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This course is an introduction to the stock market and stock investing for novices and experienced investors alike. Professor DeGennaro uses simple analogies to explain the origin of stocks and other securities, as well as their relative risks. He stresses the danger of trying to beat the market by trying to pick winners, predict price trends, or otherwise find opportunities that other investors have missed. Far better, he counsels, to own a well-diversified portfolio of individual stocks or stock funds, which tend to grow as the economy grows. He offers detailed guidance on how to pursue this course. Among the topics covered in these 18 lectures are how to open a brokerage account and choose a financial advisor; the essentials of mutual funds, including index funds, and exchange traded funds (ETFs); how to trade individual stocks, including how to use options; the relative advantages of traditional IRAs, Roth IRAs, and 401(k) plans; how to minimize transaction costs and use tax laws for your benefit; the dangers of frequent trading; and the basics of corporate balance sheets, income statements, and cash flow statements. For anyone who owns stocks or is thinking of entering the market, this course provides indispensable advice. If you entrust the management of your assets to a financial advisor, this course will give you the background you need to communicate more knowledgeably with him or her and be an informed participant in your own financial well-being.
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00:13Some things that affect a company's stock price are out of its control.
00:17We still need to be aware of them, though.
00:20Being unable to control something and preparing for it are two different things.
00:25If you were to look at how stock prices behave during a recession, for example, you'd find
00:31a fairly consistent relationship.
00:33The S&P 500 declined during all six recessions between 1956 and 1987.
00:42If you move to more recent times, that pattern holds.
00:46The stock market fell during the three recessions of 1990 to 91, the early 21st century, and
00:53the so-called Great Recession of 2007.
00:57Every time that the economy has gone into a recession since 1950, stocks have declined
01:04significantly.
01:07That makes sense.
01:09The word recession connotes an economic downturn or contraction.
01:14The unofficial definition of a recession is two consecutive quarters of declining gross
01:19domestic product, more commonly called just GDP.
01:24GDP is the total value of the nation's production of goods and services.
01:29If a nation produces less, then people earn less and they buy less.
01:35Companies sell less and they earn less.
01:38Because stocks are claims on those company earnings, I'm not at all surprised that investors
01:44decide that they don't want to pay as much for those claims as they would during good times.
01:51Can we make money on this information?
01:54If we can predict recessions, then we ought to be able to sell beforehand and buy when the
02:00economy rebounds.
02:02Let's think about how we'd make that work.
02:06First, we'd need to be able to forecast turning points of the economy.
02:10Second, we'd need to sell before other investors see the recession coming.
02:16Third, we'd need to start buying again before other investors see the light at the end of
02:22the tunnel.
02:25We do have some reasonably good predictors of economic activity.
02:30The Conference Board Leading Economic Index, more commonly called just the Index of Leading
02:36Economic Indicators, is the best known.
02:38This index is a composite of about ten factors, such as consumer expectations, initial unemployment
02:46claims, and new orders for consumer goods.
02:49The problem with using this to call market trends is that the information it uses is available
02:56to market participants, who can make their own guesses and act at least as fast as we can.
03:02This means that any decline in stock prices as we head into a recession should begin before
03:08the recession.
03:09And, in fact, that's what tends to happen.
03:13Stocks started declining before every recession since at least 1950.
03:20Investors see the economic contraction coming.
03:24Okay, you say?
03:26Then why don't we just wait for stocks to signal a recession by declining, and then sell before
03:31the onset of the recession itself?
03:33History shows that stocks have continued to decline after the recession starts, so we ought
03:39to be able to save some money.
03:41History also shows us three problems with this plan.
03:45First, since at least 1950, stocks have always declined during recessions, but every decline
03:53hasn't signaled an imminent recession.
03:56Cynical analysts like to say that the stock market has successfully predicted 16 of the last
04:02nine recessions.
04:04This means that if we had followed our rule of selling after a decline, then we would have
04:09sold seven times when we shouldn't have.
04:11For example, we'd have sold near the end of 2012 and missed a run-up of almost 40% over
04:18the next 10 or 12 months.
04:22Second, we don't have a good way to tell how long the stock market downturn will last.
