Financial Markets and Institutions (2-downloads)

Required Return (%)

Price

10

$42.00

11

35.00

12

30.00

13

26.25

14

23.33

15

21.00

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The 2007–2009 Financial Crisis and the

Stock Market

The subprime financial crisis that started in August 2007 led to one of the worst bear

markets in the last 50 years. Our analysis of stock price valuation, again using the

Gordon growth model, can help us understand how this event affected stock prices.

The subprime financial crisis had a major negative impact on the economy lead-

ing to a downward revision of the growth prospects for U.S. companies, thus low-

ering the dividend growth rate (g) in the Gordon model. The resulting increase in

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Chapter 13 The Stock Market

315

the denominator in Equation 5 would lead to a decline in P

0

and hence a decline

in stock prices.

Increased uncertainty for the U.S. economy and the widening credit spreads

resulting from the subprime crisis would also raise the required return on investment

in equity. A higher k

e

also leads to an increase in the denominator in Equation 5, a

decline in P

0

, and a general fall in stock prices.

In the early stages of the financial crisis, the decline in growth prospects and

credit spreads were moderate and so, as the Gordon model predicts, the stock mar-

ket decline was also moderate. However, when the crisis entered a particularly vir-

ulent stage credit spreads shot through the roof, the economy tanked, and as the

Gordon model predicts, the stock market crashed. Between January 6, 2009, and

March 6, 2009, the Dow Jones Industrial Average fell from 9,015 to 6,547. Between

October 2007 (high of 14,066) and March 2009 the market lost 53% of its value.

Within a year the index was back over 10,000.

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