Jenny Wu

Overall, the Dotcom bubble was created by over-optimistic of the potential of the internet, which lead to over-speculation in the stock market. In the late 20th country, the emergence of the internet created an optimistic and euphoria attitude toward business as more firms held great hopes for online commerce. Many internet companies were launched and investors predicted that companies that operate online are going to be worth millions.

Figure 1 shows the index of the internet stocks over the same period from January 1998 to December 2000 versus the S&P 500 and Nasdaq indices over the same period. Apart from the big price differences between the two, the Internet index also shows higher volatility. (1)

Figure 1: Comparison of index levels of the equally weighted Internet index, the S&P 500 index, and the Nasdaq composite index.

Many investors ignore the fundamental indexes of the stock market, including P/E ratio, market trends and reviewing business financial performances and plans. Instead, they are preoccupied with the new products in the industry and dream of becoming dot-com millionaires. These companies were inspired by Amazon, eBay, Kozmo. A lot of companies with no earnings at all were experiencing significant increases in their stock prices. According to Harlan Cole, a cultural historian, “The dot-com bubble, was business plans written on the backs of napkins.” (2)

Just like the presence of pessimistic investors, I’m also curious about if there were any alarm and warnings during the time, and why that didn’t stop the crisis. There had been some warnings coming from the calmer voices, but the companies are preoccupied with a ‘grow big, grow fast’ mentality, and view them as hostile and unwelcome. During an interview in the financial column, when being asked about whether the dot-com was profitable, the vice-president of the start-up said: we’re a pre-revenue company. (3) On April 6, dot-com stocks had lost nearly 1 trillion dollars in stock value. By 2004, more than half of new dot-coms – hundreds of companies – had failed. About $5 trillion in stock value was lost. 

Companies including eBay, Monster, WebMD, were the ones that have a thoughtful business model based on realistic projections and solid financial planning and had not over-promised and over-expanded.(4) Even though many industries lost faith on the internet, going online continued to increase. 

bibliography: 

(1) Kalen Smith. “History of the Dot-Com Bubble Burst and How to Avoid Another.” Moneycrashers.Com, 27 Mar. 2019, www.moneycrashers.com/dot-com-bubble-burst/.‌‌

(2) Ofek, Eli, and Matthew Richardson. DotCom Mania: The Rise and Fall of Internet Stock Prices. 2001.

(3) “The Internet At 50: How the Dot-Com Bubble Burst |  History News        Network.” Historynewsnetwork.Org, 2020, historynewsnetwork.org/article/173359. Accessed 18 Jan. 2020.

1. too big to fail

Too big to fail just means that the natural cost of the bankruptcy of a financial institution is bigger than the cost of the bailout by the government. Banks at the time made careless bets using the money of their customers, believing in the safety of the financial system. Nowadays, the banking system is more stable and is in stricter supervision of various oversight agencies.

2. There are great risks when engaging in speculative behaviours. Nowadays, there are higher standards of leverage and capital ratios required for the banks in order to ensure a stable and less risky financial environment. Financial regulations have also increased significantly throughout the years.

3. Excess lending will lead to overheating housing estate market. Looking at the fundamental cause of the financial crisis, over-lending to unfit, low-profiled borrowers have been the greatest cause. With an adjustable mortgage rate, these borrowers were quickly unable to pay back as the rate increased. Today, only 15% of the mortgages are adjustable, with tightening lending policy being set up.

4. Moral Hazard. During the financial crisis, banks behaved badly, and like the last paragraph of the previous article stated, the true victims are the ones who put their money into the investment and lost all of them. What’s worse, none of these banks was indicted or charged after the financial crisis, as it’s way too hard to prove the illegality.

Introduction

The Great Recession in 2008 is viewed as the second terrifying crisis in addition to the great depression. I found it very interesting and also valuable as my parents have been in the crisis. Served in a US company, my parents were largely affected by the crisis, however every time I ask them what this whole thing is about, they always gave a vague answer, saying that it triggered a stock market crash and caused unemployment in China. I was curious as for how this crisis would spread to so many countries and the causes of it. Statistics show that the great recession result in a 35% real drop in housing prices spread over a period of 6 years. Equity price fell 55% over 3 years. Output fell 9% over two years, while unemployment rises 7% one 4 years. Finally, central government debt rises to 86% compared to its pre-crisis level.

What caused the crisis

new government policy- a look at the US history

After the Second World War, America introduced a new lending system called mortgage. A mortgage is a legal agreement between two parties which transfers the ownership of a property to a lender as a security for a loan. That means that if the borrower default on the loan, the lender has the right to take back the property of the borrower. Traditionally, banks would raise funds, screen borrowers, and would lend out money only to those who are qualified. If the borrower default, banks would bear the loss. Therefore, the traditional system makes sure that banks will carefully assess the creditworthiness of borrowers so that the default rate is minimized. however, after “mortgages” are invented, banks wouldn’t have to worry because they can simply sell off their property. These means that the loans are made for prime market citizens, and therefore a lot of citizens are excluded out of the “American dream” of owning a house. Therefore, in 1992 the US government started to lower its interest rate, relax underwriting standards, and also created a secondary market so-called subprime mortgages to enable the homeownership dream for middle-class citizens. By 2004, the interest rate had been lowered to 0.4%. Due to the low-interest rate, many citizens saw a chance to own a house, the increased demand for houses leads to a rising price for houses.

US real estate crisis and the housing bubble

After mortgages are created, to earn a profit, US banks bundled thousands of mortgages together and securitized them, turning them into something called mortgage-backed securities and sold to other investors. Part of the reasons why the financial crisis is so severe is because no one really thought the Americans are going to default in mass on their mortgages. Bankers and investors all believe that MBS was very safe because: first of all, it’s very rare that people default, secondly, even if they default, chances are all of America wouldn’t default at once. Thirdly, the house still has some intrinsic value so if banks foreclose on the home they can still recoup some of their investments by reselling. It seemed that MBS is a very safe option for investors.  

