of these actions that were taking place in the market led to the Wall Street Market Crash. The prices of shares went so high until they could not be valued any more.

The effects of the Wall Street Market Crash

Huge loss of money initially invested in the stocks – All loans invested in the stock markets were lost in the crash. The loss was to the tune of trillions of US dollars. This was a great blow to the US economy; it literally crippled it.

Lack of startup capital for businesses–The crash led to lack of capital to start businesses or for expansion of existing businesses. Therefore, business became stagnant in their growth and had to make do with the little cash that they had to take care of their expenses.[4]

Downsizing of businesses leading to firing of some workers–Business enterprises reduced the number of their employees to help them minimize costs. This led to many people losing their jobs and other workers paid low wages.

Decreased level of consumption– The level of income for most individuals, whether rich or poor, reduced significantly. As a result, people consumed less than they used to. Manufacturing companies had to lower their production levels. Consequently, the cost of production went high due to lack of the application of the economies of scale.

Business closures and bankruptcies– While other businesses considered downsizing, others closed down. Many other businesses went bankrupt, as their funds were lost in the crash.

The failure of banks– Banks has a duty to be a business partner to all businesses. They have the obligation of keeping funds safely and providing funds whenever required by individuals and corporates. The banks shield the economy from crisis such as the Wall Street crash. However, the US banks failed in their mandate. They also became victims of the catastrophe.

The Great Depression–The crash became a foundation upon which the Great Depression of 1930 took place.

Negative impact on other economies such as Germany– The famous German leader, Adolf Hitler, rose up at this time of the crash. This was because the US recalled its loan fund to Germany to jumpstart its economy. Germany struggled economically and needed a leader to take them through the hard economic times and revive its economy. Adolf Hitler successfully brought the German economy back to its feet.

Conclusion

            The stock market is highly volatile and unpredictable at the same time (Manda 2010).[5] Most people ignore the impact that it has on their daily lives. The stock markets directly or indirectly affect the education, agricultural, industrial, political, health, and development sectors of every nation. Their operations should be accessible to all individuals and its impact on economic activities explained to them. This information will then guide decisions made by these people. The prices of stocks keep fluctuating; however, wise investors should not make selling decisions based on these movements. They should watch the trend of prices for a relatively longtime. They should avoid investing in growth stocks, instead, their focus should be on the shares of established, steadily growing firms such as Coca- Cola, Wal-Mart and Apple. Crisis affects the stock markets in very adverse ways as seen in the case of the Wall Street Crash that occurred in the US in the year 1929. Therefore, as scholars give investors confidence on the efficiency of the stock markets through the EMH model and the Random Walk Theory, governments should shields their markets against such occurrences.

            Crisis affects the stock market by bringing fear and uncertainty. These two factors negatively influence the share prices. Statistics show that when investors are uncertain about the state of a company, most of them will sell their shares, reducing the share value of the company. Fear of closure, bankruptcy and war all lead to people selling their shares and investing them in countries or sectors that are more promising. Crisis also affects the stock market by causing an imbalance in the share pricing. They prices could be either overvalued or undervalued. These two extremes do not reflect the actual state of the market. Crisis also drives away investors from the affected markets to markets that are doing better. Crisis has an effect on the stock exchanges called a “market spike.” This leads to low stock exchange indices that are unfavorable for investors. Crisis has a direct effect on the value of world currencies that affects export and import activities of investors (Commonwealth Financial Network 2008).[6]

            Most people believe that crisis only affects the stock markets negatively. This phenomenon does not apply to all occurrences. It is interesting to note that sometimes the stock markets remain strong during crisis. An example of such an incidence is the recent Malaysian aircraft crash. The stock markets were stable during the event and there were no losses. Additionally, in Egypt during a political talk that took place in Al-Azhar that brought together rival political parties, the stock markets gained approximately US $417. This proves that if there are good measures in place to monitor the stock markets, they can be stable during crisis.

Financial experts need to be alert today more than those that existed in the year 1929 when the market crash occurred.

            Crises such as inter-community conflicts, border conflicts, aircraft crashes, bombings, unpredictable weather conditions, rise of gangs that strike anywhere and diseases like Ebola occur more today than any other time in history. Going by the discussions held in this paper, the stock markets may not escape the negative effects. Prevention strategies should be in the pipeline for every country and every stock exchange markets. Then the stability of the markets will lead to more stable economies. The people will be able to earn their living, as they will have access to income. Manufacturing companies will in turn produce goods enough to meet the demand on economies of scale, hence reducing the costs of production. Business enterprises will keep expanding due to access to funds from banks and the stock markets. They will have great profits shared with the shareholders in form of dividends. Nations will then have robust economies seen through their steady GDP growth. These are the results of steady and stable stock markets. They are unaffected by the uncertainties of crises. Instead, they have strong systems that shield them from the negative effects of crises.

Tables and figures

Tabel 1 Crisis events

Source: The Wall Street Journal

Figure 1: Wall Street Crash measured by the Dow Jones Industrial Average

http://upload.wikimedia.org/wikipedia/commons/thumb/c/c5/1929_wall_street_crash_graph.svg/400px-1929_wall_street_crash_graph.svg.png

References

Baden Ben, “5 Factors that drive stock prices,” Money: US News and World Report, July 14, 2011, accessed March 1 2015 http://money.usnews.com/money/personal-finance/mutual-funds/articles/2011/07/14/5-factors-that-drive-stock-prices

Commonwealth Financial Network, What’s Stock market volatility? Commonwealth Financial Network, 2008 accessed 1 March 2015 http://www.commonwealth.com/RepSiteContent/stock_volatility.htm

Curtis Glen, “Eight factors that influence daily trading,” Forbes, August 29, 2007, accessed March 1 2015 http://www.forbes.com/2007/08/29/market-timing-djia-pf-education-in_gc_0829investopedia_inl.html

Higgins Michelle Perry, “How crisis affect the stock market,” The Wall Street Journal, December 11, 2014 accessed March 1 2015 http://blogs.wsj.com/experts/2014/12/11/how-crises-affect-the-stock-market/

Manda Kiran, Stock Market Volatility during the 2008 Financial Crisis, New York: New York University, 2010 accessed 1 March 2015 http://www.forbes.com/2007/08/29/market-timing-djia-pf-education-in_gc_0829investopedia_inl.html

Pettinger Tejvan, “How does the stock market affect the economy?” Economics, September 2, 2013, accessed March 1 2015 http://www.economicshelp.org/blog/221/stock-market/how-does-the-stock-market-effect-the-economy-2/


[1] Baden Ben, “5 Factors that drive stock prices,” Money: US News and World Report, July 14, 2011, accessed March 1 2015

[2] Curtis Glen, “Eight factors that influence daily trading,” Forbes, August 29, 2007, accessed March 1 2015

[3] Pettinger T, “How does the stock market affect the economy?” Economics, September 2, 2013, accessed March 1 2015

[4] Higgins Michelle Perry, “How crisis affect the stock market,” The Wall Street Journal, December 11, 2014 accessed March 1 2015 http://blogs.wsj.com/experts/2014/12/11/how-crises-affect-the-stock-market/

[5] Manda Kiran, Stock Market Volatility during the 2008 Financial Crisis (New York: New York University, 2010)

[6] Commonwealth Financial Network, What’s Stock market volatility? Commonwealth Financial Network, 2008 accessed 1 March 2015 http://www.commonwealth.com/RepSiteContent/stock_volatility.htm