Week Ten
Linus Yamane
Phillips Curve
William Phillips“The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861‐1957”Economica1958
Phillips Curve • Missing link between output and prices for Keynesians
• Okun’s law links output and unemployment• Paul Samuelson and Bob Solow examined inflation rather than nominal wages
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Phillips Curve 1960s
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Phillips Curve 1960-79
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Phillips Curve 1960-89
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Phillips Curve 1960-99
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Phillips Curve 1960-09
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Phillips Curve 1960‐2013
Expectations Augmented Phillips Curve
• Central short run idea• When unemployment falls below the natural rate– GDP rises above potential output, and– Inflation rises above expected inflation rate
• When∗ ∗∗ ∗∗ ∗
Expectations Augmented Phillips Curve
• ∗
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• Negatively sloped• When ∗
• When , unemployment intercept is at ∗
• When changes, the Phillips curve shifts
Phillips Curve
• Short Run– When expected inflation is held constant, the Phillips curve shows a trade‐off between inflation and unemployment
• Long Run– No trade‐off between inflation and unemployment– , ∗ in long run– Unemployment is independent of the inflation rate– Long run Phillips curve is vertical at ∗
Phillips Curve
• Explains the clockwise spiral motion of the past five decades
• If government tries to maintain an unemployment rate below the natural rate, it leads to accelerating inflation
• Can be derived from the short run Lucas aggregate supply curve function
∗
Anti‐Inflation Policies• Regime change
– Credible public announcement• Gradualism• Cold Turkey
– Decrease expected inflation– More credible
• Incomes Policies– Policies which attempt to reduce the rate of wage and price inflation with direct action by government control or persuasion
• Kennedy Wage‐Price Guideposts• Nixon Wage‐Price Freeze• Ford WIN buttons
Anti‐Inflation Policies (cont)
• Tax based Incomes Policy– Encourage firms and workers to keep prices and wages stable by providing tax incentives
• Profit Sharing– Set wage as % of per worker profits or revenues so wages and prices move together
• Supply‐side policies– Shift out the AS curve– Good idea, but hard to do
Stock Market
Stock Market• If a country has a stock market, it is a capitalist country.
• A corporation is a legal entity• A share of stock represents a fraction of ownership in a corporation
• The stock of a corporation constitutes the equity stake of its owners
• The equity stake is the value of the assets of the company after all its creditors have been paid
Spectrum of Financial AssetsLow Risk Money
Treasury Bills, Money Market FundsTreasury BondsMunicipal Bonds, Corporate BondsPreferred Stock (Blue Chip, Growth, Speculative)Common Stock (Blue Chip, Growth, Speculative)
High Risk
Derivatives (Futures contracts, forward contracts, options, and swaps)
• Different assets have different maturity, risk, liquidity, tax treatment
• Stocks have yield (dividends)• Stocks are bought and sold on auction markets
Stock Tables
1 52 week high 7 Price/Earnings Ratio
2 52 week low 8 # of shares traded
3 Name of company 9 High price for the day
4 Ticker symbol 10 Low price for the day
5 Annual Dividend per share 11 Closing price
6 Dividend/Share Price 12 Change since previous day
Yahoo! Finance
Price – current pricePrevious Closing Price – price when market
closedOpen – price when market openedBid – what you can sell forAsk – what you can buy for1 year Target EstimateBeta = measure of riskNext Earnings DateDay’s Range52 Week RangeVolumeAverage Volume (3 months)Market CapitalizationP/E Ratio (trailing twelve months)Earnings Per Share (trailing 12 months)Dividend and Yield
PE ratio and Dividends
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• If a $100 firm is making $5 a year in earnings, the PE ratio will be 20.
• If all the profits are paid to shareholders as dividends, the yield will be 5%.
• The yield is always less than 1/PE ratio• If a firm has zero earnings, the PE ratio is infinite.
What determines the price of a stock?
Firm Foundation Theory• Stock has some intrinsic value• Price of stock is the present discounted value of the future stream of dividends
• ⋯ – is the dividend in year t– is the interest rate
• Price should be higher if– Dividends are higher (present and future)– The company will be around longer (n is big)– Interest rates are lower– The company is less risky
Firm Foundation Theory?
