Stock Prices: S&P 500

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The following perspective is from the Board Of Governors of the Federal Reserve System Finance And Economics Discussion Series. It is excerpted from a paper titled "Money Demand And Equity Markets" by Seth B. Carpenter and Joe Lange. In it they discuss the complex relationship between the liquidity of money and the investment potential of equities, of which households are more heavily invested than in the past:

"A stable money demand function has long been sought after because it can be very useful for explaining, and even predicting, the behavior of other aspects of the macro-economy. In traditional formulations, money demand is a function of a scale variable, like nominal GDP, and the opportunity cost of holding money. If 1.) the elasticity with respect to the opportunity cost is known, and 2.) the relationship between money with GDP is stable, then the observation of money data, which tend to be relatively high frequency, can help to predict nominal output, which is observed at a lower frequency. While both of those conditions are important, it is the second that is most often called into question. Conceptually, money is an asset with a particular set of characteristics, most notably its liquidity. Like other financial assets, demand for money is part of a portfolio allocation decision, in which an agent's wealth is distributed among competing assets based on each asset's relative benefits (see e.g., Tobin 1969). To a certain extent, agents are willing to give up the higher return of alternative assets in order to receive the benefit of liquidity that money provides. Thus, standard money demand equations include an interest rate or interest rate spread to measure the opportunity cost of holding non-interest earning money. Typically the assumed alternative asset used to measure the opportunity cost of holding money is a risk-free instrument, such as a Treasury security, though this is often viewed as a proxy for all substitute assets for money.

"Through time, the stock market has become a more important store of wealth for households. Growth and innovations in mutual fund industry and the emergence of internet trading have reduced transaction costs and thus increased the substitutability between equities and money. Bertaut and Starr-McCluer (2000) explore the evolution of household portfolios. Using survey data, they report that the fraction of households that own bank accounts has remained steady, between 87 and 90 percent from 1983 through
1998. In contrast, only 4-1/2 percent of households owned mutual funds in 1983, compared to 10-1/2 percent in 1992 and 16-1/2 percent in 1998. In terms of the fraction of households' portfolios, Bertaut and Starr-McCluer report that bank accounts declined from 8-1/4 percent of total assets in 1983 to 6-1/4 percent in 1998. Wealth in mutual funds increased from about one percent of total assets in 1983 to 5 percent in 1998;mutual funds represent almost as large a share of households' assets as bank deposits, and direct ownership of individual stocks makes up another 10 percent of total assets."

http://www.federalreserve.gov/pubs/feds/2003/200303/200303pap.pdf

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The following is excerpted from a speech given by Federal Reserve Governor Susan Schmidt Bies at a joint presentation to the National Economics Club and the Committee on the Status of Women in the Economics Profession of the American Economics Association in Washington, DC on February 27, 2003. In it she discusses the broadening participation in stock ownership through retirement account investing:

"As Americans have stepped up their use of employee-directed savings accounts in the past couple of decades, many have also purchased their first shares of corporate equity--often within their 401(k) plans. More than half of U.S. households now own either stock or stock mutual funds. Moreover, equity ownership reaches further into younger generations and the middle class now than it did in the 1980s. From 1989 to 2001, the fraction of Americans younger than 35 who owned stock more than doubled, as did stock ownership among families with below-median income. This striking increase in equity ownership is, in part, an outgrowth of the move toward worker-directed savings plans, as I've already discussed. More than two-thirds of U.S. stockholders now hold some stock in an employer-sponsored retirement plan. In addition, the heightened popularity of owning stocks probably reflects a broadened understanding of the potential benefits of equity investments and perhaps an increased tolerance for financial risk. Also important, especially for investors of relatively modest means, is that mutual funds in particular have substantially reduced the cost of purchasing a diversified portfolio. Despite the ease with which corporate equities can be traded directly nowadays--through on-line brokerage accounts, for example--a recent survey found that two-thirds of stockholders first bought their equity shares through mutual funds. Besides its financial risks and potential rewards, stock ownership imparts important corporate governance responsibilities. In fact, economic theories of firm behavior often stress the competing interests of management and ownership. With an ownership share in a business, every stock investor has a role in providing oversight on how that company is run. The egregious corporate scandals in the headlines last year have highlighted the need for responsible oversight by corporate boards and shareholders alike to check the behavior of management. So, as we look for solutions to corporate governance problems, we should not forget that every individual who owns stock has a role--perhaps a small one, but an important one."

http://www.federalreserve.gov/boarddocs/speeches/2003/20030227/default.htm

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The following perspective is excerpted from an article called "The Stock Market: Beyond Risk Lies Uncertainty" written by Frank A. Schmid and published in the July 2002 issue of the Federal Reserve Bank of St. Louis's periodical The Regional Economist. In it he discusses the concepts of risk and uncertainty in relation to equity investments:

"Life is risky. The future is uncertain. These two phrases, I suppose, we all have heard--and possibly used--many times. Although the words risk and uncertainty seem to cross our lips easily, how well do we understand the concepts? More specifically, are we aware of the implications of risk and uncertainty for stock market investments? If the decline in headline stock market indexes--such as the Dow Jones Industrial Average, the Nasdaq Composite or the S&P 500--over the past two years has reminded you of the possibility of steep declines, stay tuned. Risk and uncertainty are manifestations of the same underlying force--randomness. In fact, one of the most significant advances in understanding randomness lies in distinguishing between the two concepts. Risk is randomness in which events have measurable probabilities, wrote economist Frank Knight in 1921 in Meaning of Risk and Uncertainty, a seminal treatment on the topic. Probabilities may be attained either by deduction--using theoretical models--or induction--using the observed frequency of events. For instance, we can easily deduce the probabilities of the possible outcomes of a game of dice. In a similar vein, economists deduce probability distributions for stock market returns from theoretical models of investor behavior. On the other hand, induction allows us to calculate probabilities from past observations where theoretical models are unavailable, possibly because of a dearth of knowledge about the underlying relation between cause and effect. As an example, we can induce the probability of suffering a head injury when riding a bicycle from observing how frequently it has happened in the past. Similarly, economists estimate probability distributions for stock market returns from the history of past returns."

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