CAPITAL, SAVINGS, AND INVESTMENT

CAPITAL, SAVINGS, AND INVESTMENT
In the United States and in other market economies, financial firms and markets channel savings into capital investments. Financial markets, and the economy as a whole, work much better when the value of the dollar is stable, experiencing neither rapid inflation nor deflation. In the United States, the Federal Reserve System functions as the central banking institution. It has the primary responsibility to keep the right amount of money circulating in the economy.

Investments are one of the most important ways that economies are able to grow over time. Investments allow businesses to purchase factories, machines, and other capital goods, which in turn increase the production of goods and services and thus the standard of living of those who live in the economy. That is especially true when capital goods incorporate recently developed technologies that allow new goods and services to be produced, or existing goods and services to be produced more efficiently with fewer resources.

Investing in capital goods has a cost, however. For investment to take place, some resources that could have been used to produce goods and services for consumption today must be used, instead, to make the capital goods. People must save and reduce their current consumption to allow this investment to take place. In the U.S. economy, these are usually not the same people or organizations that use those funds to buy capital goods. Banks and other financial institutions in the economy play a key role by providing incentives for some people to save, and then lend those funds to firms and other people who are investing in capital goods.

Interest rates are the price someone pays to borrow money. Savings institutions pay interest to people who deposit funds with the institution, and borrowers pay interest on their loans. Like any other price in a market economy, supply and demand determine the interest rate. The demand for money depends on how much money people and organizations want to have to meet their everyday expenses, how much they want to save to protect themselves against times when their income may fall or their expenses may rise, and how much they want to borrow to invest. The supply of money is largely controlled by a nation’s central bank—which in the United States is the Federal Reserve System. The Federal Reserve increases or decreases the money supply to try to keep the right amount of money in the economy. Too much money leads to inflation. Too little results in high interest rates that make it more expensive to invest and may lead to a slowdown in the national economy, with rising levels of unemployment.

Providing Funds for Investments in Capital
To take advantage of specialization and economies of scale, firms must build large production facilities that can cost hundreds of millions of dollars. The firms that build these plants raise some funds with new issues of stock, as described above. But firms also borrow huge sums of money every year to undertake these capital investments. When they do that, they compete with government agencies that are borrowing money to finance construction projects and other public spending programs, and with households that are borrowing money to finance the purchase of housing, automobiles, and other goods and services.

Savings play an important role in the lending process. For any of this borrowing to take place, banks and other lenders must have funds to lend out. They obtain these funds from people or organizations that are willing to deposit money in accounts at the bank, including savings accounts. If everyone spent all of the income they earned each year, there would be no funds available for banks to lend out.

Among the three major sectors of the U.S. economy—households, businesses, and government—only households are net savers. In other words, households save more money than they borrow. Conversely, businesses and government are net borrowers. A few businesses may save more than they invest in business ventures. However, overall, businesses in the United States, like businesses in virtually all countries, invest far more than they save. Many companies borrow funds to finance their investments. And while some local and state governments occasionally run budget surpluses, overall the government sector is also a large net borrower in the U.S. economy. The government borrows money by issuing various forms of bonds. Like corporate bonds, government bonds are contractual obligations to repay what is borrowed, plus some specified rate of interest, at a specified time.

Matching Borrowers and Lenders in Financial Markets
Households save money for several reasons: to provide a cushion against bad times, as when wage earners or others in the household become sick, injured, or disabled; to pay for large expenditures such as houses, cars, and vacations; to set aside money for retirement; or to invest. Banks and other financial institutions compete for households’ savings deposits by paying interest to the savers. Then banks lend those funds out to borrowers at a higher rate of interest than they pay to savers. The difference between the interest rates charged to borrowers and paid to savers is the main way that banks earn profits.

Of course banks must also be careful to lend the money to people and firms that are creditworthy—meaning they will be able to repay the loans. The creditworthiness of the borrower is one reason why some kinds of loans have higher rates of interest than others do. Short-term loans made to people or businesses with a long history of stable income and employment, and who have assets that can be pledged as collateral that will become the bank’s property if a loan is not repaid, will receive the lowest interest rates. For example, well-established firms such as AT&T often pay what is called the bank’s prime rate—the lowest available rate for business loans—when they borrow money. New, start-up companies pay higher rates because there is a greater risk they will default on the loan or even go out of business.

