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[music playing]
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There is an interesting two-way relationship between financial markets and the macroeconomy. Investors in financial markets rely a lot on having early access to good information about macroeconomic variables like interest rates, inflation, GDP, and unemployment. The never-ending search for good information results in macroeconomic variables having large impacts on financial market outcomes. In the other direction, financial markets play a vital
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role in allocating capital to productive activities in the economy. Turmoil in financial markets can therefore lead to substantial negative shocks for the macroeconomy. Why do people buy shares of stock? A share of stock is a claim on the ownership of a firm. Typically, the owner of a group of shares, also known as a shareholder in the company, owns a portion of the firm that is equivalent to her stake divided by the number of total shares issued by the company.
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Shareholders are therefore entitled to vote at company meetings and decide who should run the company. The extent of one's clout within the firm is proportional to the number of shares one holds. So, for example, Microsoft has 8.6 billion shares, of which Bill Gates owns 600 million. If I own 100 shares of Microsoft, then I can cast 100 votes for various issues at shareholder meetings, but Mr. Gates can cast 600 million votes. So he has somewhat more of a say in how Microsoft is run.
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There are exceptions in that some companies issue shares that either carry less voting rights or more voting rights than other shares━but these are not the norm, so it's okay to think about shares as proportional ownership stakes. Given how much of a stake Mr. Gates has, it is probably safe to say that most ordinary people probably do not buy Microsoft shares expecting to have much of a voice in how Microsoft is run. So what else do shareholders get from being a shareholder?
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A key source of income comes in the form of dividend payments━these are a portion of corporate profits that are paid out by the company to shareholders. Profits not paid out as dividends are reinvested in the company to develop new products, to buy more capital, to hire more workers, etc. The other source of income comes in the form of a capital gain━which is a rise in the value of the shares of the firm that you own━because other investors are
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willing to pay a higher price to stake their own claim to owning a piece of the company. So, how does one make money on the stock market? The answer is deceptively easy: buy low and sell high. But how much should one pay for a share of stock in a company? Let's think about an investor who wants to buy a share of stock, hold it for one period (could be a year, a month, or a week), and then sell it. This investor's decision is going to depend on three things:
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the price of the stock when she pays for it now, the price she expects to be able to sell it for next period, and the dividend payments she expects to receive on the share of stock. She will be paying a price P of (t) and earning a dividend d of (t plus 1) and a sale price of P of (t plus 1). There are four key concepts to keep in mind about how to price a share of stock. First, and most importantly, our expectation about the dividend and stock price for the next period depends on the
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information we have today. A lot of what goes into the price of a stock represents people's expectations about the future, and those expectations (by definition) can only be formed on the basis of what we know today. Second, since the dividend and sale price are obtained next period rather than this period, we need to discount those gains relative to the price we pay today. What discount rate should we use? In a previous lecture we talked about using the nominal interest
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rate to discount future dollars into current dollars, but here the discount rate should be higher than the nominal interest rate. A dollar in an FDIC-insured bank account next period can be discounted at the nominal interest rate, but since any gains from the stock market are uncertain, a promised dollar from stock returns next period should be discounted more heavily than a promised dollar from your bank account. Third, the discount rate depends on how the stock price varies
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with the state of the macroeconomy. Asset pricing theory says that we should discount stocks that are pro-cyclical (that is, stocks that pay high dividends and capital gains in good times and low dividends and capital gains in bad times) more than we discount stocks that are countercyclical (that is, they pay high dividends and capital gains in bad times and low dividends and capital gains in good times). To put it another way, we should value stocks that provide gains
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in bad times more than we value stocks that pay gains in good times. Fourth, we need to keep in mind that stocks do not have to pay dividends at all. Many newly formed companies will often forego paying dividends since they are focused on growth. Hence, any profits they make (and sometimes it may take years before a new company makes any profits at all) will be reinvested into growing the business. In that case, people will be buying stocks simply for the
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capital gain━the difference between the selling price and the buying price━and there is no guarantee that you can sell the stock for a higher price than you bought it for. You can win big or lose big in the stock market. How do we know whether a particular share is going to increase or decrease in value? We need information about what the company's future prospects are. You have to buy stocks of companies whose profits will grow over time and thus whose shares will be desirable to many
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investors in the future. The key to doing this is information━we have to find good information about companies and their prospects, and we have to ideally find this information out before anyone else does. The key difference between the stock market and, say, the market for oranges comes from the role that information plays. In the stock market, both buyers and sellers have similar profiles, by which I mean that any particular individual or
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bank or investment firm could be a buyer or a seller at a point in time. So, good news about a company means lots of prospective buyers but few sellers, and bad news means lots of prospective sellers but few buyers. This creates fluctuations in excess demand and supply that exceed conventional goods markets and make stock markets very volatile. As an illustrative example, consider the share price of the online marketplace and e-commerce company Etsy over a period of five years.
