Econ 2121 Note Chapter 3

Econ 2121 Note Chapter 3

Understanding Market Averages and Indexes NB 94-106

Studying the performance of market averages and indexes allow you to conveniently

1. Gauge general market conditions
2. Compare your portfolio’s performance to that of a large, diversified (market) portfolio
3. Study the market’s historical performance and use that as a guide to understand future market behavior

• Stock Market Averages and Indexes
• Bond Market Indicators
• Stock Market Averages and Indexes

• Averages: reflect the arithmetic average price behavior of a representative group of stocks at a given point in time.
• Indexes: measure the current price behavior of a representative group of stocks in relation to a base value set at an earlier point in time.

• Stock Market Averages and Indexes

• The Dow Jones Averages

• Dow Jones Industrial Average (DJIA): average made up of 30 stocks, most of which are issued by large, well-respected companies with long operating histories from industry sectors such as technology, transportation, banking, energy, healthcare, consumer products and many others.

• Price-weighted (stocks with higher prices get more weight than stocks with lower prices)
• Stock makeup can change due to a merger or bankruptcy as well as when Dow Jones believes the average does not reflect the broader market.

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• Stock Market Averages and Indexes

1. The Dow Jones Averages

1. Dow Jones Transportation Average: based on 20 stocks, including railroads, airlines, freight forwarders and mixed transportation companies
2. Dow Jones Utility Average: comprised of 15 public utility stocks
3. Dow Jones Composite Average: made up of 65 stocks, including 30 industrials, 20 transportations and 15 utilities
4. Dow Jones also publishes numerous indexes including:

1. U.S. Total Stock Market Index
2. Indexes for various sectors based on company size (e.g. large cap, mid cap, small cap) or industry.
3. Indexes that track global equities market, developed and emerging stock markets, and regional markets in Asia, Europe, the Americas, the Middle East, and Africa.

• Stock Market Averages and Indexes

1. Standard & Poor’s Indexes: Many investors feel they provide a more broad-based and representative measure of general market conditions than do the Dow averages.  They are widely used, frequently as a basis for estimating “market return”

1. S&P 500 Index: Common stock index comprising 500 large (but not necessarily the largest) companies

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• NOTE
  
  THE S& P and most other indices are market capitalization indices.
• They are based on market “cap”.   This is the price of a share x number of shares.
• Stock Market Averages and Indexes

• NYSE, NYSE MKT, and Nasdaq Indexes: each index reflects the movement of stocks listed on its exchange

• NYSE Composite Index: includes all stocks listed on the NYSE; behavior of index is normally similar to that of the DJIA and S&P 500 indexes.

• NYSE MKT Composite Index: reflects the price of all shares traded on the NYSE MKT Exchange; tends to move in the general direction, but not exactly as the S&P and NYSE indexes

• Nasdaq Stock Market Indexes: reflect Nasdaq stock market activity

• Composite Index: most comprehensive, calculated using 3,000 common stocks traded on the Nasdaq
• Nasdaq 100: includes 100 of the largest domestic and international nonfinancial companies listed on Nasdaq
• Biotech and Computer Indexes
• Movements of these indexes are often sharper than those of the other major indexes

• Stock Market Averages and Indexes

• Value Line Indexes: stock indexes constructed by equally weighting the price of each stock included to eliminate the bias of stocks with large total market values.

• Value Line Composite Index: includes nearly 1,700 stocks in the Value Line Investment Survey that are traded on the NYSE, NYSE MKT, and OTC markets.

• Other Averages and Indexes

• Frank Russell Company (pension advisory firm) publishes three primary indexes:

• Russell 1000: 1,000 largest companies
• Russell 2000: 2,000 small to medium-sized companies
• Russell 3000: 3,000 companies in the Russell 1000 and 2000

• Wall Street Journal publishes a number of global and foreign stock market indexes:

• World Index
• Europe/Australia/Far East (EAFE MSCI) Index

• Bond Market Indicators

• Bond Yields

• Bond yield: the return an investor would receive on a bond if it were purchased and held to maturity
• Reported as annual rates of return
• Reflects the interest payments an investor receives as well as gains or losses in the bond’s value from the date of purchase until it is redeemed

• Bond Indexes

• Dow Jones Corporate Bond Index: equal-weighted index of 96 U.S.-issued corporate bonds:

• 48 industrial
• 36 financial
• 12 utility

You need to understand how to make securities transactions based on the information you’ve used to locate attractive security investments.

• The Role of Stockbrokers
• Basic Types of Orders
• Online Transactions
• Transaction Costs
• Investor Protection: SIPC and Arbitration
• The Role of Stockbrokers

• Stockbrokers: (also called account executives, investment executives, and financial consultants) act as intermediaries between buyers and sellers of securities

• Must be licensed by both the SEC and the securities exchanges where they place orders

• Client places order with stockbroker. Stockbroker works for a brokerage firm that maintains memberships on the securities exchanges, and members of the securities exchange execute orders that the brokers in the firm’s various sales offices transmit to them
• For transactions in markets such as Nasdaq, brokerage firms typically transmit orders to market makers; these transactions are executed rapidly due to competition among dealers  → OTC

• The Role of Stockbrokers

• Brokerage Services

• Primary service is to execute clients’ purchase and sale transactions at the best possible price
• Client’s security certificates are typically held in street name

• Street name: stock certificates issued in brokerage firm’s name, but held in trust for the client who actually owns them

• Research information is often provided on specific stocks or economic conditions
• Statements showing detailed account transactions are provided

• The Role of Stockbrokers

• Types of Brokerage Firms

• Full-Service Broker: offers an investor a full array of brokerage services such as providing investment advice and information, holding securities in street name, offering online brokerage services and extending margin loans
• Premium Discount Broker: focus primarily on making transactions for customers.

• Charge low commissions
• Limited free research information and investment advice

• Basic Discount Broker: typically deep-discount brokers through whom investors can execute trades electronically online via a commercial service, on the Internet, or by phone.

• The Role of Stockbrokers

• Opening an Account

• Single or Joint

• Joint accounts are most common between a husband and wife or parent and child
• Custodial account: brokerage account of a minor that requires a parent or guardian to be involved in all transactions

• Cash or Margin

• Cash account: brokerage account where customer can make only cash transactions
• Margin account: brokerage account in which brokerage firm extends borrowing privileges to a creditworthy customer

• Wrap account: account that allows brokerage customers with large portfolios to shift stock selection decisions to a professional money manager, in return for a flat annual fee

• The Role of Stockbrokers

• Odd-Lot and Round-Lot Transactions

• Odd lot: order consists of less than 100 shares of stock
• Round lot: orders for a 100-share unit or multiples thereof

• Basic Types of Orders

• Market Order:

• Orders to buy or sell stock at the best price available at the time the order is placed
• Quickest way to fill order

• Limit Order:

• Order to buy at or below a specified price (limit buy order) or to sell at or above a specified price (limit sell order)

• Fill-or-Kill: order cancelled if not immediately filled
• Day Order: order expires at the end of the day if not filled
• Good-’til-Canceled (GTC) Order:  Order remains in effect for six months unless executed, canceled, or renewed

• Basic Types of Orders

• Stop-Loss Order:

• “Suspended order” placed to sell a stock if the price reaches or falls below a specified level
• Orders can be day orders or GTC orders
• Once activated, becomes a market order
• Used to protect against adverse effects of a rapid decline in share price
• Can also use stop orders to buy stocks, such as to limit risk on short sales
• Stop-Limit Order: order to buy or sell stock at a given or better price once a stipulated stop price has been met

• Prevents sales at an undesirable price
• No sale may occur if price continues to decline