04:28John P. Hussman, president of Hussman Investment Trust, has found that serious market declines,
04:34let's call them bear markets, that occur during recessions last longer than what he calls a
04:41stand-alone bear market.
04:43Hussman says that from 1950 to 2007, the seven stand-alone bear markets lasted an average of
04:50215 days.
04:53In contrast, the nine bear markets that coincided with recessions lasted more than twice as long,
04:59an average of almost 500 days.
05:02Hussman says that these market declines tended to be more severe, too.
05:06But, since we can't tell whether a recession will follow the stock price decline, we can't
05:12tell how long the downturn will last.
05:14That means that we can't tell when to get back into the stock market.
05:19Third, we haven't specified what we mean by a decline in stock prices.
05:25Do we mean, say, a 5% drop, or do we mean a 10% drop?
05:31Over what time period?
05:33Do we mean a 5% drop in a week, or a 10% drop in a calendar quarter?
05:39Lots of smart people have come up with different answers.
05:42The bottom line is that it's almost impossible to call stock market turning points at the right
05:48time, even if you can call recessions and recoveries with reasonable accuracy.
05:54We do know that these business cycle changes affect risk premiums on stocks.
06:00Donald Keim and Robert Stambaugh, writing in the Journal of Financial Economics, found that
06:06the difference between the yield on risky bonds and safe bonds signals higher expected stock returns.
06:13The idea is that a big spread between the yield of a safe bond and a risky one signals that
06:19times are risky, and we've already seen that stocks tend to return more during risky times.
06:26The timing of these economic forces driving these stories is a little tricky.
06:32Stock prices should fall at the onset of the increased risk, which is then reflected in higher
06:38dividend yields.
06:39Bond spreads widen.
06:40That's unexpected bad news, and stocks take a hit.
06:44But once investors are aware of the risky situation, stock prices have already fallen and risk premiums
06:52have increased, then from that point on we expect higher returns during the risky period itself.
06:59That might seem counterintuitive, but it actually fits.
07:03Stocks fall on the bad news that increases risk, but after the prices have fallen, the expected returns
07:10from then on are higher.
07:13Let's reverse the situation for practice.
07:15If investors see more normal times ahead, then they're willing to bid more for stocks.
07:21Stock prices rise, which is then reflected in more normal dividend yields, and risk premiums decline.
07:28From then on during the safe period, we expect normal stock returns during the period of normal risk.
07:36International tensions or political uncertainty might increase risk premiums.
07:41That would cause a broad decline in stock prices.
07:44International tensions or political uncertainty are beyond the control of a company.
07:50It's just part of the risk of doing business.
07:55Being unable to make investing profits by observing the macro economy doesn't mean that it's a waste of time.
08:01You can do two things to help you manage your risk and sleep better at night.
08:06The first is that you might want to take a little money off the table when the market gets unsettled.
08:11Remember, you're managing risk by doing this, not trying to make a profit.
08:17If you're happy with the amount of risk you have in your portfolio and then the world gets riskier,
08:22then it's understandable if you feel a little uneasy and want to lighten up on your stock holdings.
08:28I know lots of smart people who do that.
08:31I also know lots of smart people who stick with their holdings when the world gets riskier.
08:36They don't make any changes at all.
08:38Instead, they focus on the higher expected returns going forward.
08:44Because they understand that the increased risk is likely to lead to higher expected returns,
08:49they're comfortable with that risk.
08:52They reason that risk itself isn't bad as long as they can expect to get paid for taking it.
08:58Either of these two approaches can help you sleep better at night.
09:03Some industries and companies are more susceptible to business cycles than others.
09:07If you think about it, then you'll get a feel for why.
09:11Let's take a look at two companies.
09:13Ford, the car company, and Colgate, the toothpaste company.
09:17How do you think these companies will be affected by business cycles?
09:22Let's get the bad scenario out of the way first.
09:25The economy isn't doing too well.
09:27Your job prospects are a little shakier than they were a couple of months ago,
09:31and it doesn't look as if you'll get a raise this year.
09:34Your car has been causing problems here and there.
09:37It might be time to think about replacing it.
09:40Oh, and to top it all off, you're almost out of toothpaste.
09:45You need to come up with a plan to get you through this rough patch.