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Stock price decreases of 50 percent to 75 percent were interspersed with periods where the stock price rose by 100 percent. Between 2020 and 2022, Etsy shares doubled in price, but that was after a 75 percent drop in the share price just in 2022, so dramatic was the run-up in 2021. But even more, this volatility creates an insatiable demand for information. As a result, the stock market becomes one of the world's most amazing repositories of information and news.
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Every day, many thousands of people look at millions of pieces of information in order to determine whether they should buy or sell certain stocks. In order to really make money in a consistent fashion, then, we need to have access to as much information as quickly as possible. Because information is so valuable in the stock market, the Nobel Prize-winning economist Eugene Fama defined the stock market as being "informationally efficient," in
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the sense that all relevant publicly available information will be quickly incorporated into the price of a stock. If a new piece of information that is informative about the future dividend or future price of a company's stock appears, that information will be valuable to traders on the stock market, and they will buy or sell the stock accordingly until the current price more accurately reflects the future dividend or future stock price. This belief about market efficiency is sometimes stated
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as "there are no 100 dollar bills laying around on the street": All genuine profit-making opportunities are exploited, so only unanticipated news can move stock prices. This search for an informational edge can have important consequences. First, economists generally believe that it is unlikely for ordinary individuals to be able to make money in a sustained fashion on the stock market because there are many other investment firms, mutual funds, and brokers who have access to
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more information than we do. This doesn't mean that individuals can't become rich by buying stocks━some people may have been lucky and/or smart and been among the first to buy companies like Microsoft or Google or Amazon and made millions of dollars━but they can't do this in a consistent, sustained fashion. In a famous paper entitled "Do Investors Trade Too Much?," the economist Terrance Odean used data from a discount brokerage and showed that stocks that people sold tended to do better
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than stocks that people bought by 1.4 to 3.3 percentage points over various time horizons. Second, this means that the best thing for ordinary investors to do may be to entrust their money to people who have more information than they do━become a passive investor and use mutual funds or investment advisors. What this does is create large pools of investor funds at mutual fund companies, hedge funds, and private equity firms. These large pools of passive investments create both
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opportunity and risk for the macroeconomy. A running joke among economists is that if you get into a cab at the airport and the driver asks you what you do, you should never say that you are an economist, because if you do, the driver will immediately ask you for stock tips. You will proceed to tell him to put his money into a low-cost broad-based index fund at Vanguard or Fidelity, and the driver will think you're a terrible economist. Third, the search for an informational edge can lead to
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all kinds of illegal activity. Recall that the definition of an efficient market was one that incorporated all publicly available information. Regulators of financial markets, like the Securities and Exchange Commission (or SEC) in the United States, work to ensure that there is no insider trading on stock markets. The SEC prohibits corporate executives, directors, and other employees with access to confidential information from trading on that information or providing tips about that
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information to others. Examples could include a pharmaceutical company executive with information about the success or failure of a clinical trial, a CFO who has information about a recently completed company audit, or a CEO who has information about an impending corporate takeover. The most famous case of insider trading in recent times was the 2009 conviction for insider trading of Raj Rajaratnam, who headed a 7 billion dollar hedge fund.
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Mr. Rajaratnam was fined 150 million dollars and sentenced to 11 years in jail for receiving information from business school classmates who had become high-ranking executives at elite firms like Intel, IBM, and McKinsey. One of the specific charges was that a member of the board of directors at Goldman Sachs had passed information to Mr. Rajaratnam that Warren Buffett was going to spend 5 billion dollars purchasing Goldman Sachs shares in the aftermath of the
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turmoil of the 2008/09 financial crisis. Such news, when made public, would provide substantially positive news about Goldman's health relative to other banks and would therefore have a substantial impact on the stock price. Having access to this information early would have given Mr. Rajaratnam a massive profit-making opportunity. Insider information can also relate to news about the macroeconomy. Information about whether or not the Fed will raise interest
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rates; information about what the latest unemployment, GDP, or inflation numbers are━all are extremely valuable and relevant for assessing the future prospects of a company. Trading on such information is also strictly restricted. When journalists go to the Fed or the BLS on the day a key macroeconomic variable is released, the journalists have to give up all their communication devices before they are given the news an hour before the public release so they can draft their news stories.