Other kinds of loans also have greater risks of default, so banks and other lenders charge different rates of interest. Mortgage loans are backed by the collateral of the property the loan was used to purchase. If someone does not pay his or her mortgage, the bank has the right to sell the property that was pledged as collateral and to collect the proceeds as payment for what it is owed. That means the bank’s risks are lower, so interest rates on these loans are typically lower, too. The money that is loaned to people who do not pay off the balances on their credit cards every month represents a greater risk to banks, because no collateral is provided. Because the bank does not hold any title to the consumer’s property for these loans, it charges a higher interest rate than it charges on mortgages. The higher rate allows the bank to collect enough money overall so that it can cover its losses when some of these riskier loans are not repaid.

If a bank makes too many loans that are not repaid, it will go out of business. The effects of bank failures on depositors and the overall economy can be very severe, especially if many banks fail at the same time and the deposits are not insured. In the United States, the most famous example of this kind of financial disaster occurred during the Great Depression of the 1930s, when a large number of banks failed. Many other businesses also closed and many people lost both their jobs and savings.

Bank failures are fairly rare events in the U.S. economy. Banks do not want to lose money or go out of business, and they try to avoid making loans to individuals and businesses who will be unable to repay them. In addition, a number of safeguards protect U.S. financial institutions and their customers against failures. The Federal Deposit Insurance Corporation (FDIC) insures most bank and savings and loan deposits up to $100,000. Government examiners conduct regular inspections of banks and other financial institutions to try to ensure that these firms are operating safely and responsibly.

A Money and the Value of Money

MONEY AND FINANCIAL MARKETS
A Money and the Value of Money

Money is anything generally accepted as final payment for goods and services. Throughout history many things have been used around the world as money, including gold, silver, tobacco, cattle, and rare feathers or animal skins. In the U.S. economy today, there are three basic forms of money: currency (dollar bills), coins, and checks drawn on deposits at banks and other financial firms that offer checking services. Most of the time, when households, businesses, and government agencies pay their bills they use checks, but for smaller purchases they also use currency or coins.

People can change the type of the money they hold by withdrawing funds from their checking account to receive currency or coins, or by depositing currency and coins in their checking accounts. But the money that people have in their checking accounts is really just the balance in that account, and most of those balances are never converted to currency or coins. Most people deposit their paychecks and then write checks to pay most of their bills. They only convert a small part of their pay to currency and coins. Strange as it seems, therefore, most money in the U.S. economy is just the dollar amount written on checks or showing in checking account balances. Sometimes, economists also count money in savings accounts in broader measures of the U.S. money supply, because it is easy and inexpensive to move money from savings accounts to checking accounts





Most people are surprised to learn that when banks make loans, the loans create new money in the economy. As we’ve seen, banks earn profits by lending out some of the money that people have deposited. A bank can make loans safely because on most days, the amount some customers are depositing in the bank is about the same amount that other customers are withdrawing. A bank with many customers holding a lot of deposits can lend out a lot of money and earn interest on those loans. But of course when that happens, the bank does not subtract the amount it has loaned out from the accounts of the people who deposited funds in savings and checking accounts. Instead, these depositors still have the money in their accounts, but now the people and firms to whom the bank has loaned money also have that money in their accounts to spend. That means the total amount of money in the economy has increased. This process is called fractional reserve banking, because after making loans the bank retains only a fraction of its deposits as reserves. The bank really could not pay all of its depositors without calling in the loans it has made. It also means that money is created when banks make loans but destroyed when loans are paid off.
At one time the dollar, like most other national currencies, was backed by a specified quantity of gold or silver held by the federal government. At that time, people could redeem their dollars for gold or silver. But in practice paper currency is much easier to carry around than large amounts of gold or silver. Therefore, most people have preferred to hold paper money or checking balances, as long as paper currency and checks are accepted as payment for goods and services and maintain their value in terms of the amount of goods and services they can buy.

Eventually governments around the world also found it expensive to hold and guard large quantities of gold or silver. As foreign trade grew, governments found it especially difficult to transfer gold and silver to other countries that decided to redeem paper money acquired through international trade. They, too, changed to using paper currencies and writing checks against deposits in accounts. In 1971 the United States suspended the international payment of gold for U.S. currency. This action effectively ended the gold standard, the name for this official link between the dollar and the price of gold. Since then, there has been no official link between the dollar and a set price for gold, or to the amount of gold or other precious metals held by the U.S. government.

