Lecture06

Topic 6

The Stock Market

Topic 6, page 1

ECO 350 • Money and Banking

The Stock Market

Department of Economics, SUNY

[Background]

A. Common Stock and Stockholders

i. Equity capital, dividends

ii. Residual claimant

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ECO350 • Money and BankingDepartment of Economics, SUNY

[Background]




B. Basic Principle of Finance

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ECO350 • Money and Banking

o The value of any investment is found by computing

the present value of all cash flows the investment

will generate over its life.


[Background]





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C. Common stock is valued as the value in today’s dollars of

all future cash flows

o The cash flows a stockholder might earn from stock

are---Department of Economics, SUNY

[Background]





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C. Common stock is valued as the value in today’s dollars of

all future cash flows

o The cash flows a stockholder might earn from stock

are---dividends, the sales price, or both.Department of Economics, SUNY

1. Fundamental Stock Price

A. Fundamental stock price = discounted sum of expected

dividends:

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1+i (1+i)2+ + + …

(1+i)3div2

e div3e

div1e

PSF =


1. Fundamental Stock Price

A. Fundamental stock price = discounted sum of expected

dividends:

B. Gordon Growth model

i. Constant dividend growth:

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1+i (1+i)2+ + + …

(1+i)3div2

e div3e

div1e

PSF =


i. Constant dividend growth:

ii. If i > g,

iii. If i ≤ g, PSF = ∞.


div2 = (1+g)div1;e e

div3 = (1+g)div2 = (1+g)2div1

e e e

div1i – g

e

PSF =

1. Fundamental Stock Price (continued)

[Example] D1 = $2, g = 3%

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Investor Discount Rate Stock Price

You 15% $16.67

Jennifer 12% $22.22


Jennifer 12% $22.22

Bud 10% $28.57


C. How the market sets stock prices

i. The price is set by the buyer willing to pay the

highest price.

• The price is not necessarily the highest price the

asset could fetch. It is incrementally greater than

what any other buyer is willing to pay.

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what any other buyer is willing to pay.

ii. The market price will be set by the buyer who can

take best advantage of the asset.



C. How the market sets stock prices

iii. Superior information about an asset can increase its

value by reducing its risk.

• The buyers who has the best information about

the future cash flows will discount them at a

lower interest rate than will a buyer who is very

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lower interest rate than will a buyer who is very

uncertain.

D. An Application---Monetary Policy and Stock Prices

i. lower interest rate → lower required rate of return

on equity

ii. lower interest rate → higher g


2. Rational Expectations

A. Rational expectations: Expectations (predictions) are

statistically optimal forecasts using all available

information.

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2. Rational Expectations

A. Rational expectations: Expectations (predictions) are

statistically optimal forecasts using all available

information.

• Best possible given the available information

• The forecast does not have to be perfectly

accurate to be rational.

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2. Rational Expectations (continued)

[Example] Best possible given the available information

o If a forecaster spends hours every day studying data

to forecast interest rates but his expectations are

not as accurate as predicting that tomorrow’s

interest rates will be identical to today’s interest rate,

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are his expectations rational?




o If a forecaster spends hours every day studying data

to forecast interest rates but his expectations are

not as accurate as predicting that tomorrow’s

interest rates will be identical to today’s interest rate,

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are his expectations rational?

o No. Because he could improve the accuracy of his

forecasts, his forecast is not optimal.




o Whenever it is snowing when Joe Commuter gets up

in the morning, he misjudges how long it will take

him to drive to work. Otherwise, his expectations of

the driving time are perfectly accurate. Considering

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that it snows only once every ten years where Joe

lives, Joe’s expectations are almost always perfectly

accurate. Are Joe’s expectations rational?




o Whenever it is snowing when Joe Commuter gets up

in the morning, he misjudges how long it will take

him to drive to work. Otherwise, his expectations of

the driving time are perfectly accurate. Considering

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that it snows only once every then years where Joe

lives, Joe’s expectations are almost always perfectly

accurate. Are Joe’s expectations rational?

o No. He doesn’t take account of a snowfall in his

forecasts.



[Example] The forecast does not have to be perfectly


o “Forecasters’ predictions of inflation are notoriously

inaccurate, so their expectations of inflation cannot

be rational.” Is this statement true, false, or

uncertain?

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uncertain?