                                                            Figure 1

However, there was a housing bubble in the market. Figure 1 shows the Case-Shiller 10-city index since 1990. The figure illustrates the dramatic acceleration in house price increases in the early 2000s and their fall since July 2006. The most important reason for the bubble is the US policy in 2003- 2004, which is also shown in figure 1 as a decrease in interest rate. The Fed deliberately lowered the interest rate in order to avoid a recession after the consequence of tech bubble in 2000 and 911 terrorist attacks in 2001, creating a significant incentive for people to borrow at one per cent and buy houses going up at much higher rate. In addition, there were various other public policies that made it easier to buy, leading to increased demand in the housing market.

In 2005 The Economist surveyed the widespread increase in property prices and warned:

The total value of the residential property in developed economies rose by more than $30 trillion over the past five years to over $70 trillion, an increase equivalent to 100% of those countries’ combined GDPs. Not only does this dwarf any previous house-price boom, but it is also larger than the global stock market bubble in the late 1920s (55% of GDP). In other words, it looks like the biggest bubble in history.1

What happened later is the subprime mortgages default rate soon started to rise as borrowers are not able to serve the monthly payment. Shown by the chart below, in 2004 the Federal Reserve gradually increase the interest rate due to a fear of inflation. However, the CPI didn’t fall, shown by figure 2, leading to the continuous increase in interest rate to 5.25% in 2006. (the Fed keep raising interest rates, hoping it would respond at some point) This severely affected the mortgages that have flexible interest rates, leading to further delinquencies. The untimely increase in interest rate leads to accusations that the Fed was blindly following the targeting rule without thinking about the consequences for the rest of the economy. As a result, the houses went into the property of banks and investors who bought MBS. As houses prices went up, the banks still have the opportunity to sell their houses with a profit, as emerging house prices prevented them from the loss.

(figure 2)

Soon, the housing supply in the US exceeded the demand for houses, leading to a stagnation of house prices. The housing bubble busted and bankers, investors wanted to sell off the property before losing more money. In the subprime mortgage market, foreclosure rates increased by 43% over the last two quarters of 2006 and increased by a staggering 75% in 2007 compared with 2006”8   It soon became a virtuous cycle.

3. deregulation and the creation of CDO

Through mergers and acquisition, investment banks joined together and gained substantial monopoly power. In 2000, the government announced the deregulation of derivatives in the financial market. As a result, investment banks were encouraged to search for new financial products with higher risks and higher return. Just as stated above, mortgages and MBS are some of their products. A new financial derivative called collateralized debt obligation (CDO) is created. The difference between CDO and MBS is that CDO offers different interest rates and is possible to serve the needs of all investors because this derivative is divided into three different tranches. Rating agencies are responsible to rate and evaluate the value and risk of CDO. The CDO is divided into three tranches senior CDO with triple-A rating, mezzanine tranche with A or B ratings and finally equity tranche which provides both the highest possible risk and highest possible returns. Therefore, rating agencies usually don’t even give them any rating and refer to them as “junk” debt.

The market for CDO grew tremendously and the demand for this new financial product went global. Countries, especially in Europe, started to buy CDO shares. On the other hand, as investment banks charged a fee for every share, they made millions of dollars of profit.

4. Corruption of investment banks and rating agencies

In order to sell those CDO with high risks to investors, US investment banks paid rating agencies to continue giving high ratings to the CDO, although they were actually very risky and toxic. In this way, rating agencies tippled their profit and also form alliances with the investment banks. For the rating agencies, they have no liability if their ratings went wrong because they can simply say that it’s their personal opinion. As a result, buyers feel trusted and secured by the rising house prices in the market and therefore purchased abundant shares of CDO.

5. AIG- the biggest insurance company in the world

AIG not only spelled traditional insurance to the customers, but they also created credit default swap (CDS), which worked like insurance. An investor who purchased CDS has to pay a premium to AIG, and the benefit that investor get is that if the CDO defaults, AIG will pay the investor for his losses. In addition, AIG could do this for unlimited quantities because there was no government regulation for CDS requiring to put one aside. Instead, they didn’t treat their customers as clients but viewed their payments as a duty as there are huge bonuses for the employees as soon as contracts were signed. In this way, AIG, investment banks were greedy to boost their profit without disclosing their secret intentions to the customers.

Consequences

Unable to pay back their mortgages, people had to leave their home for sale. Foreclosure of houses reached 6 million until 2010. But not only people suffered, but the real estate also suffered as there was no longer enough demand after the bubble busted. It wasn’t soon after then the first mortgage lending companies claimed bankruptcy, and the subprime mortgage crisis turned into a financial crisis. In 2008, two giant mortgage lenders, Fannie Mae and Freddy Mac, got taken over by the Federal Reserve. Afraid that the loans will not be paid back by firms, there was rising insecurity and mistrust among the banks and the banks stopped lending each other. For AIG, it was taken over by the government because certainly, I didn’t have enough cash to pay back losses for CDS. For investors, they are probably the most severe sufferer from the financial crisis. For private investors and small institutions who placed their money in CDO’s almost lasted all of their money.

Consumers around the world consume less and spend less in the fear that they may lose their jobs and money in an insecure environment. China manufactures, who are the main suppliers of the US suffered as US companies stopped to invest and reduced demand. In China, more than 10 million migrant workers lost their jobs. In Europe, especially Germany, several subsidiaries and offices of the banking companies had to close because they heavily invested in US security market.

At the end of the crisis, the unemployment rate in the US and Europe rose to 10%, the highest value since the 1970s. Some of the biggest financial firms that were ‘too big to fail” were bailed out by the government, or rescued by the government funds.

Conclusion

After looking at the causes from different perspectives, we can conclude that the crisis started from the government policy- low-interest rate by the Fed, which led to increasing demand in real estate market, increase price in housing. In addition, it also led to an increase in mortgage, especially unsafe subprime mortgages. In addition, reduced underwriting standards- a fundamental change in the lending policy. The government failed to identify theirs of mortgaged product and therefore the housing meltdown happened. There are low or even no regulation among investment banks, rating agencies and insurance companies such as AIG, leading to the bribery between these financial institutions. Therefore, these different causes are highly interrelated and complex.