The real value of the dollar today depends only on the amount of goods and services a dollar can purchase. That purchasing power depends primarily on the relationship between the number of dollars people are holding as currency and in their checking and savings accounts, and the quantity of goods and services that are produced in the economy each year. If the number of dollars increases much more rapidly than the quantity of goods and services produced each year, or if people start spending the dollars they hold more rapidly, the result is likely to be inflation. Inflation is an increase in the average price of all goods and services. In other words, it is a decrease in the value of what each dollar can buy.

The Federal Reserve System and Monetary Policy

Governments often attempt to reduce inflation by controlling the supply of money. Consequently, organizations that control how much money is issued in an economy play a major role in how the economy performs, in terms of prices, output and employment levels, and economic growth. In the United States, that organization is the nation’s central bank, the Federal Reserve System. The system’s name comes from the fact that the Federal Reserve has the legal authority to make banks hold some of their deposits as reserves, which means the banks cannot lend out those deposits. These reserve funds are held in the Federal Reserve Bank. The Federal Reserve also acts as the banker for the federal government, but the government does not own the Federal Reserve. It is actually owned by the nation’s banks, which by law must join the Federal Reserve System and observe its regulations.

There are 12 regional Federal Reserve banks. These banks are not commercial banks. They do not accept savings deposits from or provide loans to individuals or businesses. Instead, the Federal Reserve functions as a central bank for other banks and for the federal government. In that role the Federal Reserve System performs several important functions in the national economy. First, the branches of the Federal Reserve distribute paper currency in their regions. Dollar bills are actually Federal Reserve notes. You can look at a dollar bill of any denomination and see the number for the regional Federal Reserve Bank where the bill was originally issued. But of course the dollar is a national currency, so a bill issued by any regional Federal Reserve Bank is good anyplace in the country. The distribution of currency occurs as commercial banks convert some of their reserve balances at the Federal Reserve System into currency, and then provide that currency to bank depositors who decide to hold some of their money balances as currency rather than deposits in checking accounts. The U.S. Treasury prints new currency for the Federal Reserve System. The bills are introduced into circulation when commercial banks use their reserves to buy currency from the Federal Reserve Bank.

Second, the regional Federal Reserve banks transfer funds for checks that are deposited by a bank in one part of the country, but were written by someone who has a checking account with a bank in another part of the country. Millions of checks are processed this way every business day. Third, the regional Federal Reserve Banks collect and analyze data on the economic performance of their regions, and provide that information and their analysis of it to the national Federal Reserve System. Each of the 12 regions served by the Federal Reserve banks has its own economic characteristics. Some of these regional economies are concerned more with agricultural issues than others; some with different types of manufacturing and industries; some with international trade; and some with financial markets and firms. After reviewing the reports from all different parts of the country, the national Federal Reserve System then adopts policies that have major effects on the entire U.S. economy.

By far the most important function of the Federal Reserve System is controlling the nation’s money supply and the overall availability of credit in the economy. If the Federal Reserve System wants to put more money in the economy, it does not ask the Treasury to print more dollar bills. Remember, much more money is held in checking and savings accounts than as currency, and it is through those deposit accounts that the Federal Reserve System most directly controls the money supply. The Federal Reserve affects deposit accounts in one of three ways.

First, it can allow banks to hold a smaller percentage of their deposits as reserves at the Federal Reserve System. A lower reserve requirement allows banks to make more loans and earn more money from the interest paid on those loans. Banks making more loans increase the money supply. Conversely, a higher reserve requirement reduces the amount of loans banks can make, which reduces or tightens the money supply.

The second way the Federal Reserve System can put more money into the economy is by lowering the rate it charges banks when they borrow money from the Federal Reserve System. This particular interest rate is known as the discount rate. When the discount rate goes down, it is more likely that banks will borrow money from the Federal Reserve System, to cover their reserve requirements and support more loans to borrowers. Once again, those loans will increase the nation’s money supply. Therefore, a decrease in the discount rate can increase the money supply, while an increase in the discount rate can decrease the money supply.