[Example] The forecast does not have to be perfectly


o “Forecasters’ predictions of inflation are notoriously

inaccurate, so their expectations of inflation cannot

be rational.” Is this statement true, false, or

uncertain?

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uncertain?

o False. A forecast is optimal if it is the best possible

even if the forecast errors are large.



B. Implication: The forecast errors of expectations will, on

average, be zero and cannot be predicted ahead of time.

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B. Implication: The forecast errors of expectations will, on

average, be zero and cannot be predicted ahead of time.

C. Justification: Suboptimal forecasts are costly.

• How much inventory should Wal-Mart keep?

• In financial markets, people loss money if their

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• In financial markets, people loss money if their

expectations are not rational.


3. The Efficient Market Hypothesis

A. Efficient Market Hypothesis

i. Rational expectations applied to the pricing of stocks

and other securities

ii. The hypothesis says that: In an efficient market, a

security’s price fully reflects all publicly available

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information and all unexpected profit opportunities

will be eliminated.








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will be eliminated.

iii. Justification: if prices are not rational, there are

unexploited profit opportunities. Ex.


*RRof >







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will be eliminated.

iii. Justification: if prices are not rational, there are

unexploited profit opportunities. Ex.

⇒ profits available to investors who buy ⇒ Pt bid up

until .


*RRof >

*RRof =

3. The Efficient Market Hypothesis (continued)

B. Implications of RE/EMH

i. Past values of ret do not predict future values.

ii. Events that were predicted should not affect stock

prices.

iii. Future changes in stock prices should be

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iii. Future changes in stock prices should be

unpredictable: Random Walk Hypothesis



[Example] Implications of RE/EMH

o If you read in the Wall Street Journal that the “smart

money” on Wall Street expects stock prices to fall,

should you follow that lead and sell all your stocks?

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o If you read in the Wall Street Journal that the “smart

money” on Wall Street expects stock prices to fall,

should you follow that lead and sell all your stocks?

o No, because this is publicly available information and

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o No, because this is publicly available information and

is already incorporated into stock prices. The optimal

forecast of stock returns will equal the equilibrium

return. Therefore, there is no benefit from selling

your stocks.




o If the public expects a corporation to lose $5 per

share this quarter and it actually loses $4, which is

still the largest loss in the history of the company,

what does the efficient market hypothesis say will

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happen to the price of the stock when the $4 loss is

announced?




o If the public expects a corporation to lose $5 per

share this quarter and it actually loses $4, which is

still the largest loss in the history of the company,

what does the efficient market hypothesis say will

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happen to the price of the stock when the $4 loss is

announced?

o The stock price will rise. The price of the stock

reflects an even larger expected loss.



B. Empirical Evidence

i. Generally favorable

• Performance of Investment Analysts and Mutual

Funds

• Stock prices reflect publicly available information.

• Stock prices follow random-walk.

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B. Empirical Evidence

i. Generally favorable

• Performance of Investment Analysts and Mutual

Funds

• Stock prices reflect publicly available information.


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ii. Anomalies

• Small-Firm Effect

• January Effect

• Market Overreaction

• Excessive Volatility

• Mean Reversion


4. Speculative Bubbles

A. Speculative Bubble: the price of an asset differs from its

fundamental (intrinsic) market value.

i. Prices rise today because investors expect them to

rise tomorrow, regardless of fundamentals.

(overconfidence and social contagion)

• P is high because investors expect P to be even

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• Pt is high because investors expect Pt+1 to be even

higher.

• Pt+1 is expected to be high because investors

expect Pt+2 to be even higher.


4. Speculative Bubbles (continued)

B. Speculative bubbles can be consistent with rational

expectations.

• Stock market crashes (or the bursting of the bubble)

are unpredictable and so there are no unexploited

profit opportunities.

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4. Speculative Bubbles (continued)

B. Speculative bubbles can be consistent with rational

expectations.

• Stock market crashes (or the bursting of the bubble)

are unpredictable and so there are no unexploited

profit opportunities.

C. Strong version of efficient market hypothesis: Forecasts

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C. Strong version of efficient market hypothesis: Forecasts

are rational, and there are no speculative bubbles.


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Was there a speculative bubble in housing in the early 2000s?

S&P/Case-Shiller Housing Price Index

225.54

150

200

250


http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_History_122622.xls

123.93

62.82

0

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87

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91

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95

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99

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Lecture06