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Only after the public release time is reached are they allowed to send their stories back to their outlets. Getting this information even five minutes early can be enormously valuable. In fact, a 2012 study done by the economists Martin Scholtus, Dick van Dijk, and Bart Frijns using detailed trading data found that a delay of one second getting an order in after a macroeconomic good news release would result in a return that was 7.3 percent lower━that is, the price would have jumped over
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7 percent in that first second the news came out! Fourth, the search for information can lead to what economists call herd mentality, where individuals end up buying or selling stocks not because of information they have but because they see others buying or selling. If you want to understand herd mentality, imagine you are in a new city walking down an unknown street when you see a large group of panicked people come around a corner and run screaming in the direction from which you came.
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Now, human nature is such that your reaction to this is unlikely to be "Hmmm, let's just go around the corner and see what these guys were all scared by." It's more likely to be "Uh-oh, I'd better go back the way I came from because something bad is about to happen." In stock markets, we see these types of "rush to enter" and "rush to exit" scenarios all the time. "Everyone seems to be buying Tesla, so I should buy Tesla." "Everyone is selling Kmart, so I should sell Kmart."
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I may make these decisions even though I personally have not received any pertinent information about either Tesla or Kmart. As a result, stock markets are particularly vulnerable to self-reinforcing changes in price known as stock bubbles. The term bubble is used to describe a movement, typically an increase, in the price of a stock that is driven solely by the expectation that someone will pay a higher price for it in the future rather than by any information about brighter
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future prospects for profits or dividends. In other words, even if you think that the price of a stock is too high, you are still tempted to buy because you know you can sell it to someone else for a higher price. Two of the most notorious stock bubbles of recent times were the dot-com boom in the United States in the late 1990s and the Japanese stock market bubble in the early 1990s. In the 1990s, the widespread adoption of email and the
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creation of web browsers meant that the internet emerged as a new "information superhighway." This enhanced the ability of existing companies to reach new customers and created an opportunity for new companies to create entirely new markets. The euphoria over the endless possibilities that this new technology made available, combined with the uncertainty about exactly which companies would be successful in this new setting━and mixed with a healthy dose of the fear of missing
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out━led to vast sums of money being used to purchase shares in virtually any company that promised it had a business model related to the internet in some way. Between 1998 and 2000 (the shaded area on the diagram), the NASDAQ index, which represented the stock market valuation of tech companies, tripled in value before crashing. The danger of a bubble is that, like its namesake, it will inevitably pop at some point. Since the rising price is not based on any fundamentals━that
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is, not based on any actual profits that the company is making━the price rise is entirely predicated on new buyers emerging to keep driving the price higher. Suppose you were a lucky early buyer of shares in an internet company at 2 dollars a share and the price has risen to 20 dollars. Then you are in an enviable position of having increased your stake tenfold. But the person who bought at 20 dollars would need the share price to go to 200 dollars to have the same gain you did, and
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that may be considerably harder to do. At some point, the share price will plateau as new buyers go in search of other, more attractively priced stocks. And when the price plateaus, early investors will now decide to cash out. When they sell their shares, the stock price starts to fall. But then herd mentality can lead to even more sales and the price begins to drop. In fact, when the NASDAQ bubble popped, within a year it had plummeted to around a quarter of the peak value, and it took
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almost 14 years (shown by the dashed line) before it returned to the peak that it reached in 2000. In hindsight, there were some great investments that were made in companies like Google and Amazon who emerged from this period as the leaders in a new economic structure. But the landscape was littered with the carcasses of other companies that were once among the highest flyers in the then-new internet world━eToys, Pets.com, JDS Uniphase. The Japanese stock market bubble was even more astounding.
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The postwar economic boom of Japan was one of the most remarkable economic success stories of the world. In the 1980s, over-exuberance regarding the prospects of Japanese companies led to sharp increases in Japanese stock market prices, resulting in the Nikkei index increasing fourfold in the space of four years in the late 1980s (shown in the shaded area). The Japanese stock market━and the real estate market, which had seen a similar unsustainable increase━collapsed suddenly in the early 1990s.
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In hindsight, the bubble was even more dramatic━even a quarter century later, the Nikkei was only half of what it had been at the peak of the bubble. And 30 years after the collapse, the Nikkei index still has not returned to its prior heights. From a macroeconomic perspective, the suddenness with which the bubble collapses and the severity of the collapse have a devastating effect on the economy. The stock market collapse in Japan led to a massive recession
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and almost three decades of a near-stagnant economy. The United States experienced a similar event in the Great Crash of 1929 that precipitated the Great Depression. So, when financial markets experience upheaval, there are often macroeconomic consequences that follow. The primary channel through which macroeconomists study the impact of the stock market on the economy is through wealth effects━how changes in the value of stock holdings impact a household's wealth and influence its consumption.