09:49What would be a reasonable plan?
09:52First, you could postpone getting a new car.
09:55Sure, you'll need to budget for repairs, but buying a new one just isn't in the cards right now.
10:01As for the toothpaste, my guess is that you're going to buy the toothpaste anyway.
10:08It doesn't cost that much, and you need it all the time, including right now.
10:13Compared to Ford, Colgate is relatively immune to economic downturns.
10:20Now that we've considered the bad scenario, the good one is easy.
10:24The economy is growing, your company is hiring, and you just got a promotion.
10:29Your car is still causing problems though, and yes, you're still almost out of toothpaste.
10:36In this case, you're much more likely to buy that new car,
10:40and you can see why Ford Motor Company shares tend to be so cyclical.
10:44Now about that toothpaste.
10:46With your economic prospects looking so good, you can afford to buy tons of toothpaste.
10:53But you won't.
10:54You're probably going to buy the same amount of toothpaste as you would in bad times.
10:59Yes, you can afford to buy more, and yes, you do need toothpaste all the time.
11:06But you only need so much of it.
11:08Toothpaste isn't like a car.
11:10You can delay replacing your car, and a nice new luxury model is a whole lot better than
11:16a smaller, plainer one with some wear on it already.
11:20Toothpaste isn't like that.
11:22Despite what the glitzy ads claim, toothpaste is pretty much just toothpaste.
11:29You can see why the toothpaste business is less susceptible to the ups and downs of business
11:34cycles than car manufacturers.
11:36Because it's safer, it tends to return less.
11:42Booms and busts are the bane of economies everywhere.
11:46Throughout the early years of the Republic, the United States endured its share of financial
11:50panics and bank failures.
11:52People weren't sure what to do.
11:54To tell the truth, we're still not sure what to do.
11:58But people did want an end to the instability.
12:01Congress decided that the U.S. needed a way to supply a lot of currency fast if demand
12:08for it increased significantly in a short time.
12:12Insufficient amounts of currency could cause a panic.
12:16In 1912, the National Monetary Commission presented its recommendations.
12:21Congress passed the Federal Reserve Act, creating the Federal Reserve System,
12:25and then President Woodrow Wilson signed it into law on December 23, 1913.
12:32The Federal Reserve System, comprising the Board of Governors located in Washington, D.C.,
12:37and the twelve regional banks located throughout the country, was born.
12:43The Fed is the United States' central bank.
12:46Most nations with well-developed banking systems have a central bank.
12:50In Germany, it's called the Deutsche Bundesbank.
12:53In England, it's the Bank of England.
12:56The Federal Reserve has three primary functions.
13:00First, the Fed system serves as the nation's banker.
13:04It's the banker's bank and the government's bank.
13:07Banks rely on the Fed to handle a large portion of the nation's payments.
13:12We take it for granted that when we swipe our credit card,
13:16the proceeds of the purchase will eventually end up in the merchant's bank account.
13:21When you deposit a check, you expect the proceeds to end up in your account, not someone else's.
13:27These accounts are unlikely to be in the same bank,
13:30and you probably don't even notice the name of the bank.
13:33The payment system just works, plain and simple.
13:37The odds are good that a Fed bank will handle the transfer of money from one bank to the other.
13:45The Fed's role as the government's bank is a lot like your personal bank account writ large.
13:52Very, very large.
13:54The U.S. Treasury has what amounts to a checking account with the Federal Reserve.
13:59All federal tax revenues go into this account, and all federal payments go out of this account.
14:05The Fed also handles the Treasury's security auctions and redemptions.
14:11The U.S. Treasury actually produces the currency in our pockets,
14:14but the Fed banks distribute it to financial institutions.
14:18The Fed also checks bills for wear and tear and removes damaged currency from circulation.
14:25What happens to it?
14:27Take a tour of a Fed bank sometime.
14:29If you ask nicely, I'll bet that they'll give you a small bag of shredded bills.
14:34The ones I have contain about $100 worth of shredded bills.
14:39The Fed has excellent shredding facilities.
14:42Don't even think about reassembling the currency.
14:45Second, the Federal Reserve System is one of the country's bank regulators and supervisors.