(WTO) and Its Predecessors

World Trade Organization (WTO) and Its Predecessors
As World War II drew to a close, leaders in the United States and other Western nations began working to promote freer trade for the post-war world. They set up the International Monetary Fund (IMF) in 1944 to stabilize exchange rates across member nations. The Marshall Plan, developed by U.S. general and economist George Marshall, promoted free trade. It gave U.S. aid to European nations rebuilding after the war, provided those nations reduced tariffs and other trade barriers.

In 1947 the United States and many of its allies signed the General Agreement on Tariffs and Trade (GATT), which was especially successful in reducing tariffs over the next five decades. In 1995 the member nations of the GATT founded the World Trade Organization (WTO), which set even greater obligations on member countries to follow the rules established under GATT. It also established procedures and organizations to deal with disputes among member nations about the trading policies adopted by individual nations.

In 1992 the United States also signed the North American Free Trade Agreement (NAFTA) with its closest neighbors and major trading partners, Canada and Mexico. The provisions of this agreement took effect in 1994. Since then, studies by economists have found that NAFTA has benefited all three nations, although greater competition has resulted in some factories closing. As a percentage of national income, the benefits from NAFTA have been greater in Canada and Mexico than in the United States, because international trade represents a larger part of those economies. While the United States is the largest trading nation in the world, it has a very large and prosperous domestic economy; therefore international trade is a much smaller percentage of the U.S. economy than it is in many countries with much smaller domestic economies.

Exchange Rates

Exchange Rates and the Balance of Payments
Currencies from different nations are traded in the foreign exchange market, where the price of the U.S. dollar, for instance, rises and falls against other currencies with changes in supply and demand. When firms in the United States want to buy goods and services made in France, or when U.S. tourists visit France, they have to trade dollars for French francs. That creates a demand for French francs and a supply of dollars in the foreign exchange market. When people or firms in France want to buy goods and services made in the United States they supply French francs to the foreign exchange market and create a demand for U.S. dollars.

Changes in people’s preferences for goods and services from other countries result in changes in the supply and demand for different national currencies. Other factors also affect the supply and demand for a national currency. These include the prices of goods and services in a country, the country’s national inflation rate, its interest rates, and its investment opportunities. If people in other countries want to make investments in the United States, they will demand more dollars. When the demand for dollars increases faster than the supply of dollars on the exchange markets, the price of the dollar will rise against other national currencies. The dollar will fall, or depreciate, against other currencies when the supply of dollars on the exchange market increases faster than the demand.

All international transactions made by U.S. citizens, firms, and the government are recorded in the U.S. annual balance of payments account. This account has two basic sections. The first is the current account, which records transactions involving the purchase (imports) and sale (exports) of goods and services, interest payments paid to and received from people and firms in other nations, and net transfers (gifts and aid) paid to other nations. The second section is the capital account, which records investments in the United States made by people and firms from other countries, and investments that U.S. citizens and firms make in other nations.

These two accounts must balance. When the United States runs a deficit on its current account, often because it imports more that it exports, that deficit must be offset by a surplus on its capital account. If foreign investments in the United States do not create a large enough surplus to cover the deficit on the current account, the U.S. government must transfer currency and other financial reserves to the governments of the countries that have the current account surplus. In recent decades, the United States has usually had annual deficits in its current account, with most of that deficit offset by a surplus of foreign investments in the U.S. economy.

Economists offer divergent views on the persistent surpluses in the U.S. capital account. Some analysts view these surpluses as evidence that the United States must borrow from foreigners to pay for importing more than it exports. Other analysts attribute the surpluses to a strong desire by foreigners to invest their funds in the U.S. economy. Both interpretations have some validity. But either way, it is clear that foreign investors have a claim on future production and income generated in the U.S. economy. Whether that situation is good or bad depends how the foreign funds are used. If they are used mainly to finance current consumption, they will prove detrimental to the long-term health of the U.S. economy. On the other hand, their effect will be positive if they are used primarily to fund investments that increase future levels of U.S. output and income.

CURRENT TRENDS AND ISSUES

In the early decades of the 21st century, many different social, economic and technological changes in the United States and around the world will affect the U.S. economy. The population of the United States will become older and more racially and ethnically diverse. The world population is expected to continue to grow at a rapid rate, while the U.S. population will likely grow much more slowly. World trade will almost certainly continue to expand rapidly if current trade policies and rates of economic growth are maintained, which in turn will make competition in the production of many goods and services increasingly global in scope. Technological progress is likely to continue at least at current rates, and perhaps faster. How will all of this affect U.S. consumers, businesses, and government?