• Airbnb ($10 billion) vs Hyatt Hotels ($8.5 billion)– Hotel chain without any hotels vs hotel chain with hotels
• Facebook is worth more than Disney, Home Depot, McDonalds, Boeing, GM
• In the first quarter 2014, 45% of all companies that conducted initial public offerings (IPOs) were in biotech. Half had no revenue. All were losing money. Median valuation was $199 million.
John Maynard Keynes
• Criticized the firm foundation approach– It is too hard to predict the future– People have a much shorter view
• “Like a beauty judging contest in which you have to select the six prettiest faces out of a hundred photographs, with the prize going to the person whose selection more nearly conforms to those of the group as a whole”
Castle in the Air Theory
• A stock is worth what someone else is willing to pay for it
•• You buy if the price is likely to go up, you sell if the price is likely to go down
• Greater Fool TheoryIt’s okay to pay 3 times what something is worth as long as you can find someone willing to pay 5 times what it’s worth a little later
Bubbles
• Tulip Bulb Craze– Tulips introduced into Holland 1593– Flowers succumb to nonfatal mosaic virus– Become popular and more expensive– Cost more than houses 1634‐38
• South Sea Company– England 1711‐1721– Given monopoly over all trade in south seas– No sales, no earnings
Bubbles
March 1928
September 1929
Gain in 18 months 1932
RCA 94 505 434.5% 12
Montgomery Ward 132 466 251.4% 11
1961 1962
IBM 607 300Texas Instruments 206 49
Stock Market Crash 1929
Electronics Boom 1959‐62
Bubbles
PE Ratio 1972 1980
Sony 92 17
Polaroid 90 16
McDonalds 83 9
Crash of Blue Chip Stock 1972
The NASDAQ Composite is a stock market index of the common stocks and similar securities listed on the NASDAQ stock market. It has over 3,000 components, mostly technology companies and growth companies, and includes both U.S. and non‐U.S. companies.
National Association of Securities Dealers Automated Quotations
Dot Com Bubble 1997‐2000
0
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1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Inde
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Year
NASDAQ Composite
Dot Com BubbleDate Price
NASDAQ January 1995 743.58
Composite Index March 2000 5,048.62
October 2002 1,114.11
YAHOO December 1999 108.17
September 2001 4.41
AMAZON April 1999 86.03
September 2001 5.97
CISCO May 2000 77.31
October 2002 11.18
Can you make money systematically?
• Chartists (technical analysts) say YES!– Head and Shoulders– Support and resistance levels– Hemline method– Odd Lot Theory– Super Bowl Indicator– Company disaster
• Efficient Market Hypothesis says NO!
Why is Warren Buffet so rich?
• Chartists (technical analysts) say he is smart.• Efficient Market Hypothesis says he is lucky.
Efficient Market Hypothesis
• Assume all available information is contained in the price of an asset
• All new information is quickly understood by the market participants and becomes immediately incorporated into the market price
• What information?– Weak form: past prices of an asset– * Semi‐strong form: all public information– Strong: all information
Efficient Market Hypothesis
• Then the ideal stock price moves like a random walk• where is a random error term• Random walk: when changes in a variable are unpredictable
• New information (about dividends, interest rates, economy, etc) will change the value of a stock
• But real news is fundamentally random (if it’s predictable, then it’s already incorporated into the price)
• So changes in stock prices will appear random
Random Walks
Efficient Market Hypothesis
• The efficient‐market hypothesis (EMH) asserts that financial markets are "informationallyefficient".
• Consequently you cannot consistently achieve returns in excess of average market returns on a risk‐adjusted basis given the information available at the time the investment is made.
• Stock market prices move erratically, seemingly without reason
• Perfect stock prices should look very erratic
Forbes Magazine
• June 1967– Editors selects 28 companies at random– Buy $1,000 in stock in each of these 28 companies
• June 1984– Portfolio is worth $131,697.61– 370% gain– Beat all market indices– Better than most professional money managers
Efficient Market Hypothesis
• The uninformed investor can do just as well as anyone by buying a random selection of stocks
• Recommendations– Buy from a discount broker – Buy a broadly diversified mutual fund of common stock (good return with least possible risk)
• S&P 500 index fund
– You can increase your expected return by bearing more risk
Is the stock market really efficient?
• First order approximation, yes– Stock prices are well modeled as a random walk
–Hard to beat the market systematically• Strictly speaking, no.