14:52Ultimately, the goal is a safe and sound banking system.
14:56The Fed does allow individual banks to fail now and then. That's okay.
15:01If a grocery store closes, you wouldn't lose confidence in food distribution, would you?
15:06No, you wouldn't. You'd just shop at another store.
15:10The banking system is no different.
15:12The Fed's job isn't to ensure that banks never fail.
15:15The Fed's job is to ensure that people have confidence in the banking system as a whole.
15:24More recently, the Fed has been charged with implementing laws governing consumer credit.
15:30You've probably heard of the Truth in Lending Act, or the Equal Credit Opportunity Act, or the Home Mortgage Disclosure
15:38Act.
15:38This casts the Federal Reserve in the role of law enforcement rather than banking or monetary policy.
15:45The Fed's roles in payments and supervision are usually done behind the curtain.
15:50It's like your appendix.
15:52Most people never need to think about it, and if they do, then it's because something went wrong.
15:58But that's not true of the Fed's third main function, which is devising and implementing monetary policy.
16:06Monetary policy refers to the Fed changing the supply of money in the U.S. economy.
16:12If money is plentiful, then credit is easier to get, and interest rates tend to fall.
16:18The idea is that this induces people and firms to borrow money, to spend, and to make investments.
16:25That should boost the economy.
16:29It's not that simple, of course.
16:31Lower interest rates affect the income of lenders, too.
16:35People who buy bonds and other debt securities have loaned money to the bond issuers.
16:40The lenders have less income when rates are low.
16:44That means that they have less to spend, and that slows the economy.
16:49Economies are complex, and trying to fine-tune them is a tough job.
16:55Moreover, economists have lots of different definitions of money.
16:59Not all economists even agree on which of them affects the economy the most.
17:04M1 includes all coins and currency, plus demand deposits, which are mostly checking accounts.
17:11M2 adds savings deposits and certain small deposits with withdrawal restrictions,
17:17plus money market accounts not held by institutions, and some important bank funding tools.
17:24M3 is the broadest measure of the money supply.
17:28It equals M2 plus all large time deposits, institutional money market fund assets, and other larger liquid assets.
17:37Most people play fast and loose with language when they refer to the money supply.
17:44Most of the time, they don't say which one they mean, and usually it doesn't matter too much.
17:49Most likely, though, they mean M3.
17:53The Fed changes the money supply in three ways.
17:56First, the Fed can change the discount rate.
17:59The discount rate is the interest rate that the Fed charges banks on short-term loans.
18:05In practice, the discount rate is more important as a policy signal rather than as a way to change the
18:12money supply.
18:13It's a way for the Fed to tell the world where it thinks interest rates should be.
18:18The second way that the Fed changes the money supply is by changing reserve requirements.
18:24Like most countries, the United States has a fractional reserve banking system.
18:29When you deposit $100 in a bank, the bank only has to keep a fraction of that $100 on hand.
18:37The reserve requirement is usually around 10%.
18:40That means that the bank only needs to keep $10 of your $100 on hand and can lend the rest.
18:47If the Fed wants to tighten the money supply, then it can raise the reserve requirement to, say, 12%.
18:54That would mean that the bank would only be able to lend $88 of your $100 deposit, so credit would
19:01be tighter.
19:02In practice, the Fed doesn't change reserve requirements very often.
19:07It's less disruptive to conduct what people call open market operations.
19:13To increase the money supply, the Fed buys securities in the financial markets.
19:19That puts money into the financial system, increasing the money supply.
19:23You'll hear that the Fed injected reserves because the new money eventually goes into the banking system somewhere,
19:31and collectively, the banks have more reserves as a result.
19:37When the Fed drains reserves, it reverses the process.
19:42It sells securities from its inventory.
19:45Buyers take money from their accounts and send it to the Fed in exchange for the securities.
19:50That reduces the money supply.
19:52The Fed uses open market operations far more often than changes in the discount rate or reserve requirements.
20:01You might ask why the Fed tries to affect interest rates.
20:05That's because, by law, the Fed has twin goals, full employment and stable prices.
20:12That boils down to asking the Fed to fine-tune the economy.
20:16That's a tough job, and many economists think it's impossible.