Over the next century, average standards of living in the United States will almost certainly rise, so that on average, people living at the end of the century are likely to be better off in material terms than people are today. During the past century, the primary reasons for the increase in living standards in the United States were technological progress, business investments in capital goods, and people’s investments in greater education and training (which were often subsidized by government programs). There is no evident reason why these same factors will not continue to be the most important reasons underlying changes in the standard of living in the United States and other industrialized economies. A comparatively small number of economists and scientists from other fields argue that limited supplies of energy or of other natural resources will eventually slow or stop economic growth. Most, however, expect those limits to be offset by discoveries of new deposits or new types of resources, by other technological breakthroughs, and by greater substitution of other products for the increasingly scarce resources.

Although the U.S. economy will likely remain the world’s largest national economy for many decades, it is far less certain that U.S. households will continue to enjoy the highest average standard of living among industrialized nations. A number of other nations have rapidly caught up to U.S. levels of income and per capita output over the last five decades of the 20th century. They did this partly by adopting technologies and business practices that were first developed in the United States, or by developing their own technological and managerial innovations. But in large part, these nations have caught up with the United States because of their higher rates of savings and investment, and in some cases, because of their stronger systems for elementary and secondary education and for training of workers.

Most U.S. workers and families will still be better off as the U.S. economy grows, even if some other economies are growing faster and becoming somewhat more prosperous, as measured per capita. Certainly families in Britain today are far better off materially than they were 150 to 200 years ago, when Britain was the largest and wealthiest economy in the world, despite the fact that many other nations have since surpassed the British economy in size and affluence.

A more important problem for the U.S. economy in the next few decades is the unequal distribution of gains from growth in the economy. In recent decades, the wealth created by economic growth has not been as evenly distributed as was the wealth created in earlier periods. Incomes for highly educated and trained workers have risen faster than average, while incomes for workers with low levels of education and training have not increased and have even fallen for some groups of workers, after adjusting for inflation. Other industrialized market economies have also experienced rising disparity between high-income and low-income families, but wages of low-income workers have not actually fallen in real terms in those countries as they have in the United States.

In most industrialized nations, the demand for highly educated and trained workers has risen sharply in recent decades. That happened in part because many kinds of jobs now require higher skill levels, but other factors were also important. New production methods require workers to frequently and rapidly change what they do on the job. They also increase the need for quality products and customer service and the ability of employees to work in teams. Increased levels of competition, including competition from foreign producers, have put a higher premium on producing high quality products.

Several other factors help explain why the relative position of low-income workers has fallen more in the United States than in other industrialized Western nations. The growth of college graduates has slowed in the United States but not in other nations. United States immigration policies have not been as closely tied to job-market requirements as immigration policies in many other nations have been. Also, government assistance programs for low-income families are usually not as generous in the United States as they are in other industrialized nations.

Changes in the make-up of the U.S. population are likely to cause income disparity to grow, at least through the first half of the 21st century. The U.S. population is growing most rapidly among the groups that are most likely to have low incomes and experience some form of discrimination. Children in these groups are less likely to attend college or to receive other educational opportunities that might help them acquire higher-paying jobs.

The U.S. population will also be aging during this period. As people born during the baby boom of 1946 to 1964 reach retirement age, the percentage of the population that is retired will increase sharply, while the percentage that is working will fall. The demand for medical care and long-term care facilities will increase, and the number of people drawing Social Security benefits will rise sharply. That will increase pressure on government budgets. Eventually, taxes to pay for these services will have to be increased, or the level of these services provided by the government will have to be cut back. Neither of those approaches will be politically popular.

Stock (business)

INTRODUCTION
Stock (business), in business and finance, a share of ownership in a corporation. Shares in a corporation can be bought and sold, usually on a public stock exchange. Consequently, the owner of shares can realize a profit or capital gain if the stock is sold at a price above what the owner originally paid for it.

