💳Principles of Finance Unit 12 – US Market Performance: A Historical View

Key Economic Indicators

• Gross Domestic Product (GDP) measures the total value of goods and services produced within a country's borders over a specific period
  • Real GDP adjusts for inflation providing a more accurate picture of economic growth
  • Nominal GDP does not account for inflation and can be misleading
• Unemployment rate represents the percentage of the labor force that is actively seeking work but unable to find employment
  • Cyclical unemployment occurs during economic downturns when demand for goods and services decreases
  • Structural unemployment results from a mismatch between the skills of workers and the requirements of available jobs
• Inflation rate measures the rate at which the general price level of goods and services is rising
  • Consumer Price Index (CPI) tracks the cost of a basket of commonly purchased goods and services
  • Core inflation excludes volatile food and energy prices for a more stable measure
• Interest rates represent the cost of borrowing money and the return on savings
  • Federal funds rate is the rate at which banks lend money to each other overnight
  • Higher interest rates can slow economic growth by making borrowing more expensive
• Consumer confidence index gauges the level of optimism that consumers have about the economy and their personal financial situation
  • Higher consumer confidence often correlates with increased spending and economic growth
• Leading Economic Index (LEI) is a composite of 10 economic indicators that tend to move before changes in the overall economy
  • Includes measures like manufacturing orders, stock prices, and consumer expectations
  • Provides insight into future economic trends and potential turning points

Historical Market Trends

• Long-term trend of the US stock market has been positive with an average annual return of around 10% since 1926
  • Driven by economic growth, technological advancements, and population increases
  • Short-term fluctuations and bear markets occur but are typically followed by recoveries
• Market returns vary significantly across different time periods and economic conditions
  • Great Depression era (1929-1939) saw a decline of over 80% in the Dow Jones Industrial Average
  • Post-World War II period (1945-1960) experienced strong economic growth and rising stock prices
• Diversification across sectors and asset classes can help mitigate risk and smooth out returns over time
  • Historically, a balanced portfolio of 60% stocks and 40% bonds has provided stable returns with lower volatility
• Value stocks (low price-to-earnings ratio) have outperformed growth stocks (high price-to-earnings ratio) over the long term
  • Small-cap stocks have also generated higher returns than large-cap stocks but with greater volatility
• International markets have become increasingly important for diversification and growth opportunities
  • Emerging markets like China and India have experienced rapid economic development in recent decades
  • Correlations between US and international markets have increased over time reducing diversification benefits

Major Market Events

• Black Monday (October 19, 1987) saw the Dow Jones Industrial Average fall by over 22% in a single day
  • Triggered by a combination of factors including program trading, overvaluation, and global economic concerns
  • Markets recovered relatively quickly but led to changes in circuit breaker rules and trading halts
• Dot-com bubble (1995-2000) was characterized by a rapid rise in technology stock prices followed by a sharp decline
  • Fueled by speculation and overvaluation of internet-based companies with little or no profits
  • Nasdaq Composite Index fell by over 75% from peak to trough wiping out trillions in market value
• September 11th terrorist attacks (2001) led to a temporary closure of US financial markets and a sharp decline in stock prices
  • Markets reopened on September 17th with the Dow falling over 7% but recovered in the following months
  • Attacks highlighted the vulnerability of financial systems to external shocks and the importance of contingency planning
• Global Financial Crisis (2007-2009) was triggered by a collapse in the US housing market and the failure of major financial institutions
  • Dow Jones Industrial Average fell by over 50% from peak to trough
  • Crisis spread globally leading to a worldwide recession and unprecedented government interventions
• COVID-19 pandemic (2020) caused a sharp sell-off in global markets as countries implemented lockdowns and travel restrictions
  • S&P 500 fell by over 30% in March 2020 but recovered to new highs by the end of the year
  • Pandemic accelerated trends like remote work, e-commerce, and digital transformation