On May 17th, Luckin Coffee, a Beijing-based company that hopes to rival Starbucks, started its first trading on Nasdaq with 25 dollars a share, well above the company’s IPO price of 17 dollars. As a two-year start-up company, I found it very interesting when I take a glimpse at its financial reports on its official website. I share the company’s profit and loss account, balance sheet as well as the cash flow forecast with my fellow members in the finance club regarding my own opinion. 

(all the figures below are written in thousands)

profit and loss account 

I was able to calculate the company’s net profit margin by using gross profit devided by sales revenue. 

2019 gross profit margin= (78539)/71300= -110%

2018 gross profit margin=(238111)/125267= -190%

2017 gross profit margin=(56207)/56371= -99.7%

The data shows that from 2017 to 2018, the business experienced an increased net loss, as the net profit margin increases from -110% to -190%. The net loss in 2018 even reached 16 hundred million. This is due to the sudden increase in the store opening expenses as in 2018 lucking coffee opened more than 2000 stores at once. In 2019, the business earned half of the revenue of that of 2018 just in three months, so the sales revenue is likely to increase in the rest of the months and the NPM is likely to improve as well.

balance sheet

2017 Current ratio= 259108/388295=66%

2018 current ratio= 361885/116358=311%

2019 current ratio=995665/126403=787%

The current ratio suggests whether the business has enough liquid asset to cover up its current liability. Although the business has a too low current ratio in 2017, in 2018 and 2019, the business holds a way to high current ratio, meaning that it holds too much cash. I suggest that the business use more of its cash into investments or to improve its operation, which will bring more returns in the long run.

cash flow forecast

l From the cash flow chart, we can see that the closing balance increase fivefold from 219,096 in 2017 to 1,630,983 due to the large inflow from financing activities, however, since the business is making more and more loss and that the financing activities gradually decrease, the net cash flow deteriorated to 1,158,841 in March 2019. However, I believe the cash flow position in the future is likely to improve due to the increasing return from investment and decreasing loss, and also since the business just started in 2017, it is reasonable to make a loss in the short run. Therefore, from the long run perspective, the cash flow is likely to improve. 

In addition, I find it very interesting that this business generates profit not from its core operation--selling coffee, but from its investing activities. Also, most of its cash inflow is generated from its financing activities. As a result, I believe that the aim of its IPO is mainly to seek another source of finance from the public. ( Maybe they have drained most of the money from venture capitalist) 

whereas most of the current generation may not have experienced the dreadful experience of The Great Depression in 1920, the painful consequences of the Great Depression had been hotly debated by different economists. To be detailed, the Great Depression resulted in drastic declines in output, severe unemployment and acute deflation. Unemployment reached 25%, and US GDP fell by 30%. It is ranked as second only to the Civil War as the greatest crisis, causing long-lasting social unrest and bank runs. This essay examines the cause, recovery and implications of the Great Depression happened in the 1920s, based on my self-study on related articles and online resources.

1. Causes:

Excess stock market:

There are two maim causes posed by the economists and the first one is the demand-driven theory: a decline in spending, which led to a decline in production. In 1920, there are a lot of excesses: excessive commodities, excessive buildings, excessive financial speculation and an excessively skewed distribution of income and wealth. Taking a simple look at the US stock market, we will see the skyrocketing market price. At that time, every American was interested in participating in the wave of equity investment as most of the people believe that it is the only way to be wealthy. Also, most of the stocks are held with low margins, meaning that a lot of investors could buy one-dollar stock with 10 cents as provided as credit from the stock brokerage firms. Therefore, as stock prices went up, everybody was a winner, and that attracted more investors to the market. As more investors piled in stock prices made new highs, the market turned into a bubble. Investors were no longer investing in the merits of corporations but were betting on the continued rise in the market. In 1929, the stock price was four times than that of 1920. With more bubbles being generated, the government increased interest rate as a mean to repress stock-market demand. The higher interest rate depressed interest-sensitive spending in areas such as construction and automobile purchases, which in turn reduced production, thereby leading to a decline in spending. Also, due to the excess housing bubbles, there was a boom in housing construction in 1928, and the 1929 gradual price decline made investors lose confidence, and the bubble, therefore, burst, On Oct.24, 1929, the day viewed as “Black Thursday” as the stock declined

33% and investors liquidated their holdings which further severe the declines. The loss of wealth of the stock market is relatively small, but what is most dreadful is that it caused people to feel poorer and uncertain about the future, which led to the decline in consumption and firm spending as well as the real output in the United States. The excess stock market approach is also supported by Keynesian economists who believe that the stock market crash led to a demand-driven persistent under-consumptions as many people believe that they can avoid further losses by keeping them clear from the market.

Banking panics and monetary contraction

In addition to the demand-driven theory, other monetarists focus on the policy-driven theory, namely, the misleading contractionary policy of the Federal Reserve which exasperated the deflationary crisis. In the fall of 1930, depositors lost confidence in the solvency of banks and simultaneously demanded their deposits be paid to them in cash. Banks, therefore, liquidated reserves to satisfy this sudden and rising demand. As banks only hold a fraction of their deposits as demand according to RRR, this rising need lead to banks borrowing reserves from other banks, and the rising need makes it very expensive or even impossible. During the Great Depression, many banks could not or would not borrow from the Federal Reserve because they either lacked acceptable collateral or did not belong to the Federal Reserve System. Also, the conditions of banks were worsened due to deflation, which increased the value of loans and left many households unable to pay back. Banks failure culminated in 1933 on the day of “banks holiday”, when one-fifth of the banks had failed.

Another misleading policy was enacted to reduce excessive stock and housing markets stated above. The Federal Reserve deliberately contracted the money supply and raised interest rates in 1931, when Britain quited the gold standard and investors were worried that the US dollars would devalue as well. Therefore, strict contractionary policies have implemented that result in severe reduction in output. Decreased money supply leads to depressing spending as deflation made each dollar more worthy. Even though the Federal Reserve lowered the interest rates later, still, consumers expected wages and prices to be lower in the future, and they didn’t want to borrow as they feared that future wages and profits would be insufficient to pay back. The decrease in consumption and investment further depressed the decline in spending.

