7. Stock Market Valuation & 7. Stock Market Valuation & the EMHthe EMH

7. Stock Market Valuation & 7. Stock Market Valuation & the EMHthe EMH

• Role of Expectations

• Rational Expectations

• Efficient Markets Theory

• Role of Expectations

• Rational Expectations

• Efficient Markets Theory

Role of ExpectationsRole of ExpectationsRole of ExpectationsRole of Expectations

• expectations have played a role in several topics studied this semester• bond market• interest rates• inflation• profits

• expectations have played a role in several topics studied this semester• bond market• interest rates• inflation• profits

Rational ExpectationsRational ExpectationsRational ExpectationsRational Expectations

• prior to 1960s, economists assumed adaptive expectations• forecast of inflation based on past

values of inflation• expectations change slowly over

time

• prior to 1960s, economists assumed adaptive expectations• forecast of inflation based on past

values of inflation• expectations change slowly over

time

• problems with adaptive expectations• inflation is affected by many

variables• not just past values

• if economy changes• expectations should change

quickly, not slowly

• problems with adaptive expectations• inflation is affected by many

variables• not just past values

• if economy changes• expectations should change

quickly, not slowly

A better model of expectationsA better model of expectationsA better model of expectationsA better model of expectations

• rational expectations• use all available information to

make best forecast• not exact, but best possible

• rational expectations• use all available information to

make best forecast• not exact, but best possible

why rational expectations?why rational expectations?why rational expectations?why rational expectations?

• better forecasts mean better decisions• firms make more profits• consumers better off• Federal Reserve is better at

achieving goals

• better forecasts mean better decisions• firms make more profits• consumers better off• Federal Reserve is better at

achieving goals

why not rational?why not rational?why not rational?why not rational?

• people do not take time to look at all relevant info in making decisions

• people not aware of all of the relevant info

• people do not take time to look at all relevant info in making decisions

• people not aware of all of the relevant info

If most expectations are rational, If most expectations are rational, thenthenIf most expectations are rational, If most expectations are rational, thenthen

changes in the behaviorof a variable

changes in howwe forecast this variable

examplesexamplesexamplesexamples

• yield curve usually slopes up

• but now suppose it starts being flat most of the time

• predictions about yield curve will use this

• yield curve usually slopes up

• but now suppose it starts being flat most of the time

• predictions about yield curve will use this

• your professor NEVER offers extra credit

• your professor starts offering extra credit after exams

• you start going to class after an exam to get extra credit

• your professor NEVER offers extra credit

• your professor starts offering extra credit after exams

• you start going to class after an exam to get extra credit

also,also,also,also,

• forecast errors

= actual value - predicted value• will average zero over time

• forecast errors

= actual value - predicted value• will average zero over time

Efficient Markets HypothesisEfficient Markets HypothesisEfficient Markets HypothesisEfficient Markets Hypothesis

• apply rational expectations to financial markets• stock market

• asset prices (stock prices) reflect all available information

• apply rational expectations to financial markets• stock market

• asset prices (stock prices) reflect all available information

exampleexampleexampleexample

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

--past prices, profits, trading, litigation

--forecasts about future profits, litigation, market share

--relevant economic conditions

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

--past prices, profits, trading, litigation

--forecasts about future profits, litigation, market share

--relevant economic conditions

• buyers & sellers of Microsoft stock,• trying to profits from trading• use all info that will help them

arrive at true value of stock

• buyers & sellers of Microsoft stock,• trying to profits from trading• use all info that will help them

arrive at true value of stock

• return on microsoft stock always reverts to some level that reflects• expected future earnings• risk

• why?

• recall

• return on microsoft stock always reverts to some level that reflects• expected future earnings• risk

• why?

• recall

return =future price - purchase price + cash flow

purchase price

• if returns are high relative to equil.• people buy stock• stock price rises• return falls

• if returns are low relative to equil.• people sell stock• stock price falls• return rises

• if returns are high relative to equil.• people buy stock• stock price rises• return falls

• if returns are low relative to equil.• people sell stock• stock price falls• return rises

• 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

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

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

• 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• over 50% will have below-average

returns in a given year• funds that do well in one year do

not do well in subsequent year

• do professionally managed mutual funds beat the market?• no, on average• over 50% will have below-average

returns in a given year• funds that do well in one year do

not do well in subsequent year

• 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

• technical analysis• using past price patterns to predict

future price patterns • no evidence this technique beats

the market

• technical analysis• using past price patterns to predict

future price patterns • no evidence this technique beats

the market

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• effect has become smaller over

time

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

firms higher over time• 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

• 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

• 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

• excess volatility• stock prices fluctuate more than

their fundamentals

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

bad/good news

• excess volatility• stock prices fluctuate more than

their fundamentals

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

Crash of 1987Crash of 1987Crash of 1987Crash of 1987

• October 19, 1987• Dow lost 500 points (20%)• is such a large loss in 1 day

consistent with efficiency?

• October 19, 1987• Dow lost 500 points (20%)• is such a large loss in 1 day

consistent with efficiency?

causescausescausescauses

• rising federal budget deficit

• rising trade deficit

• anti-corporate legislation

• rising inflation

• falling $

• but none had a dramatic 1-day change

• rising federal budget deficit

• rising trade deficit

• anti-corporate legislation

• rising inflation

• falling $

• but none had a dramatic 1-day change

conclusionconclusionconclusionconclusion

• stock market price behavior combines• fundamentals• investor psychology

• markets are not perfectly efficient• field of behavioral finance

• stock market price behavior combines• fundamentals• investor psychology

• markets are not perfectly efficient• field of behavioral finance