20:20These economists argue that fine-tuning interest rates away from market levels is just price-fixing.
20:27Interest rates are the price of money, right?
20:30History shows that price-fixing doesn't work very well for other goods and services,
20:35and they think it doesn't work with money either.
20:40These economists would rather see the Fed just set a rule and follow it.
20:44Under a system of monetary rules, the Fed would let the money supply grow a few percent a year
20:50and let interest rates settle where they may.
20:54You might be saying, as an investor, do I need to care what the Fed does?
21:01Yes!
21:03And no.
21:05Yes, Fed actions absolutely do affect the economy and the stock market.
21:11Walker Todd is a Ph.D., J.D., and research fellow at the American Institute for Economic Research,
21:18who spent 20 years as a legal officer and later as a research officer at the Federal Reserve Banks of
21:24New York and Cleveland.
21:25Dr. Todd explains that the Fed's open market operations can have a measurable effect on stock market prices.
21:34Monetary tightening operations, which usually raise market interest rates, tend to reduce domestic activity and cause share prices to fall.
21:44Monetary easing operations, which usually lower interest rates, tend to increase domestic activity and cause share prices to rise.
21:54But no.
21:55You can't expect to make money by trading on Fed actions unless you can outguess the experts.
22:02The markets are really efficient with respect to Fed activity.
22:07Fed actions are supposed to be transparent and predictable anyway.
22:10So when the Fed acts, it shouldn't be a surprise that would affect market rates.
22:16It doesn't work that way in practice, of course.
22:18In fact, former Federal Reserve Chairman Alan Greenspan reportedly once said, tongue-in-cheek,
22:25if you understood what I said, I must have misspoke.
22:30Fed spokesmen are indeed more open than they were in decades past, though.
22:35The Federal Reserve is a great source of information about the economy and the stock market.
22:41All other regional banks have good websites with lots of information, and most of them have at least one publication
22:48that you'll find helpful.
22:50If you're searching Federal Reserve Bank websites, look for links that say something like education or publications or research.
22:59You'll find all kinds of articles and videos.
23:03Some of the material will be too basic for you, and some, particularly the sophisticated research articles, will be too
23:10specialized and esoteric to be helpful.
23:13But you'll find plenty that you can use.
23:15I'm personally fond of the Cleveland Fed's economic commentary series.
23:20For example, you'll find articles like, Why Are Interest Rates So Low?, by Joseph Habrick, written in 2013.
23:28You're busy, you want the main idea rather than a lot of detail, and you'd rather see a graph than
23:34an equation, right?
23:36Dr. Habrick's article is just four pages, including figures, and he wrote it with people like you in mind.
23:44At the Atlanta Fed, you'll find economic and financial highlights, such as historical information on international trade or light vehicle
23:52sales.
23:53The Fed's research economists blog about topics ranging from banking to real estate to inflation.
23:59Give their site a look.
24:02Those are my favorite sites for articles, and the Fed system also offers data galore.
24:07Some of the data from this lesson are from FRED, for Federal Reserve Economic Data, produced by the St. Louis
24:15Fed.
24:16The last time I checked, FRED contained almost 150,000 economic data series.
24:23Exchange rates, inflation rates, stock prices, housing starts.
24:27Just about any data you want is there, and it's free.
24:33The stock market is also affected by what happens to foreign currencies.
24:38Not every country uses U.S. dollars, of course, and changes in the value of those currencies in relation to
24:44the U.S. dollar can influence the economy.
24:46For example, the countries belonging to the European Union use the Euro as their national currency.
24:53The number of countries using the Euro has varied over time.
24:57Now the figure is around 20, including major economies such as Germany, France, and Italy, plus a host of smaller
25:05economies like Estonia and Malta.
25:08You can buy foreign currencies just like you can buy foreign cars, and just like the price of foreign cars,
25:15the price of foreign currencies varies.
25:17People usually use the term exchange rates rather than prices for currencies.
25:24Since its inception in the late 20th century, the dollar-euro exchange rate has fluctuated from a low of around
25:320.85 to 1 to a high of around 1.6 to 1.
25:37Put differently, you could buy a Euro for 85 cents in late 2000, but it would have cost you about
25:44$1.60 for that same Euro in late 2008.
