8. Stocks, Stock Markets, and Market Efficiency Common stock Stock market indexes Stock valuation...

8. Stocks, Stock Markets, and 8. Stocks, Stock Markets, and Market EfficiencyMarket Efficiency8. Stocks, Stock Markets, and 8. Stocks, Stock Markets, and Market EfficiencyMarket Efficiency

• Common stock

• Stock market indexes

• Stock valuation

• Efficient Markets Theory

• Common stock

• Stock market indexes

• Stock valuation

• Efficient Markets Theory

About common stockAbout common stockAbout common stockAbout common stock

• Share of firm’s ownship

• A residual claimant• Paid after all other creditors• “last in line”

• Limited liability• Shareholders cannot be liable

beyond stock investment

• Share of firm’s ownship

• A residual claimant• Paid after all other creditors• “last in line”

• Limited liability• Shareholders cannot be liable

beyond stock investment

Measuring the Stock MarketMeasuring the Stock MarketMeasuring the Stock MarketMeasuring the Stock Market

• Stock market indexes• Average price level in part/all of

market• Benchmark for performance for

money managers

• Stock market indexes• Average price level in part/all of

market• Benchmark for performance for

money managers

Dow Jones Industrial Average (DJIA)Dow Jones Industrial Average (DJIA)Dow Jones Industrial Average (DJIA)Dow Jones Industrial Average (DJIA)

• Stock prices of 30 of the largest U.S. companies• Return to holding a portfolio of a single

share of each stock• Adjusted for splits, firm changes

• Price-weighted average• Greater wt. to higher priced stocks

• http://www.djindexes.com/mdsidx/index.cfm?event=showAvgStats

• Stock prices of 30 of the largest U.S. companies• Return to holding a portfolio of a single

share of each stock• Adjusted for splits, firm changes

• Price-weighted average• Greater wt. to higher priced stocks

• http://www.djindexes.com/mdsidx/index.cfm?event=showAvgStats

The S&P 500The S&P 500The S&P 500The S&P 500• Value of 500 of the largest firms in U.S.

economy• At least $5 billion in market capitalization• At least 50% stock held by public

• Valued-weighted• Weight to each stock price based on firms

total market value• Share price x (shares outstanding)

• Larger firms get more wt.• http://www2.standardandpoors.com/spf/pdf/index/500factsheet.pd

f

• Value of 500 of the largest firms in U.S. economy• At least $5 billion in market capitalization• At least 50% stock held by public

• Valued-weighted• Weight to each stock price based on firms

total market value• Share price x (shares outstanding)

• Larger firms get more wt.• http://www2.standardandpoors.com/spf/pdf/index/500factsheet.pd

f

Correlation: 95%

Nasdaq CompositeNasdaq CompositeNasdaq CompositeNasdaq Composite

• Over 3000 OTC traded companies

• Value-weighted

• Smaller, newer firms

• $500 billion total market value

• Over 3000 OTC traded companies

• Value-weighted

• Smaller, newer firms

• $500 billion total market value

DJ Wilshire 5000DJ Wilshire 5000DJ Wilshire 5000DJ Wilshire 5000

• “Total market index”• All publicly traded stocks in U.S.

with readily available price data

• Value-weighted

• Over $15 trillion in total market capitalization

• “Total market index”• All publicly traded stocks in U.S.

with readily available price data

• Value-weighted

• Over $15 trillion in total market capitalization

Correlation across indices: .8 - .99

Stock ValuationStock ValuationStock ValuationStock Valuation

• Recall:• We value an asset based on the

present value of the expected future cash flows• For stocks these are dividend

payments, resale price

• Recall:• We value an asset based on the

present value of the expected future cash flows• For stocks these are dividend

payments, resale price

• D0 = dividend today

• g = annual dividend growth rate

• Pn= future resale price in year n

• P = price today

• i = discount rate

• D0 = dividend today

• g = annual dividend growth rate

• Pn= future resale price in year n

• P = price today

• i = discount rate

value of a stock todayvalue of a stock todayvalue of a stock todayvalue of a stock today

nn

n

n

i

P

i

gD

i

gD

i

gDP

)1()1(

)1(...

)1(

)1(

)1(

)1( 02

200

• but we do not know the future P….

• assume stock is held indefinitely, just paying dividends….

• but we do not know the future P….

• assume stock is held indefinitely, just paying dividends….