Regulatory Changes and Impacts

• Securities Act of 1933 and Securities Exchange Act of 1934 established the framework for modern securities regulation in the US
  • Required companies to disclose financial information and prohibited fraudulent practices
  • Created the Securities and Exchange Commission (SEC) to enforce securities laws and protect investors
• Glass-Steagall Act (1933) separated commercial banking from investment banking to prevent conflicts of interest and excessive risk-taking
  • Repealed in 1999 by the Gramm-Leach-Bliley Act which allowed for the creation of financial holding companies
• Sarbanes-Oxley Act (2002) was passed in response to accounting scandals like Enron and WorldCom
  • Established new requirements for financial reporting, auditor independence, and corporate governance
  • Increased penalties for fraudulent activities and enhanced protections for whistleblowers
• Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) was enacted in the wake of the Global Financial Crisis
  • Created the Consumer Financial Protection Bureau (CFPB) to regulate consumer financial products and services
  • Established the Volcker Rule prohibiting banks from engaging in proprietary trading and limiting their investments in hedge funds and private equity
• Regulation Fair Disclosure (Reg FD) implemented in 2000 to prevent selective disclosure of material nonpublic information
  • Requires companies to disclose material information to all investors at the same time
  • Aims to level the playing field and promote transparency in financial markets
• Regulation National Market System (Reg NMS) adopted in 2005 to modernize and strengthen the US equity markets
  • Includes rules for order protection, access to market data, and sub-penny pricing
  • Aims to promote competition, transparency, and efficiency in the trading of securities

Sector Performance Analysis

• Different sectors of the economy perform differently depending on the stage of the business cycle and other factors
  • Cyclical sectors like consumer discretionary and industrials tend to outperform during expansions
  • Defensive sectors like utilities and healthcare tend to outperform during recessions
• Technology sector has been a major driver of US stock market performance in recent decades
  • Includes companies like Apple, Microsoft, and Amazon that have grown rapidly and disrupted traditional industries
  • Tech stocks can be volatile and sensitive to changes in interest rates and regulatory environment
• Energy sector performance is closely tied to the price of oil and other commodities
  • Oil price shocks like the 1973 OPEC embargo and the 2014 supply glut have had significant impacts on energy stocks
  • Transition to renewable energy sources could disrupt traditional oil and gas companies in the long term
• Financial sector includes banks, insurance companies, and other financial services firms
  • Sensitive to changes in interest rates, credit conditions, and regulatory environment
  • Sector was hit hard during the Global Financial Crisis but has recovered in recent years
• Healthcare sector includes companies involved in the delivery of medical services, production of medical equipment, and development of pharmaceuticals
  • Aging population and rising healthcare costs are long-term drivers of demand
  • Sector can be impacted by changes in government policies and regulations
• Real estate sector includes companies that own, develop, and manage properties like office buildings, shopping centers, and apartments
  • Sensitive to changes in interest rates, economic conditions, and demographic trends
  • Real Estate Investment Trusts (REITs) allow investors to gain exposure to the sector without directly owning property

Market Cycles and Patterns

• Business cycles refer to the fluctuations in economic activity that an economy experiences over time
  • Expansion phase characterized by economic growth, rising employment, and increasing consumer spending
  • Contraction phase characterized by declining economic activity, rising unemployment, and falling consumer spending
• Stock market cycles often coincide with business cycles but can also be influenced by other factors like investor sentiment and geopolitical events
  • Bull markets occur when stock prices are rising and investor optimism is high
  • Bear markets occur when stock prices are falling and investor pessimism is high
• Seasonal patterns in stock returns have been observed but are not always consistent
  • "Sell in May and go away" refers to the tendency for stocks to underperform during the summer months
  • "January effect" refers to the tendency for small-cap stocks to outperform in January
• Presidential election cycles have also been associated with patterns in stock market returns
  • Historically, stocks have tended to perform better in the second half of a president's term
  • Uncertainty surrounding elections can lead to increased volatility in the short term
• Sector rotation refers to the tendency for different sectors to outperform at different stages of the business cycle
  • Early cycle: consumer discretionary, financials, and industrials tend to outperform
  • Mid-cycle: technology, communication services, and healthcare tend to outperform
  • Late cycle: energy, materials, and utilities tend to outperform
• Market sentiment refers to the overall attitude of investors toward the market and can be a contrarian indicator
  • Extreme optimism can be a sign that the market is overheated and due for a correction
  • Extreme pessimism can be a sign that the market is oversold and due for a rebound