The gold standard

In the gold standard, every country set a fixed value of its currency in terms of gold, and use monetary policy to defend the fixed price. The gold standard implies that only an increase in gold reserves, coming from domestic mining or inflows of gold from abroad/ would enable banks to increase their lending and therefore increase the money supply. The preservation of the gold standard during the great depression is viewed as one of the critical factors that transmit the depression to the world. The reason behind that was a fear of inflation: during the 1920s, many countries experienced severe and terrible level of inflation, leading to central bank preserving the gold

standard to prevent inflation. However, the deflation at the time of depression made American goods desirable to foreigners, whereas the lower price level made people reluctant to increase their spendings. As a result, the central bank implemented a contractionary fiscal policy to limit the gold outflow, which causes even more decline in output and prices globally. All in all, the gold standard and the unwillingness of the central bank to implement any expansionary policies led to the worsening of the financial crisis.

2. Recovery

The recovery of the financial crisis began in the spring of 1933 when President Franklin D. Roosevelt declared a national bank holiday. Roosevelt ordered all the banks to be closed until every single one of them receive a government license. The federal government also established a temporary system of federal deposit insurance by creating the Federal Deposit Insurance Corporation (FDIC). Before the establishment of FDIC, more than one-third of the banks were declared failed due to contagious bank runs. However, this system successfully restores trust and boost consumer confidence. The abandonment of the gold standard allows countries to expand their money supplies without worries about the gold convertibility and ensuing monetary expansions were implemented. Between 1933 and 1937, money supply increased by nearly 42%, stimulated by lower interest rates and more accessible credit. Works Progress Administration (WPA) is established to hire the unemployed to work on government building projects.

3. Implications

From the financial crisis, one thing we could learn is that the role of US federal reserve as a lender of last resort to bail the banks and shore up the financial system, which, the federal reserve failed to do so. Also, to pursue expansionary fiscal policies, the fed can also buy securities or buy bonds in the open market and flood the financial system with currencies, especially for banks that do not belong to the federal reserve system. We also learn the importance of sound macroeconomic policies and stable price levels, which is to ensure the strong economy, as both inflation and deflation can cause financial instability and hinder economic growth. Finally, looking from the global output perspective, the US Congress raised tariffs from an average rate of 15% from 1929 to an average rate of 60% in 1930. By 1934, the volume of total world trade had plummeted to one-sixth of the initial level. The skyrocket in tariffs is also retaliated by other countries, which led to the failure of the US to provide support to other countries who need exports to maintain stability.

Bibliography

-  Mcglynn, Conor, and Senior Sophister. The Great Depression and the Gold Standard. Accessed 25 Feb. 2019.

-  Romer, Christina. Forthcoming in the Encyclopaedia Britannica Great Depression. 2003.

-  Wheelock, David. The Great Depression: An Overview. Accessed 25 Feb. 2019.

-  Matziorinis, Kenneth. The Causes of the Great Depression: A Retrospective. Accessed 25 Feb.

Comparing the US Stock Market of 1920s to that of 2018

This essay compares the US stock market of 2018 to that of 1920s, before the great market crash of 1929. It examines both periods in terms of artificial inflationary prices level, the speculative behavior, economics trends, interest rate, and how the Fed’s behavior differed in terms of monetary policy.

The great crash in 1929 is considered to be one of the factors that contributed to the cause of the Great Depression the 1930s. It is most associated with plummeting stock prices on two consecutive trading days, known as “Black Monday” and “Black Tuesday”. The Dow plummeted from a value of 381.17 on September 1929 to a mere 41.22 within the following two days. with a “cumulative loss of 89%”. It would take until November 23, 1954 - 25 years later - for the Dow to regain its pre-crash high.

The Stock Market of 1929- booming industrialization and speculation

The roaring trend of stock market prices was partly due to huge industrialization, urbanization and new technology. However, one of the biggest causes of the market crash of the 1920s is the mentality that “ the soaring markets would continue to grow”. This mindset led investors to speculate recklessness throughout the 1920s, as they borrowed more than 8.5 billion dollars to buy stocks. As more and more stock purchasers invested into the stock market, prices kept rising, further justifying the “success” of the investment. However, the inflation was artificial, and once the price dipped, nervous investors began selling, and the entire market crashed.

The stock market of 2018: Roaring Trend

The chart above shows how the Dow in two periods grew differently, but the increasing trend is very steep in both periods. “Both markets achieved new highs with only minor pullbacks along the way.” For the 1920s, there was higher growth with a staggering growth rate of 239%, whereas, for the 2016s, there is surge of 139% from March 2009 to today.

Therefore, the current stock market resembles the stock market of 1928 in terms of the euphoric stock market growth. According to Dustin Parrett, “The Dow exploded for triple-digit gains starting at the beginning of the bull market in October 1923. The current Dow bull market has also delivered triple-digit gains.” There are several signs that there is a stock market bubble in the US economy, primarily due to the speculation of the investors.

Speculative behavior

Today, the US market continues to show a lot of speculation behaviors. According to the graph below which shows Margin debts (trades made using loans from brokers), which has set an all-time high with more than 600 billion dollars in 2018. This means that investors are taking out more and more money to buy stocks as prices continue to rise, believing that they can easily pay back the loan due to returns on the stock. However, this may have a catastrophic knock-on effect once interest rises of prices of stocks dip.

Low interest rates

Also, The United States is in a period of historically low-interest rates, shown by the diagram below. Due to the low-interest rate, bonds are unprofitable investments so investors may turn to the stock market for higher returns. As more investors enter the stock market, they bid up the stock prices instantaneously. This has also helped to fuel stock market growth to unsustainable levels. To cope with the financial crisis, the Federal Reserve implemented a record low of 0.25% in December 2008, which persisted until December of 2015. The Fed has raised interest rate to 2.5% to curb inflation in the US.  

