IntroductionThe efficiency of the U.S. capital market is legendary. Historically, virtually every major city once had a stock market, but by the 1990s there were only three major markets: New York, New York; Chicago, Illinois; and San Francisco, California. Local markets persisted in such cities as Boston, Massachusetts, and Philadelphia, Pennsylvania, but trading was limited.
Capital markets in the United States have provided much of the money -- the lifeblood of capitalism -- to finance the building of thousands of factories and plants, research laboratories and office buildings, airplanes and ships. It is fair to say that if capital markets did not exist in the United States, they would have had to be invented. Although in recent years much capital has been raised through bond markets and in other ways, stock markets have often proved to be useful money-raising tools for new struggling companies.
Capital markets are said to be efficient when they can match quickly vast numbers of stocks put forth by sellers with vast demands for stocks put forth by buyers. In part, it is a matter of technology. The modern markets, particularly those in New York and Chicago, rely heavily on computerization each day to process millions of transactions. But also, in part, it is a matter of tradition and experience. The stock market works largely on one broker's trust in another broker's word. The brokers, in turn depend on the faith of the customers they represent. Occasionally this trust is abused. But during the last half century, the federal government has played an increasingly important role in insisting on clean dealing and unambiguous language.
This chapter is an attempt to explain how the stock market works. In large measure it is written from the standpoint of the small buyer and seller of stocks. But it is not hard to see how these small customers are able to interact to provide a quickly responding market.
The principles of this market are similar to all others. For every buyer there has to be a seller. When more people wish to buy than to sell, the price tends to rise; when fewer people wish to buy and many wish to sell, the price tends to fall.
So broad is the ownership of stock shares that owners can easily follow the fortunes of the market on a daily or even hourly basis. Investors get their information in a variety of ways. If they are willing to wait until the markets close, they can simply look at the markets pages of large daily newspapers to find out what happened in the previous trading session. There are a variety of indexes that measure market activity broadly, and individual stocks are also listed, showing the number of shares traded, the closing price, and high and low prices reached during the trading session. Certain television programs devoted to business report immediate developments in market movements. For those who insist on getting up-to-the-minute information about price movements of individual stocks, computerized services will deliver this information almost instantaneously to their homes over telephone lines.
Also, investors often subscribe to magazines and newsletters devoted to analyzing movements in individual stocks and the markets in general, and speculating about the future.
Once a company has sold its original stock to the public and it is traded freely in the market, the price will be determined continuously during the trading day by what buyers will pay and what sellers will take. It is simply a matter of supply and demand. Thus, the price is the composite opinion of all the people who buy and sell that stock. Factors that influence how much people will pay include:
- The general business climate or trend, depending on the state
of the overall national economy, and the amount of confidence the
public has in it;
- The amount of profit the company that issued the stock has
been making, or is predicted to make, and its financial
- The rate at which the company is growing or declining;
- The ability of a company to compete successfully with its
rivals over a period of time;
- Whether the product or service is one that is popular, and
whether the market for that product or service is growing or
- The general interest rate, or the market price for bonds;
- The rate of return the company offers compared to the rate of return on alternative investments.