Financial Markets and Institutions (2-downloads)

The September 11 Terrorist Attack, the

Enron Scandal, and the Stock Market

In 2001, two big shocks hit the stock market: the September 11 terrorist attack and

the Enron scandal. Our analysis of stock price evaluation, again using the Gordon

growth model, can help us understand how these events affected stock prices.

The September 11 terrorist attack raised the possibility that terrorism against

the United States would paralyze the country. These fears led to a downward revi-

sion of the growth prospects for U.S. companies, thus lowering the dividend growth

rate g in the Gordon model. The resulting rise in the denominator in Equation 5

should lead to a decline in P

0

and hence a decline in stock prices.

Increased uncertainty for the U.S. economy would also raise the required

return on investment in equity. A higher k

e

also leads to a rise in the denomi-

nator in Equation 5, a decline in P

0

, and a general fall in stock prices. As the

Gordon model predicts, the stock market fell by over 10% immediately after

September 11.

Subsequently, the U.S. successes against the Taliban in Afghanistan and the

absence of further terrorist attacks reduced market fears and uncertainty, causing

g to recover and k

e

to fall. The denominator in Equation 5 then fell, leading to a recov-

ery in P

0

and the stock market in October and November. However, by the begin-

ning of 2002, the Enron scandal and disclosures that many companies had overstated

their earnings caused many investors to doubt the formerly rosy forecast of earn-

ings and dividend growth for corporations. The resulting revision of g downward, and

the rise in k

e

because of increased uncertainty about the quality of accounting infor-

mation, should have led to a rise in the denominator in the Gordon Equation 5,

thereby lowering P

0

for many companies and hence the overall stock market. As

predicted by our analysis, this is exactly what happened. The stock market recov-

ery was aborted and it entered a downward slide.

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Stock Market Indexes

A stock market index is used to monitor the behavior of a group of stocks. By review-

ing the average behavior of a group of stocks, investors are able to gain some insight

as to how a broad group of stocks may have performed. Various stock market indexes

are reported to give investors an indication of the performance of different groups

of stocks. The most commonly quoted index is the Dow Jones Industrial Average

(DJIA), an index based on the performance of the stocks of 30 large companies.

The following Mini-Case box provides more background on this famous index.

Table 13.3 lists the 30 stocks that made up the index in May 2010.

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Part 5 Financial Markets

TA B L E   1 3 . 3

The Thirty Companies That Make Up the Dow Jones 

Industrial Average