On the other hand, low interest rates mean borrowing money is cheap, especially for corporations. This is in part the reason why the Fed uses low interest rate to stimulate the economy, since low interest rate motivates corporations to borrow more money and then inject the money into new projects or expansion; growing the economy. However,  corporations are using these cheap-credit loan to purchase shares of their own stocks as a way to drive up the price and reward shareholders, which is unsustainable once the stock price dips.

United States Fed Funds Rate from 2018 to 2019 (trading economics)

Tight aggressive monetary policy in 1928

In 1928, due to the artificial inflationary prices level in the stock market, many people were buying stocks due to the increasing prices, instead of the merits of the company itself. Concerned about the speculation and a possible market bubble, the Federal Reserve “responded aggressively with tight monetary policies starting in 1928”. Also, the Fed pursued a policy of stopping banks giving extended loans to stock speculators. According to rot the FRBSF economic letter, “The Fed succeeded in putting a halt to the rapid increase in share prices, but in doing so, it may have contributed one of the main impulses for the Great Depression”. After the Fed pursued aggressively tight monetary policies, investors could pull out of the stock market and trigger a stock market crash. Investors may turn to bonds investment and saving due to higher interest rates.

Gradual increase in interest rate combined with expansionary fiscal policy

In contrast, after the experience of the 1929s, the Fed has been reluctant to tighten monetary policy to reduce asset bubbles. However, as economic growth reports improve, the Fed is increasingly concerned today about keeping inflation in check. The Fed is now increasing its interest rate gradually in order not to spark a recession and send “both stocks and bond prices tumbling downwards.” Trump, on the other hand, has stimulated the growth potential of the US stock market due to his plans for tax cuts and higher infrastructure spending. We can't predict what will happen with certainty, but with borrowed money contributing to the current bull market, a routine correction could lead to a dramatic sell-off. On the other hand, the Fed could raise rates and trigger a different kind of sell-off, justifying its newly increased interest rate from 2.25% to 2.5%.

A sudden plummet: the fourth quarter of 2018

The rising stock market of 2018 was stroke by the sudden plummet of during the worst week in the fourth quarter. It was said that the US stock market melted down one trillion dollars in market and it quickly scared a lot of investors. The total returns of the Dows was -11.31% and the S&P 500 index even plummeted to a return of -13.52%. The reasons of this sudden plummet are various: The Trump Trade War, the rising uncertainty of the Fed, slowing growth and so on.

Conclusion

Above is an overall analysis of the similarities and differences of the stock market of both periods in terms of stock prices, interests rate, economic trend and monetary policies. Certainly, the sudden crash of the fourth quarter doesn’t mean that a great recession like the Great Depression in 1930s is triggered.  However, it does call into some caution as for whether there is some “bubbles” in the market or if the Fed has pushed up interests rate too high. Standing from the point of 2019, the stock market price is still very high, and hopefully there will be less booms and bumps in future stock market.

Reference:

Works Cited

Kolakowski, Mark. “Why The 1929 Stock Market Crash Could Happen In 2018.” Investopedia, 2019, www.investopedia.com/investing/1929-stock-market-crash-could-happen-again/. Accessed 24 Apr. 2019.

GNP, world bank, IMF

income earned by residents of a country both at home an abroad

World bank: encourage the flow of capital to poor countries

IMF: economic distress often leads to political turmoil, international tensions, and military conflict—- both of the organizations were established to promote economic prosperity around the world

financial market

bond market: term, credit risk (higher interest rate, higher risk), tax treatment (municipal bonds are not required)

The stock market: higher risk than the bond, higher return; price determined by supply and demand for the stock in the company; reflects people’s perception of the corporation’s future profitability (optimistic, raise their demand, bid up the price)

Financial institutions:

bank, mutual funds (sells shares to the public and use the proceeds to buy portfolio)

Saving and investment

income exceeds consumption- deposits at a bank— count as saving rather than investment

Investment: purchase of new capital (equipment, building ) ，buy a new house- investment

The market of loanable funds

supply: people who have extra income they want to save and lend out

Demand: households and firms who wish to borrow to make investments

Interest rate: the price of the loans

Policy 1: saving incentives- tax law: less heavily tax - more money to save/ buy bonds- Q of loanable funds increase—- lower interest rate and greater investment

Policy 2: investment incentives- investment tax credit— demand curve shift to the right

Policy 3: government budget deficits (government spending exceeds tax revenue, financed by borrowing in the bond market) and surpluses (excess of tax revenue), balanced budget. Eg. Budget deficit—lack of national savings (public saving+ private saving) ——when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment— supply of lovable funds decrease

Policy 3 affects the supply rather than demand: lovable funds—means flows of resources available to fund private investment, thus it reduces the supply.

Policy 4: budget surplus: more national saving- increase the supply- reduces int rate and stimulates investment

CPI

measure of the overall cost of the g and s bought by a typical consumer (issued by BLS)

Calculated as: Price of basket of goods and services in current year / price of basket in base year , *100

Inflation rate in year 2= (CPI in year 2- CPI in year 1)/ CPI in year 1, *100

Disadvantages of CPI

Differences between CPI and GDP deflator

Price level, price index

Amount in today’s dollars= amount in year T dollars * (price level today/ price level in year T)

Real and nominal interest rate

the higher the inflation rate, the smaller the increase in purchasing power

Real interest rate= nominal interest rate- inflation rate

Productivity

determinant of productivity: physical capital, human capital, natural resources and technological knowledge

difference: Human capital: resources expended transmitting this understanding to the labor force ( the amount of time that the ppl has devoted to reading them); tech knowledge: society’s understanding about how the world works ( society’s textbooks)

diminishing returns and the catch-up effect

as the stock of capital rises, the extra output produced from an additional unit of capital falls

It relatively easy for a country to grow fast if it starts out relatively poor—-catch-up effect

GNP, world bank, IMF

income earned by residents of a country both at home an abroad

World bank: encourage the flow of capital to poor countries

Measurement of GDP

GDP (Y)= C+ I +G +NX (consumption+ investment+ government purchases +net exports)

Consumption: exception of new housing

investment: purchase of good used to produce other goods ( inventories included, if the company sell its products from the inventory, the inventory becomes negative, offsetting the positive addition of expenditure)

Government purchases: includes salaries of government workers + expenditures on public works. Transfer payments ( social security benefit to elderly person) is not counted in, viewed as negative taxes

Net export: foreign purchases of domestically produced goods (export) minus the domestic purchases of foreign goods (imports) ; net export is often offset by consumption/ investment/ government purchases so that domestic consumer buys g/s form abroad does not affect GDP.