Some companies enable stockholders to share in the profits of the company. These payments of corporate profits to stockholders are called dividends. In addition to having a claim on company profits, stockholders are entitled to share in the sale of the company if it is dissolved. They may also vote in person or by proxy on a variety of corporate matters, including the most important matter of who should run the corporation. When the company issues new stock, stockholders have priority to buy a certain number of shares before they are offered for public sale. Stockholders also receive periodic reports, usually quarterly, that provide information regarding the corporation’s business performance. Stocks generally are negotiable, which means stockholders have the right to assign or transfer their shares to another individual.

A stockholder is considered a business owner and has the protection of limited liability under United States laws. Limited liability means that a stockholder is not personally liable for the debts of the corporation. The most a stockholder can lose if the company fails is the amount of his or her investment—what he or she originally paid for the stock. This arrangement differs from that of other forms of business organization, which are known as sole proprietorships and partnerships. These business owners are personally liable for the debts of their businesses.

WHY CORPORATIONS ISSUE STOCK

Corporations issue stock in order to finance their business activities. This method of raising funds is only available to business firms organized as corporations; it is not available to sole proprietorships and partnerships. The corporation can use the proceeds of a stock offering in a variety of ways. Depending on the type of company, this might involve increasing research and development operations, purchasing new equipment, opening new facilities or improving old ones, or hiring new employees.

An alternative to stock financing is debt financing or the sale of bonds, an interest-bearing loan. This alternative is also available to sole proprietorships and partnerships. With the issuance of a bond a company typically promises to make periodic interest payments to the lender or bondholder as well as pay back the amount of the bond when the term of the bond expires. Thus bonds are evidence of loans while stocks are evidence of ownership. Stocks and bonds are collectively known as securities.

When a corporation first makes stock available for public purchase, it works with an investment banking firm to arrange an initial public offering (IPO). The investment bank acquires the first issue of stocks from the corporation at a negotiated price, and then makes the shares available for sale to its clients and other investors. Corporations that have IPOs are usually young companies in need of large amounts of capital.

A corporation can only have one IPO—the first time it makes stock available to the public. After its IPO, a company is said to be public. Public corporations that need additional financing for further business development may choose to issue more stock at a later time. This is called a subsequent, or follow-on, offering.

Some corporations may choose not to go public. In this case it is said to be a privately held corporation. A corporation may elect to remain private because it does not want to share its profits, or it may not want to relinquish control to shareholders.

Most of the information reported in the daily news media about the buying and selling of stock refers to transactions involving previously issued stock. The daily buying and selling of stock rarely involves IPOs. Almost all stock transactions are “second-hand transactions.” The corporation that initially issued the stock is not directly involved.

A corporation’s capitalized value refers to the market value of the stock that it has issued and that remains outstanding—that is, available for sale or purchase. A corporation’s capitalized value may be greater or less than its book value. Book value is the value of the corporation’s assets as reflected in its accounting statements—that is, on its books. Capitalized value may also be greater or less than the corporation’s replacement value, the amount that it would take to replace all of the corporation’s assets.

Corporations will sometimes split their stock. This means the corporation replaces outstanding shares with new shares on some multiple basis, such as a two-for-one or three-for-one split. When a corporation splits its stock, it does not obtain any new funding. Splits usually occur when the market price of shares is deemed too high by corporate management. With a split the price of shares falls, making purchase by smaller investors more affordable. Keeping a stock relatively affordable for smaller investors makes it easier for a corporation to raise money with a follow-on stock offering.

WHY PEOPLE BUY STOCK???

Economic gain represents the primary motive for the purchase of stock. The gain or return from stock consists of two parts: dividends, the periodic payments made from profits, and appreciation, the capital gain realized from selling a stock for more than its purchase price.

An investor really has only two choices in acquiring the financial assets of a corporation—buying stocks or bonds. As a financial claim against a company, bonds take precedence over all types of stock. Thus, they are a safer investment than stocks, especially in times of deflation (a period when the prices of goods and services are generally falling). Stocks, however, are usually the better investment during periods of inflation (a period when the prices of goods and services are generally rising) because they represent ownership of assets that will probably rise in value as fast as or faster than prices in general. Because the dollar value of bonds is fixed, they cannot serve as a hedge or protection against inflation as do common stocks.