Dividend-discount modelDividend-discount modelDividend-discount modelDividend-discount model

gi

DP

0

• interest rate = risk free rate + risk premium

• i = rf + rp

• then

• interest rate = risk free rate + risk premium

• i = rf + rp

• then

grprf

DP

0

• higher risk free rate, lower stock price

• higher risk premium, lower stock price

• higher dividends, higher stock price

• higher dividend growth, higher stock price

• higher risk free rate, lower stock price

• higher risk premium, lower stock price

• higher dividends, higher stock price

• higher dividend growth, higher stock price

grprf

DP

0

exampleexampleexampleexample

• D = $2, g = 2%, rf = 3%, rp = 5%

• P= $2/(.03+.05-.02)

• P = $2/.06 = $33.33

• D = $2, g = 2%, rf = 3%, rp = 5%

• P= $2/(.03+.05-.02)

• P = $2/.06 = $33.33

• what if risk premium rises to 7%?• P = $2/(.03+.07-.02) = $2/.08 =

$12.50

• what if risk premium falls to 3%?• P = $2/(.03+.03-.02) = $2/.04 = $50

• Dividend discount model shows us why stock prices are volatile

• what if risk premium rises to 7%?• P = $2/(.03+.07-.02) = $2/.08 =

$12.50

• what if risk premium falls to 3%?• P = $2/(.03+.03-.02) = $2/.04 = $50

• Dividend discount model shows us why stock prices are volatile

Theory of Efficient MarketsTheory of Efficient MarketsTheory of Efficient MarketsTheory of Efficient Markets

• efficient market hypothesis (EMH)

• asset prices (stock prices) reflect all available information• markets adjust immediately to new

information• prices incorporate expectations

about future

• efficient market hypothesis (EMH)

• asset prices (stock prices) reflect all available information• markets adjust immediately to new

information• prices incorporate expectations

about future

exampleexampleexampleexample

• XYZ stock, $25• value of $25 based on

--past prices, profits, trading, litigation

--forecasts about future profits, litigation, market share

--relevant economic conditions

• XYZ stock, $25• value of $25 based on

--past prices, profits, trading, litigation

--forecasts about future profits, litigation, market share

--relevant economic conditions

• not ALL buyers and sellers must act rationally for markets to be efficient• just most of them

• not ALL buyers and sellers must act rationally for markets to be efficient• just most of them

implicationsimplicationsimplicationsimplications

• IF stock market is efficient,• THEN stock prices already reflect

all relevant, available information• SO, using the same info to predict

future prices will not work

• IF stock market is efficient,• THEN stock prices already reflect

all relevant, available information• SO, using the same info to predict

future prices will not work

• if future stock prices were predictable…

• Expect price to rise tomorrow,

• Then you buy it today,

• Price rises TODAY

• Stock price today reflects our expectations about future price movements

• Stock prices are close to a “random walk”

• if future stock prices were predictable…

• Expect price to rise tomorrow,

• Then you buy it today,

• Price rises TODAY

• Stock price today reflects our expectations about future price movements

• Stock prices are close to a “random walk”

Are markets efficient?Are markets efficient?Are markets efficient?Are markets efficient?

• a lot of research on efficiency of U.S. stock market

• to “test” efficiency, must understand implications of efficiency

• a lot of research on efficiency of U.S. stock market

• to “test” efficiency, must understand implications of efficiency

• it should be almost impossible to

“beat the market”

(to earn above-average stock market returns over time)

Is this true?

-- most evidence says yes

-- some evidence suggests that some price inefficiencies do

exist

• it should be almost impossible to

“beat the market”

(to earn above-average stock market returns over time)

Is this true?

-- most evidence says yes

-- some evidence suggests that some price inefficiencies do

exist

Evidence for efficiencyEvidence for efficiencyEvidence for efficiencyEvidence for efficiency

• do professionally managed mutual funds beat the market?• no, on average

• do professionally managed mutual funds beat the market?• no, on average

• S&P 500 outperformed 72% of all actively managed large-cap funds in the past 5 years

• funds that do well in one year do not do well in subsequent year

• 1973-98, Wilshire 5000 outperformed 67% of equity funds

• S&P 500 outperformed 72% of all actively managed large-cap funds in the past 5 years