Investment Strategies Over Time

• Buy and hold investing involves buying stocks or other securities and holding them for the long term regardless of short-term market fluctuations
  • Relies on the idea that the market will rise over time and that trying to time the market is futile
  • Requires discipline to stay invested during market downturns and avoid panic selling
• Value investing involves buying stocks that appear undervalued based on fundamental analysis of the company's financial health and prospects
  • Pioneered by investors like Benjamin Graham and Warren Buffett
  • Requires patience to wait for the market to recognize the intrinsic value of the company
• Growth investing involves buying stocks of companies that are expected to grow earnings and revenue at an above-average rate
  • Popularized by investors like Thomas Rowe Price Jr. and Philip Fisher
  • Requires skill in identifying companies with sustainable competitive advantages and strong growth prospects
• Momentum investing involves buying stocks that have performed well in the recent past and selling those that have performed poorly
  • Based on the idea that stocks that have done well recently will continue to do well in the near future
  • Requires discipline to cut losses quickly and let winners run
• Indexing involves buying a diversified portfolio of stocks or bonds that tracks a market index like the S&P 500
  • Popularized by John Bogle and Vanguard in the 1970s as a low-cost, tax-efficient way to invest
  • Has become increasingly popular in recent years with the rise of exchange-traded funds (ETFs)
• Factor investing involves buying stocks or other securities based on specific characteristics or "factors" that have been shown to generate excess returns over time
  • Common factors include value, size, momentum, quality, and low volatility
  • Requires skill in identifying and combining factors to create a diversified portfolio
• Environmental, Social, and Governance (ESG) investing involves considering non-financial factors in investment decisions to align with personal values or mitigate risks
  • Has gained popularity in recent years as investors seek to make a positive impact on society and the environment
  • Requires skill in evaluating companies based on ESG criteria and balancing financial and non-financial objectives

Future Outlook and Predictions

• Demographic trends like the aging of the Baby Boomer generation and the rise of the Millennial generation could have significant impacts on the economy and financial markets
  • Boomers are entering retirement and may shift their investments toward income-generating assets like bonds
  • Millennials are entering their prime earning and spending years and may drive demand for housing, consumer goods, and technology
• Technological advancements like artificial intelligence, blockchain, and renewable energy could disrupt traditional industries and create new opportunities for investors
  • AI could automate many jobs and increase productivity but also raise concerns about job displacement and income inequality
  • Blockchain could revolutionize financial services, supply chain management, and other industries but also faces regulatory and scalability challenges
• Geopolitical risks like trade tensions, political instability, and climate change could create uncertainty and volatility in financial markets
  • US-China trade war has already impacted global supply chains and could escalate further
  • Political polarization and populist movements could lead to policy changes and social unrest
• Monetary policy and interest rates will continue to be important drivers of financial markets and the economy
  • Federal Reserve has signaled plans to keep interest rates low for the foreseeable future to support economic recovery from the COVID-19 pandemic
  • Low interest rates could fuel inflation and asset bubbles in the long term
• Globalization and the rise of emerging markets could create new opportunities and risks for investors
  • Growing middle class in countries like China and India could drive demand for consumer goods and services
  • Geopolitical tensions and differences in regulatory environments could create challenges for multinational corporations
• Sustainable investing and the transition to a low-carbon economy could create winners and losers in the coming decades
  • Companies that adapt to changing consumer preferences and regulatory requirements could outperform
  • Fossil fuel companies and other industries that fail to adapt could face significant headwinds
• Potential for a market correction or recession in the near term as the economy recovers from the COVID-19 pandemic
  • High levels of government debt, corporate debt, and household debt could create vulnerabilities
  • Valuations in some sectors like technology and real estate appear stretched by historical standards