THE LANGUAGE OF STOCKS

People who invest in stocks or follow the progress of the stock market encounter a wide variety of terms unique to these investments. These terms include price-to-earnings ratio, earnings per share, market capitalization, mutual fund, bull market, bear market, and day trading, among others. Understanding this vocabulary helps explain many of the workings of the market in stocks.

Price-to-Earnings Ratio and Earnings Per Share

Investors use several techniques to determine whether a particular stock should be purchased. Some investors examine a stock’s fundamentals such as its earnings per share or its price-to-earnings ratio. Earnings per share is calculated by dividing the corporation’s total earnings or income by the number of shares the corporation has outstanding. A corporation’s price-earnings ratio is calculated by dividing the current price of a share of the company’s stock by its earnings per share. These calculations represent fundamentals in the sense that they reflect the effectiveness of a company’s business operation (earnings per share) and the market’s current assessment of the company’s worth in relation to its earnings (price-earnings ratio).

In making a decision to buy or sell a particular stock, expectations are formed regarding future fundamentals. If expectations about the corporation’s operations improve and investors expect higher earnings per share, then the price of the stock is likely to rise. Investors expect that more people will want to buy shares to participate in the increased profitability. If, however, expectations turn pessimistic and shareholders anticipate lower earnings per share, then holders of the stock will try to sell their shares, reducing the stock’s price.


Mutual Fund
Investors can own stock in two different ways. The first is direct ownership, in which investors add a corporation’s stock to their personal portfolio or account. The second type of ownership is indirect and involves participation in a mutual fund. A mutual fund is operated by a management-investment company that combines the money of its shareholders and invests that money in a wide variety of stocks. A mutual fund is thought to be safer because it is diversified. Diversification means that shareholders are less likely to lose their investment because the risk is spread among the stocks of many corporations rather than just a few. Investors add the stock of the mutual fund to their personal accounts. However, the mutual fund has direct ownership of the corporations’ stocks.


Bull Market, Bear Market
Bull market is a term applied to a period when stock prices on average experience a sustained increase. During a bull market investors are optimistic about future business conditions and expect corporate profits to rise. So they will want to acquire stock to participate in the expected higher profits. A bear market describes the opposite situation, when stock prices on average experience a sustained decrease. Pessimism regarding the economic future dominates investor thinking during a bear market.

The most recent bull market extended from 1990 to early 2000 when the market value of the outstanding shares of domestically issued stock rose from $3.5 trillion to $19.6 trillion. During the bear market that followed, the market value of these stocks fell from their high point to $13.3 trillion as of mid-2002.


Dealers and Brokers
Investors typically employ the services of dealers and brokers to execute the purchase and sale of securities. Some of these brokers are considered full-service brokers. Full-service brokers provide a wide variety of services for the investor, including the provision of investment advice. Other firms are considered discount brokers. Discount brokers basically provide the single service of executing the buy and sell orders of investors. For mutual fund transactions the investor can deal directly with the mutual fund. Thus, the investor need not use the services of a broker or a dealer for these types of transactions. Even in these instances, however, an investor may seek the advice of a financial adviser to determine which mutual fund to buy or whether to sell fund shares.


Day Traders
Some investors are known as day traders. These are individuals who sit at computer terminals continuously monitoring stock prices for profit opportunities. They typically own stocks for very short periods of time, usually for less than a day. Day trading became popular with the development of computer technology and with the bull market of the 1990s. But day trading became significantly less popular with the advent of the bear market in 2000.

WHO OWNS STOCKS?

For a long time only the wealthy were likely to own stocks. Middle-class and working-class Americans generally did not participate in the stock market. Recent estimates, however, have shown significant growth in stock ownership. In 1989, 31.6 percent of American families had either direct or indirect stock ownership. By 2001 that percentage had grown to more than half at 51.9 percent. Most families held stock in retirement accounts. Only 21.3 percent of families owned stock directly in 2001. The median value of the direct and indirect stockholdings among families holding stock was $34,300, up from $27,200 in 1998 and $10,800 in 1989. This means that half the families holding stock owned more than $34,300 worth, and half owned less than $34,300. For families holding stocks, the value of their stockholdings increased from 28 percent of all their financial assets in 1989 to about 54 percent in 1998. Financial assets include checking accounts, certificates of deposit, savings bonds, bonds, stocks, mutual funds, retirement accounts, cash value of life insurance, and the like.