• funds that do well in one year do not do well in subsequent year

• 1973-98, Wilshire 5000 outperformed 67% of equity funds

• so if professionals have difficulty earning superior returns• then prices likely reflect public

information

• so if professionals have difficulty earning superior returns• then prices likely reflect public

information

• Chartists

• using past price patterns to predict future price patterns • no evidence this technique beats

the market

• Chartists

• using past price patterns to predict future price patterns • no evidence this technique beats

the market

Technical analysisTechnical analysisTechnical analysisTechnical analysis

Fundamental AnalysisFundamental AnalysisFundamental AnalysisFundamental Analysis

• Use available data to determine proper value of stock• Which may or may not match price

• Again, we see no evidence that this earns above-average return in the long run

• Use available data to determine proper value of stock• Which may or may not match price

• Again, we see no evidence that this earns above-average return in the long run

WSJ Dartboard contestWSJ Dartboard contestWSJ Dartboard contestWSJ Dartboard contest

• 1988-2001

• Over 6-month period• 4 professionals pick 1 stock each• 4 dartboard stocks• Price appreciation of each portfolio

• Dartboard won about 40% of the time• Even the deck stacked in favor of

professionals

• 1988-2001

• Over 6-month period• 4 professionals pick 1 stock each• 4 dartboard stocks• Price appreciation of each portfolio

• Dartboard won about 40% of the time• Even the deck stacked in favor of

professionals

Evidence against efficient marketsEvidence against efficient marketsEvidence against efficient marketsEvidence against efficient markets

• certain return patterns out there• “anomalies”• should not exist if markets are fully

efficient

• certain return patterns out there• “anomalies”• should not exist if markets are fully

efficient

• small-firm effect• risk-adjusted returns of smaller

firms higher over time• Risk measure?• Survivorship bias

• effect has become smaller over time

• small-firm effect• risk-adjusted returns of smaller

firms higher over time• Risk measure?• Survivorship bias

• effect has become smaller over time

• January effect• stocks post larger returns in

January• (December sell-offs for taxes)• should disappear as tax-exempt

pension funds attempt to profit,• but still exists (but smaller)

• January effect• stocks post larger returns in

January• (December sell-offs for taxes)• should disappear as tax-exempt

pension funds attempt to profit,• but still exists (but smaller)

• P/E effect• Stocks with low P/E do better over

time• Not consistent over time

• Price-to-book value• Value investing (Buffet)• Not consistent, survivorship

• P/E effect• Stocks with low P/E do better over

time• Not consistent over time

• Price-to-book value• Value investing (Buffet)• Not consistent, survivorship

• “Dogs of the Dow”• Portfolio of 10 DJIA stocks with

highest dividend yield (D/P)• Once strategy became widespread,

it no longer worked.

• “Dogs of the Dow”• Portfolio of 10 DJIA stocks with

highest dividend yield (D/P)• Once strategy became widespread,

it no longer worked.

• other effects• day-of-the-week• weather

• most anomalies are too small to allow a profit after trading costs

• other effects• day-of-the-week• weather

• most anomalies are too small to allow a profit after trading costs

• stock price over-reaction• prices fall/rise too much with bad/good

news• A “contrarian” strategy might produce

superior returns

• excess volatility• stock prices fluctuate more than their

fundamentals

• stock price over-reaction• prices fall/rise too much with bad/good

news• A “contrarian” strategy might produce

superior returns

• excess volatility• stock prices fluctuate more than their

fundamentals

• Bubbles• Large gaps between actual asset

price and fundamental value• Internet stock bubble of late 1990s• Housing bubble?

• Eventually the bubble bursts!

• Bubbles• Large gaps between actual asset

price and fundamental value• Internet stock bubble of late 1990s• Housing bubble?

• Eventually the bubble bursts!

weight of evidenceweight of evidenceweight of evidenceweight of evidence

• so efficiency is not perfect,

• but earning above-average returns is very difficult

• so efficiency is not perfect,

• but earning above-average returns is very difficult

Implications of efficiency evidenceImplications of efficiency evidenceImplications of efficiency evidenceImplications of efficiency evidence

• very difficult for average person to beat the market• trying to do so generates trading

costs

• the alternative• buy-and-hold diversified portfolio• indexing

• very difficult for average person to beat the market• trying to do so generates trading

costs

• the alternative• buy-and-hold diversified portfolio• indexing

conclusionconclusionconclusionconclusion

• stock market price behavior combines• fundamentals• investor psychology

• markets are not perfectly efficient• field of behavioral economics,

finance

• stock market price behavior combines• fundamentals• investor psychology

• markets are not perfectly efficient• field of behavioral economics,

finance