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This is not easy to empirically estimate because investors may cut back on stock purchases when they hear news about bad economic conditions that may be forthcoming. This leads to a situation where a fall in stock prices precedes a recession, but it does not necessarily mean that the falling stock market caused the recession. Careful empirical work by the economist Alp Simsek and coauthors using data over the period 1990 to 2015 has
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estimated that a dollar of lost stock market wealth results in a fall of around 3 cents of consumption. So in 2008/09, when the value of US equities declined by around 12 trillion dollars, that would have reduced consumption spending by almost 400 billion dollars, around 3 percent to 4 percent of GDP. My late colleague Karl Case, in work with Robert Shiller and John Quigley, showed that wealth effects are even greater for housing markets: 5 cents to 9 cents of consumption change per
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dollar change in housing wealth. For most middle- to lower-income Americans, their home is the only substantial asset they have. And this, of course, explains why the 2008/09 crisis was so devastating, in that both stock market and housing market wealth were destroyed. These wealth effects are magnified when we look at all phases of a business cycle: In good times, when the economy is booming, such as in the period between 2001 and 2006, stock
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markets and housing markets rise in value, and consumer wealth increases. Consumers increase their spending. But if it's their wealth that is rising rather than their income, consumers are likely to be financing this consumption by borrowing more. In other words, if your wealth rises from 350,000 to 620,000 dollars, you don't actually get your hands on the extra 270,000 dollars unless you sell your stocks or your house, and most people probably continue to hold on to the asset rather than
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selling it. So the additional consumption comes from borrowing against that increased wealth. But when the housing market or stock market collapses, reducing wealth, then not only will consumption fall because of the wealth effect, it will also fall because the money you borrowed in good times has to be paid off. This knock-on effect on consumption had dramatic negative impacts during both the Great Depression (when banks had lent money to stock market investors) and the Great
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Recession (when banks had lent too much money to speculative home buyers). Another channel through which stock prices can affect the economy is through investment. The most famous theory about what drives investment in the macroeconomy is known as Tobin's q theory, named after the Nobel Prize-winning economist James Tobin. Tobin defined q as the ratio of market value to book value, where the market value of the firm is the value of all of its
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outstanding shares and the book value of the firm reflects what you could get if you sold off all the firm's assets━buildings, land, equipment, inventory━at market prices. If q is very large for a company, then that company has a lot of incentive to invest, because every dollar of additional investment raises its stock price by q dollars. Tesla, for example, had a market value worth 1 trillion dollars at the end of March 2022, compared with a book value that
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was estimated at around 25 billion dollars. This gave Tesla a Tobin's q of around 40. This enables Tesla to invest more in larger factories, expand into more markets, and buy up competitors using its valuable shares. This effect is compounded by what economists call the balance sheet channel of lending. When a firm approaches a lender━whether it be a bank, an investment fund, or a venture capitalist━the lender is concerned about adverse selection.
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This is a fancy word for the lender's self-doubt. "Why is this company coming to me to borrow money? Is it because other lenders have told them no? And if so, why were they told no? What is it that I don't know?" But such concerns about adverse selection will tend to dissipate with a high stock market valuation. After all, if the stock market is the hub of information aggregation in the economy, then a high market valuation must reflect good news about the future of the company and hence
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makes the lender more willing to lend. Of course, both Tobin's q and the balance sheet channel magnify economic fluctuations. In good times, stock market valuations rise. Companies are more likely to have a high Tobin's q and expand their investment, while at the same time they are more easily able to borrow money from lenders. Thus, economic activity booms. In contrast, in bad times, stock market valuations fall. Companies are likely to have a lower value of Tobin's q, invest
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less, find it difficult to borrow, and economic activity falls. Good times become better, bad times become worse, and economic fluctuations are more magnified. The allure of riches in the stock market is why most noneconomists think that economics and finance are synonymous with each other. The reality, though, is more complex━finance matters for economics, just as economics matters for finance. When markets rise or fall sharply, macroeconomic
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consequences follow━changes in stock market wealth affect consumption in the economy as well as the willingness of lenders to offer additional credit. Some of the most significant recessions in the United States have resulted from a stock market collapse, usually spiraling into a banking crisis. But the links go the other way, too. An unexpectedly bad jobs report, a burst of inflation not previously forecast, a surprise interest rate hike by the
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Federal Reserve━all lead to a flurry of action in financial markets, with the news being incorporated into stock prices in mere milliseconds. Policy makers understand these links and try to behave in a predictable way so as not to spook the stock market. When there is an unexpected downturn in the economy, the Federal Reserve usually steps in and takes action━not just to do the standard expansionary monetary policy by lowering interest rates but also by taking steps to make sure that
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financial markets keep functioning properly. The additional liquidity that the Fed provided to banks helped stem the decline in the stock market, as investors did not have to sell their shares to come up with cash to meet their needs. So part and parcel of good macroeconomic policy is to act predictably and communicate well━both of which are needed to keep the stock market from overreacting and disrupting the macroeconomy.
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