Nominal GDP

nominal GDP vs real GDP: nominal gap uses current prices whereas real GDP uses constant base-year prices

Change in real GDP reflect only changes in the amounts of being produced (not affected by changes in prices)

Real GDP is a better gauge of economic well-being

GDP Deflator

calculated as nominal GDP/ Real GDP *100

Inflation rate: (GDP deflator in year 2- GDP deflator in year 1) / GDP deflator in year 1 , *100 (percent)

Not a perfect measurement

From October to December, I have been participating in an online competition held by Warton Business School- KWHS Online Investment Competition. Being the leader of the team, I (and my teammates) developed a thorough investment strategy and asset portfolio in order to maximize the return in the long run. We achieved a satisfying return and ranking in the end. Our final score was ranked 4th in Region 1. Below is the 25-page final report that I completed for this competition.

Final Report of KWHS

Section1: Team investment strategy:

Cautious trading with “right” timing to buy in

  Our team believes that there will be a lot of ups and downs in the world-wide stock market throughout Q4 of the year. For the whole US stock market, it did undergo a lot of variations due to the trade war between the US and China, as well as political factors such as the mid-term election. The continuous rise in interest rates has also driven down the whole US market. We will choose companies cautiously with the right timing to buy in and then hold them firmly for the long term.

Asset allocation + Risk diversification

  We as a team strive to find some relatively stable individual stocks that could offer the highest rate of return as possible. We invest in 5 different sectors to diversify our risks in case any sector is not doing well. Under the risk factor, we, therefore, try our best to diversify our portfolio allocation by investing in different sectors, therefore gaining the possible best return.

Investment on the leading companies in each sector for long-term return

  Our investment strategy is focused on the leading enterprise or BIG names in each sector to gain a stable return in the long term.

Buying large-dividends companies for short-term cash generation

 In the meantime, we also look into several companies that offer GOOD dividends at the end of the year, to generate the short term cash for our client Sachin Rekhi, who has the plan to make a donation to ASPCA annually. Those are normally “blue chip companies” with impressive dividends at the end of the financial year.

In summary, our main focus is to build a portfolio with long-term wealth creation while generating short-term liquidity.

The leading ompanies that we choose may undergo fluctuation, but our team look at them from a long-term perspective and therefore would not buy low and sell high. Under our assumptions, when there are slumps in the whole industry or market, these companies would suffer the least.

   We hold a weekly meeting to monitor and discuss the performance in each sector, after which we modify and improve our tactic under each sector. In addition, we are also left about 5% of the total asset, which is about 2000 dollars as cash flow.

Sector analysis:

   The relative proportion of our team's sectors allocation is as followed:

Next, we're going to analyze each sector, industry and the stocks we selected, as shown in the above form.

Consumer discretionary sector

   Consumer discretionary sector involves goods and services that are non-essential by consumers but are desirable if consumers have enough income to purchase them. Amazon is under the industry of retail while McDonald's is considered in the industry of leisure.  

    One reason behind the selection of Amazon as a top stock holding is due to the following industry trends: Discretionary sector will focus more on Amazon as the whole discretionary sector becomes more volatile, slower and more dependent on Amazon, like Netflix, Tripadvisor and media companies move to the communications sector. Since Amazon is one of the largest e-commerce companies, it is really matched with the trend in the consumer discretionary sector as spending on traditional retail has been cautious and reluctant. Consumers are now turning to e-commerce as a source of purchase.

    We believe that Amazon’s strategy of gradually merging online and offline retail looks promising. Looking into the qualitative data such as P/E value and EPS, cash flow as well as the growth of profit, we believe the long-term return of Amazon would be very promising.

Porter's Five forces analysis of retail industry:

Amazon: retail industry

Bargaining power of supplier - Low to medium

Amazon set a supplier code of conduct which has to be followed by its suppliers, including a few key areas: Child labor, involuntary labor; safety and health; working hours; anti-discrimination; fair treatment, immigration compliance, freedom of association, as well as ethical behavior.

Bargaining power of buyers -Medium to high

Amazon has focused on Customer retention by ensuring customer satisfaction as well as product quality.

Consumers can easily switch to physical retail and other sources of online retailing without any costs

Very elastic demand of consumers

The buyers from AWS (Amazon Web Services) have less power due to switching costs when turning to its alternatives.

Threats of substitutes -High

Physical retail

Increasing entrants of online retailers

Online retailers that are specific to a sector (Noble books, Best Buy, IKEA, BHS…)

However, substitutes for AWS are minimal.

Threats of new entrants -medium

Although there are barriers to entry existed such as economies of scale and retaliation from Amazon, innovative features and services may serve as a threat to Amazon.

New-entering firms will have easy access to different distribution channels such as UPS

The increasing popularity of online shopping will attract more entrants due to the abnormal profits

SWOT Analysis:

Strength: Low-cost structure, the largest online retailer in the world allowing a huge number of sellers

Figure 1. Amazon growth rate compared to e-commerce sales growth in U.S. (Source: Amazon financial reports and Digital Commerce 360)

The figure shows that Amazon has grown faster than the entire US e-commerce market, which implies that the company has taken its competitors' market share. According to the founder and CEO, Jeff Bezos, the company follows a cost leader strategy that is illustrated in the diagram: A lower cost structure leads to lower prices, which increases the customer experience. Customers will occasionally return back to the company to purchase more products, which thereby create the ever-growing traffic. It, as a result, attracts more sellers from the market, all of which leads to the large growth undergone by Amazon.

