I. Introduction
The last 30 years have been unprecedented in terms of profits derived from the investments in the world stock market. During that time, the most important indices have gained in value thousands of percent. For example, the analyze of S&P 500 index chart ( S&P 500 groups the 500 greatest USA corporation) shows that the index rose from 63 points in October 1974 to 1503 points on July 2007, that in percentage terms means 2285 percent gain – the yearly average return from the investment was 61 percent.[1] Similarly, the analyze of London’s FTSE index shows that it gained from July1984 to June 2007 (earlier the index was not calculated) from 1045 points to 6930 points, that in percentage terms amounted to 540 percent for all period and 24,7 percent yearly[2], and German’s Xetra index since 1991, when the index was launched, ascended from 1420 points to 7870 points in July 2007, bringing investors 454 percents profits for the whole period of the time and 28 percent on average yearly.[3] Some world indexes rose in the comparable period of time even faster. For example, Hongkong Hang Seng rose from 2284 points in July 1989 to 31350 points in December 2007 that means 1360 percent gain on the whole and 75 percent gain yearly[4], and Brasilian Bovespa from 3490 points in May 1993 to 72593 points in May 2008, giving during that period of time profit of 1980 percent and 132 percent on average yearly.[5]
Simultaneously, historical data shows that total inflation in the analogous periods of time was: in the USA 435, 5 percent[6], in the UK 140 percent[7] and in Germany 85 percent[8]. It was never higher than 10 percent early, and by the most time was hovering between 2-6 percent.
As we can see, the level of the profit on the stock markets highly exceeded inflation. It could give rise to speculations as to a potential factor. In opinions of many, the factor is rapid development of economy, that is visible from the angle of the rise of the indicator, called GDP (Gross Domestic Product). It rises along with the economic growth according to the definition: “Gross Domestic Product – the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports”.[9] Indirectly, by “feedback”, the indicator reflects the condition of companies which shares are quoted on the stock market.
Unfortunately, comparisons of data show that there is no full correlation between thriving economy and the valuation of the stock market. GDP in the USA rose from $1499,5 billion in 1970 to $14061.8 in 2007.[10] In percentage terms it is 838 percent, but adjusted for inflation only 402,5 percent (838 – 435,5). Comparably, the investment in the USA stock market, also adjusted for inflation, brought investors profit of 1850 percent (2285 – 435,5). As we can see, the rise in the stock market more than quadrupled the rise of GDP. We can come to the conclusion that economic boom is not the sufficient explanation for such extreme rise of prices of shares in the stock market.
The problem connected with the valuation of the stock market is not only theoretical and by far more important that it could seem The investments in shares are made not only by individual investors or mutual funds, but also by pension funds with the idea about retired. If the valuation of the stock market is unjustifiable, enormous number of people face huge risk since the falling prices of shares would destroy pensions. Actually, such situations when stock market crashed and people had to wait many years for it to return to levels from before a crash took place a few times in contemporary stock market history. The example is the last ten years, where S&P plunged from the level of 1498 points on 3 Jan 2000 to 815 points on 1 July 2002 and after rising to the level before a fall (1526 points reaching on 2 July 2007) on 2 March 2009 crashed again, this time to 683 points, more than 50 percent, by the way returning to the level not seen since 1 July 1996. Then the index returned to the area 1200-1250 points (January 2011), but it still brings losses for many investors, who during the quoted period bought shares.[11]
Additionally, there is one more problem. Rising or falling share prices affect economy. They create the kind of “artificial money”, which when directed to buying goods and services, creates demand. This process in turn influences the condition of companies, they earnings and an increase or a decrease in employment. If share prices fall, economy also sinks into recession or even depression and if it happens, it is extremely difficult to fight it off. Should market crash, in a flash would evaporate from it unimaginable amount of money. It could result in undermining nervous investors confidence to the financial market as a whole and their willingness to sell all assets like bonds and to withdraw money from banks. This scenario is a simple way to bearing unimaginable consequences collapse the world’s financial system since nowadays any information spreads with lightning speed over the globe and all investors follow the herd and reacting in a panic way.
Actually, this kind of threat occurred in September 2007 as a result of the subprime mortgage crisis, that caused fall of the investment bank Lehman Brothers and made investors escape from bonds and shares. Immediately after the Lehman collapse the situation was extremely dangerous. During a two crucial days in September 2008, from USA money funds $150 billion were withdrawn and it resulted in a bank run. The markets died out, bringing the global financial system to the verge of collapse. Finally the situation got under control with the aid of the USA government, that injected into banks over $1 billion, but the crisis had huge negative impact on the U.S. economy. Between July 2007 and November 2008 American citizens lost about a quarter of their assets. During that period, the S&P 500, the index grouping the 500 largest US corporations, plummeted 45 percent from its 2007 peak. Housing prices fell about 20% from their 2006 top and the total value of home equities, valued at $13 trillion at its high in 2006, dropped to $8.8 trillion by summer 2008. Simultaneously, Americans' second-largest household asset - retirement assets - dropped from $10.3 trillion in 2006 to $8 trillion in summer 2008 and savings lost $1.2 trillion. Taken together, losses totaled $8.3 trillion.[12]
There are a lot of threats on the horizon – economy itself, politics or even natural disaster. Each of them could make investor nervous, bringing new waves of panic selling of shares. So, what should we expect in the nearest future? Trying to find the truth about the stock market and unravel mechanisms that govern it, first we have to learn a few of its elements.
[1] http://finance.yahoo.com/echarts?s=^GSPC+Interactive#symbol=^GSPC;range=my
[2] http://finance.yahoo.com/echarts?s=^FTSE+Interactive#symbol=^FTSE;range=my
[3] http://finance.yahoo.com/echarts?s=^GDAXI+Interactive#symbol=^GDAXI;range=my
[4]http://finance.yahoo.com/echarts?s=^HSI+Interactive#chart1:symbol=^hsi;range=my
[5] http://finance.yahoo.com/echarts?s=^BVSP+Interactive#symbol=^BVSP;range=my
[6] http://www.inflationdata.com/inflation/Inflation_Calculators/Inflation_Calculator.asp#calcresults
[7] http://safalra.com/other/historical-uk-inflation-price-conversion/
[8] http://www.global-rates.com/economic-indicators/inflation/consumer-prices/cpi/germany.aspx
[9] http://www.investorwords.com/2153/GDP.html
[10] http://www.bea.gov/national/txt/dpga.txt
[11] http://finance.yahoo.com/echarts?s=^GSPC+Interactive#symbol=^GSPC;range=my
[12] http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
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