– January effect, Low P/E effect– Excess volatility, bubbles
• Consider October 1987 and September 2008
October 19, 1987
Largest single day percentage drop ever !
September 29, 2008
• House fails to pass $700 billion TARP at 1:30pm EST
• Dow Jones falls 400 points in 5 minutes• Dow Jones is down 778 points by the end of the day (largest single day point drop)
• Dow Jones falls 7%, S&P 500 falls 9%• Loss of $1.2 trillion in market value
Risk and Return
You will be compensated for bearing more risk
Risk and Return1970‐2013 Mean Risk (SD) Min Max
S&P 500 7.61 17.41 ‐45.46 57.29
AAA Bonds* 4.18 5.21 ‐7.13 16.89
3M Treasury 1.05 2.53 ‐3.61 7.52
• After adjusting for inflation, the geometric real rate of return is• About 6% for equity• About 4% for AAA corporate bonds • About 1% for T‐bills
• Rate of return on equity is higher than can be justified by the additional risk• Perhaps people don’t know about the high rates of return• Only half of Americans own equity
Equity Premium* 1989‐2013
CAPM• Capital Asset Pricing Model (CAPM)• Risk = systematic risk + unsystematic risk
– Systematic risk: basic variability of stock prices in general– Unsystematic risk: factors peculiar to the particular company
• Systematic risk = market risk– Measured by – Can’t be eliminated by diversification
• CAPM: returns for any stock will be related to the systematic risk that can’t be diversified away
• Total risk of the security is irrelevant– You will not be compensated for bearing risk that can be diversified away
Systematic & Unsystematic50% 50%
Rain Sun Average Rate of Return
Risk (SD)
Club Med ‐5 15 5 10
Umbrella.Com 15 ‐5 5 10
Club Med + Umbrella.Com 5 5 5 0
You will not be compensated for bearing risk that you can diversify away
Options Market
• Call Option– Buyer has the right (but no obligation) to buy an asset at a fixed price at a fixed date in the future
• Put Option– Buyer has the right (but no obligation) to sell an asset at a fixed price at a fixed date in the future
• Leverage– Leverage can be created through options, futures, margin and other financial instruments.
– Leverage magnifies both potential gains and losses.
CAPM
Housing Market
Housing Market
• MYTH #1: Housing is a good investment– Since 1890 real home prices have gone up 0.16% per year
– Real home prices were pretty much the same in 1898, 1959, 1965, 1977, 1981, 1994, and 1998.
– Do not expect the real value of homes to rise over time because we can always build more houses.
Risk and Return1970‐2013 Mean Risk (SD) Min MaxS&P 500 7.61 17.41 ‐45.46 57.29AAABonds*
4.18 5.21 ‐7.13 16.89
3M Treasury
1.05 2.53 ‐3.61 7.52
Homes** 0.27 5.11 ‐21.23 12.34
Note that we are comparing apples and oranges here.Homes not like stocks and bonds.You can live in a home. You also have to maintain the value of a home.
*1989‐2013** 1953‐2013
Housing Market
• MYTH #2: It is always better to buy than to rent– If the market is working, it will not make any differences if you buy or rent.
– In any local housing market, it may be better to rent, or it may be better to buy
• MYTH #3: You should pay off your mortgage sooner rather than later– Think about opportunity costs– What else you could do with your money?
Stabilization PolicyStabilization works, but it is far from simple
• Limitations on what government can do– Policies which raise output tend to increase inflation– Only have monetary policy, fiscal policy, trade policies, etc.
• Uncertainty about the effects of policy– How big is the multiplier?– What is the natural rate of unemployment?– How long are the lags?– Role of expectations
• Private sector response to policy depends on expectations• Expectations depend on policy
Stabilization Policy• Lags in Policy
– Inside lag• Time it takes to undertake a policy action
– Recognition lag– Decision lag– Action lag
– Outside lag• Time it takes policy changes to affect the economy • 6 months to 2 years, long and variable
– Inside lags are longer for fiscal policy (Congress & President)
• shorter for the Federal Reserve • shorter for built‐in automatic stabilizers
Active Policy vs Passive Policy
• Active Policy– Select monetary and fiscal policy in response to prevailing economic conditions
– Fine tune the economy (Walter Heller)
• Passive Policy– Maintain steady monetary and fiscal policies independent of prevailing economic conditions
– Fool in the shower syndrome (Milton Friedman)
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