Figure2: Source: Seeking Alpha

In the meantime, the customer service rating of the company has remained the highest in the industry (a score of 85 on ACSI), higher than eBay, the biggest competitor. This also means that the customers have great confidence and satisfaction, and we believe that this could also reflect on its stock's future performances.

Figure 3: ACSI of Amazon from 1995 to 2018

 Weaknesses:

Increasing debt-to-asset ratio: Amazon's debt-to-asset ratio has been increasing so rapidly through 2013 which has far exceeded its main competitor, Wal-Mart.

Low-profit margin.

Opportunities:

The e-commerce sales of Amazon worldwide has been estimated to reach 4.5 trillion dollars in 2021 by forecasting, maintaining its largest e-retailer in the world.

Figure 4 total e-commerce sales of Amazon

Threats:

Wal-Mart has made great effort to establish itself as a leading online retailer

Due to the trend that the market of e-retailer is continuously being replaced by physical retail, the Walmart has also established e-commerce websites in more than 11 countries and its e-commerce sales had increased by 29% in 2016. However, we believe that it is extremely difficult to reach the magnitude or status as Amazon due to insufficient start-up capital, and it's hard to reach the same service and quality provided by Amazon.

In conclusion, low price, a huge product diversification as well as leading branding are essential factors that demonstrated the first place of Amazon being the largest retailers in the world as it has an operation in more than 100 countries.

It must be pointed out also, the other key reason that we are convinced to set a large proportion of our capital into the company is the fact that Amazon has not only been a leading E-business company, it has also successfully developed itself into a technology leading company. Amazon is leading in the key technology, such as Big Data, Cloud Computation, and AI.  Kindle E-book, Echo/Alexa, AWS and the Amazon Go are examples of a very successful product or service in the market. As a matter of fact, the R&D spending in the year 2017 from Amazon was the biggest in the world, as high as the US $ 23 billion!

We also purchased McDonald's as part of our portfolio allocation due to the short-term return: the dividend that it generates (2.5% annually) will be able to fulfill the donation requirement for our clients.

Consumer staple sector: Nestle and Moutai

Our strategy of investing in the Nestle in consumer staples sector is that the performance of the sector is relatively stable even when there are slumps in the market- the performance of food industry is always better than other sectors. On October 11th, the American stock market experienced a large decrease in value. Almost all the industries experienced a huge decline in the value per share. However, when we looked at the market of the food industry, the share values of these monopolies have increased a lot and still show a trend of going up. Compared with Coca Cola and Hersey and other big companies in this sector, Nestle had just begun to increase in the share value, and as this is the largest food company with diverse products portfolio as well as stable internal business performance, it successfully spreads its risks to a range of sectors that offers it great stability in the long run. As a result, we all agreed on the potential increase in the share value in the future.

Also, another reason why we choose to invest in the consumer staples sector is that the companies in this sector are always invested or having business activities in emerging markets, which shows a continuous growing demand in recent years, especially in the staple sector.

As for Nestle, it involves in the markets in big emerging markets like China, India. Also, it has a big percentage of business in developed countries like America and Britain. With stable revenue gained in the developed countries and stable growth in the emerging markets, the multinational food companies like Nestle will have good performance relative to other kinds of business.

We also purchased Kweichow MOUTAI, as it is symbolized as the ‘ National Wine’ in China, we see it as a potentially strong stock due to the following reasons:

First of all, it is the #1 Chinese Baijiu Company with unique brand image, as it is served as the national wine in the important banquet for visiting foreign government leaders. In addition, it is a high-end product that is viewed as a luxury brand, especially for Chinese consumers. Thirdly, Moutai company possess unique brewing techniques that can't be replicated, which All of these factors allows the company to enjoy a very high selling price, gaining an impressive net profit more than 50% in 2017, according to its financial statement. Last year, the dividend payout from the company also reached as high as 51%. This impressive dividends rate also persuade our members to buy it as a major of our short-term return that could be used for client's needs. Finally, the company has a very light asset without any heavy debt. It also possesses a large cash flow. Therefore, we believe the stock will continue to be the market STAR in the long run as well as short term, especially for the increasing demand as it is close to the Chinese New Year.

So, finally, we were happy to see the 13% return in the final result.

Technology sector

We invested a combination of 16% into the technology sector, 12% into Twitter Inc and 4% into Alphabet Inc, both of which are leading technology companies with large growth.

Our group chose Twitter seeing its constantly growing estimated earnings from 2014 to 2018 and a final reach of 2865.10 thousand at the end of 2018. The sales growth of the entire company was 28.57% in the previous year and 6.69% in the previous quarter. It also even experienced a 500% EPS growth in the previous year and 33.33% in the previous quarter. According to the Zacks Consensus Estimate, Twitter was expected to witness an increase of 11.3% to 79 cents per share, which reflects a year-over-year growth of 79.6%. Besides, its fiscal earnings have increased by 19% to 25 cents per share in the fourth quarter of 2018. It shorter term, it also experienced a 7.96% growth in its price change in the last four weeks. This demonstrates a relatively steady growth of revenue as well as a similar a rapid increase, seeing that Twitter has an imperative growth driving by currently focusing on adding new features and security initiatives, which can boost user engagement level and eventually boost its revenues.

Figure 5 sales revenue (source: Nasdaq)

In addition, Twitter’s ad revenues, which consisted 85.7% of its total revenues, are expected to be improved due to its deals with Disney’s ESPN, NBC, Universal, Viacom, Activision Blizzard, etc. It also begins to provide broadcasts of live sports which suits more for consumer’s tastes. Moreover, its another revenue source is enhanced currently, which is that its sources for new outlets and regular users to distribute instant information becomes estimated as invaluable. This helped to see its revenue jump 25% to $108 million in its ad revenues. Therefore, we believe the performance of Twitter in Q4 will be promising.

However, it is necessary to mention that we’ve invested only a small portion into this sector as our teammates agree that technology sector has been overvalued, demonstrated by several slumps in this sector in October and November.

Utility sector: American Electric Inc.

Our team has purchased 65 shares from American Electric Inc. from the utility sector. Listed at New York Stock Exchange (NYSE), it is among the largest generator of electricity in America, providing electricity for more than five million customers in eleven states.

