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