25:50In practical terms, that variation can affect U.S. stock prices.
25:54A BMW that cost 40,000 euros in 2000 would have cost you about $34,000.
26:02A BMW costing 40,000 euros in 2008 would have cost you almost double that, $64,000.
26:11Fluctuations like that can obviously affect a company's sales and profits.
26:16Determining how they affect sales and profits isn't as easy as it looks.
26:20A lot's going on behind the curtain.
26:23For one thing, BMW has to buy the components and parts for its cars.
26:28If the Euro is strong, then it can buy those components and parts for less.
26:33That will either boost BMW's profits or let it lower its prices.
26:39After all, it's competing with Mercedes, and Mercedes is in the same position,
26:43so maybe that car that cost 40,000 euros before won't cost 40,000 euros now.
26:52Projecting sales and profits gets complicated fast.
26:56These days you can buy a BMW built in the United States, so the exchange rate doesn't matter as much.
27:02Lexus, Acura, and Infiniti are also competing, and the exchange rates between the yen, the Euro, and the U.S.
27:10dollar are in the equation too.
27:12Maybe that's why the link between exchange rates and stock prices isn't as strong as it might first appear.
27:19To take the S&P 500 and the U.S. Euro exchange rate as one example,
27:24you'll find that the S&P rose while the Euro fell against the dollar in the late 20th century,
27:30and then the exchange rate stayed mostly flat or rose while stocks fell from then until about 2003.
27:38In 2003, the two began to move in mostly the same direction until about early 2012,
27:45when stocks continued to rise while the Euro flattened against the dollar.
27:50And that's just one currency, the Euro.
27:52The relationship between stock prices and foreign currencies is complicated.
27:59Using a single currency like the Euro in multiple nations has good and bad points,
28:05and some of them can affect U.S. stocks.
28:08It's nice that a French baker near the border of France and Germany
28:12doesn't have to make a lot of transactions in both currencies, for example.
28:16Customers living in Germany don't have to worry about whether their German marks
28:20will buy the same amount of goods today as they did yesterday.
28:24Record keeping and billing are a lot simpler.
28:28To get a feel for the disadvantages of a single currency,
28:31think of economic problems as infectious diseases.
28:35If I live in Germany and you live in the U.S.,
28:39then the odds of me spreading my flu virus to people who end up infecting you
28:43are a lot lower than they are if you live in, say, France.
28:48To infect you, the virus has to make it across the Atlantic from Germany all the way to the U
28:53.S.
28:54It can happen, but it's a lot easier for it to spread across a border
28:58that saw many thousands of people crossing each way every day.
29:04A common currency makes it easier for problems in one country to affect others.
29:09Most experts agree that problems in Greece, a relatively small economy compared to Germany and France,
29:16contributed to the length and severity of the European recession that began in late 2007.
29:22Normally, when a government runs big deficits, its currency falls relative to the currencies of its more frugal neighbors.
29:30That's because people understand that in the long run,
29:33the government will probably do what governments have done in the past,
29:37print more money to cover the bills.
29:41Creating more money out of nothing lowers the value of that money.
29:45But if one country overspends relative to other countries using the same currency like the euro,
29:51then it can't print more of this common currency.
29:55The result is that economic contractions can be worse.
29:59That hurts international trade a lot more for countries using the common currency than it does with the United States.
30:07Still, the U.S. needs healthy trading partners, and if a huge economic area like the Eurozone coughs,
30:13then the entire world catches a cold.
30:19Sometime during the next few days, take a couple of minutes and go to the Fed websites
30:23and look for articles and data that catch your fancy.
30:26The National Bureau of Economic Research, or NBER, also has a good site,
30:32although sometimes that information on it is very technical.
30:37You can find a lot of information about currency trading and exchange rates online, too.
30:42You'll find historical exchange rates, current exchange rates,
30:46average exchange rates for dozens of currencies over any number of different time periods,
30:52graphs, and news articles.
30:55In our next and final lecture, we'll look at some things you might want to do
30:59to make sure that you're comfortable with your decision to invest in stocks.
31:03It's time to take a closer look at your financial situation and decide what you want to do.
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