Our investment in the utilities sector and industry accounts for 5% of total purchase. The sector contains stocks for utilities such as water, electricity, natural gas, etc.

Those companies within the utility sector provide consumers with very basic needs such as power and gas, so the goods are necessities that consumers are not likely to exit the market of this sector. In other words, goods and services of public utility have inelastic demand. Consequently, under regular circumstances, the prices of stocks within the sector tend to be reliable and steady. In light of these advantages, it is wise to include a percentage of stocks from the utility sector as a defensive portion.

Health care sector

Health care is always the most significant part that everyone would care about so we can not ignore this sector. The reason why we chose JNJ as 12% of our proportion mainly because it is a worldwide famous brand in medical products and providing health care service.

Final Trading results

In general, our team earned a satisfying trading result of 5.82% return and gained class rank 4th out of 259 teams. Our portfolio has performed stronger than class average as well as S&P index, which justified our strong portfolio allocation.

Team decision-making process

   In order to gain a thorough and deep understanding of the sector to which we are dedicated, within the first 2 weeks we barely bought any stocks; instead we spent time researching in different sectors in order to find its prospect; the structure of the sector; government policies and legislation and competition pattern, monopoly, etc. We did research on the big, dominant companies in the sector as a means to achieve the long-term source of return. In the meantime, we also had research on good companies that would offer a good return in the short run.

    On choosing the individual stocks, we briefly looked at the data overview of each company such as debt/capital ratio, market cap, 52 weeks high-low prices and such. In addition, we did compare the P/E value relative to industry to see whether there is a potential for the company to be overvalued. The most importantly, we looked at the trend of EPS value, revenue and earnings; cash flows to see whether the company is making a profit by glimpsing into their financial statements. Finally, we looked at the periods of the stock graph and the general trend in 5 days, 1 month and 1 year.

   Apart from the qualitative data, we also take into account the recent news of the company: such as M&A, litigation, innovation, improving services that match the new demand of customers, investment. We believe an incidence of any listed above would affect the performance of the stock market, but it won’t have a large impact in the long run. Finally, we made a balanced investment in the companies of our choice to generate long-term and short-term profits.

   The financial statement is a great qualitative tool from our perspective, as we believe that stock is about the confidence by customers’ perceiving to the company in the future and profitability is one of the key factors. Looking at the trend of the revenue growth of a company is a direct method for us to analyze.

   We believe that Porter's five forces are a very compelling tool for us to use, as it offers a clear view of the industry that the company is in such as its competition intensity, upstream and downstream firms, bargaining powers of suppliers and buyers. We really have a better knowledge of the general framework of the company in a certain industry and therefore able to analyze the profitability it could possibly gain in the future according to these forces.

We believe seeing the trend of a company's stock value may not be good to foresee or make accurate predictions of the future, as past incidents of the sudden slumps of big tech companies has all taught our teammates a lesson about how stock market is unstable due to external factors such as political incidents or monetary policy. Thus, an increasing trend of the past does not mean that it will continue to grow in the future.

Overall, we didn’t rely heavily on a specific tool, instead, we synthetically give each tool a proportion and eventually we view them only as assistance or reference to help our decision-making.

Section 3: team dynamics

Each and every member of our team is in charge of a sector of our investment: trade, research as well as report. We face a challenge of sector allocation in the first place as we couldn't decide how much proportion to set for each sector respectively. In addition, since we have a member of 5 students in our team, it is difficult for us to keep track of each student's progress as well as attendance.

We overcame the problem by establishing an online group and have a weekly online meeting every week to ensure every member is able to express their ideas and opinions. We didn’t have a lot of disagreement since we are only focused on one sector. However, some students are prone to quantitative analysis whereas some students like to be qualitative on research. Therefore, cooperation has helped us a lot. we helped each other in the area of what we're good at. For example, the member in our group who is good at math will help other students in quantitative research, for example. The members who have difficulties in analyzing the financial statement and indicators may receive help from other members, vice versa. On writing the final report, other students also dedicated in improving the language or grammar of students who are less skilled at writing.

Our advisor has also helped us especially when encountering the situation when the stock plummets, he always offers the prior notice or news and encourage us. Also, he has taught us some strategies to allocate our capital and when to make the trade.

Section 4: Takeaway

It is very unusual for teenagers like us to have an actual operation in the US stock market and this platform is just amazing for us to have a chance to give it a try without worries about losing practical money. The competition is more difficult than what we think in the first place as we never thought about risk diversification, asset allocation or industry analysis before.

Through this competition, we as a team have come to realize the importance of long term strategy. Shortly after inception, when we had not done much research and developed a plan for investment, we chose our stocks simply by looking at the price charts of stocks in each sector. During the competition when we were considering writing mid-review, we recognize that investment is not only about “buying low and selling high”. We became interested in how miscellaneous factors such as consumers, government policies and features of sectors and companies influence the price of stocks. Though it is almost impossible to predict precisely the prospect of each enterprise. Learning not to be frustrated by the short-term fluctuation of prices, we put a lot of effort into framing a strategy for a steady return in the long run.

We held the weekly meeting and in the middle of the competition, we have met some difficulties as we believe that since the US stock market has been of high-valued (high stock price) throughout the years, due to rising interest, trade war or other political reasons, the variation and fluctuations are of high possibility. The stock of Apple, as well as some other tech stocks, have proven the point that there is going to be periods of dumping. We even sent email to ask if it's possible to short-selling. I think through this competition all of the members have gained a deep understanding of the stock market operation and the condition right now, but more importantly, we thought deeply and tried a best to find solutions.

Due to the short length of the competition, our members could only choose stocks that may generate a relatively short-term return as it has to have an impact in 3 months. But if we're truly viewing this from the long-term perspective, we would probably choose some other stocks like Apple Inc. Although it hasn’t been performing well in the stock market, mainly because of  being unable to generate innovative products in recent 2 years, we believe it has great potential for great growth in the long run, considering its unique Chip+OS+Terminal+ Service as well as its great branding worldwide, for example, when it introduces is in the market.