CHAPTER 10 Information and Financial Market...

Information and Financial Market Efficiency

CHAPTER

10The September 2001 terrorist attacks on New York City and Washington, D.C. createdstresses in financial markets. Not only did analysts fear that decisions of frightened con-sumers and businesspeople would lead to lower profits and stock prices, but physicaldamage in lower Manhattan closed U.S. stock markets for a few days. During thisperiod, it was difficult to gauge investors’ estimation of market value. The Bush admin-istration and Federal Reserve officials worked with stock exchange leaders to reopenmarkets quickly so that new information could be captured in market prices. Over thenext several months, corporate accounting scandals at Enron, WorldCom, and otherlarge firms caused investors and officials to question whether prices in financial marketsreflected the right information.

Market participants use the information contained in market prices. Borrowers usefinancial market prices as a guide in their decisions to build new factories or to expandoperations. Lenders make portfolio allocation decisions using prices of assets as an esti-mate of their value. In commodity markets, such as those for agricultural products,prices are signals to producers. An increase in wheat prices, for example, tells farmersthat there are profits to be earned by planting more wheat. In the labor market, a dropin the price of machines relative to workers’ wages tells business managers to devoteresources to mechanizing their factories. Buyers and sellers use market prices to makespending and production decisions.

In this chapter, we focus on the information content of market prices for financialassets. We begin by looking at the way in which buyers and sellers in financial marketspredict the future value of an asset and then act on their predictions. The expectationsof borrowers and lenders determine how much they are willing to accept or pay for afinancial claim. Information is an input to their decisions. Their knowledge of eco-nomic conditions, political events, consumer behavior, and conditions affecting indi-vidual industries or firms determines their estimates of the future value of financialassets. We then look at how this information is processed by financial markets. If theinformation is processed quickly and efficiently, then the prices in financial marketsreflect the estimated value of the assets. We introduce an economic theory—the efficient markets hypothesis—that describes how the actions of buyers and sellers setmarket prices and how those prices in turn communicate information for financial andeconomic decisions.

Rational ExpectationsExpectations of asset values by participants in financial markets determine marketprices and changes in market prices. In this section, we analyze how financial marketparticipants use information about financial assets to form expectations about prices.We will see that when market participants use all available information, market pricesbecome signals for financial and economic decisions, and they convey information tomarket participants.

206

Expectations figured prominently in our previous discussion of financial decisions.Recall from Chapter 6 that expected wealth affects the demand for bonds. (If you getricher, you will increase your holdings of bonds.) And expected future profits influencebond supply by businesses. (A business owner who expects to make a lot of moneyfrom a new computer invention will want to borrow to invest in a factory to producethe equipment.) In addition, expectations of future inflation affect nominal interestrates and exchange rates. Finally, expected rates of return on alternative assets provideinformation for portfolio allocation decisions.

A few examples will illustrate how market participants’ expectations of market value influence the asset’s market price. If Middleroad, Inc., bonds yield 10%while U.S. Treasury bonds of the same price and maturity yield 7%, financial marketparticipants have set the risk premium on Middleroad’s bonds at 10% � 7% � 3%.The risk premium reflects lenders’ expectations of default. Or, if the dollar is expectedto appreciate against the Japanese yen during the next 60 days, the 60-day forwardyen/dollar exchange rate should be higher than the current exchange rate. Thisexpected increase in the yen price of dollar-denominated assets reflects the expectedappreciation of the dollar. Finally, if Newfangleco discovers a cure for the commoncold, the price of its shares should rise dramatically. The discovery leads investors toexpect higher future returns and a higher share value. In each case, the current valuesof Middleroad’s bonds, the yen/dollar exchange rate, and Newfangleco stock reflect thepresent value of expected future returns. When the market price of the financial instru-ment equals that present value, savers and borrowers can be sure that the price com-municates information about market participants’ expectations of value.

The market’s valuation process is an ongoing activity. An investor does not assessa stock, make an investment decision, and consider that a complete task. The investorcontinues to monitor information that affects the security and adjusts the estimate ofthe security’s value. The incorporation of new information into the analysis results innew estimates and new market prices. For example, if financial market participantsexpect that Slipperyslope Company may default on its bonds at some point during thenext five years, investors, using this information, will require a higher return on Slip-peryslope’s bonds. Hence the interest rate that lenders will charge Slipperyslope on newdebt will rise, and the price of its outstanding bonds will fall. This incorporation of newinformation into the price of the bonds tells lenders to require a higher expected rateof return on loans to Slipperyslope. It also tells the managers of Slipperyslope that thecost of funds has gone up to reflect the investment risk associated with the firm. In theearly 1990s, IBM witnessed a drop in market value due to the erosion of its mainframebusiness and competition from other makers of personal computers. Investors observ-ing these conditions tended to reduce their assessment of the value of IBM stock, andthe price fell. IBM responded by cutting costs and introducing new products.

How do market participants form expectations of prices of future returns? Earlystudies by economists of expectations focused on the use of information from the past.For example, expectations of the price of a company’s stock would depend on the his-tory of prices for the company’s shares. This use of information is called adaptiveexpectations. When market participants have adaptive expectations, their expectationsof changes in prices or returns change gradually over time as data on past prices orreturns become available. That is, market participants only slowly adjust their expec-tations to news that could affect prices or returns.

When market participants have rational expectations, they use all informationavailable to them. The information that they use includes not only past experiences, but

CHAPTER 10 Information and Financial Market Efficiency 207

also their expectations and predictions for the future. Therefore, in a market in whichinvestors and traders have rational expectations, the market price of an asset equals thebest guess of present value of expected future returns, or the asset’s fundamental value.Market participants can then use the price as a measure of fundamental value.

Formally, economists define rational expectations to mean that expectations equalthe optimal forecast (the best guess) of prices using all available information.✝ For anyasset, the expectation of the asset’s price, Pe, equals the optimal (best guess) price fore-cast, Pf; if market participants use all available information, Pe � Pf. For example,recall that the value of a bond today equals the present value of future interest andprincipal payments. If the price is greater than the value of the expected future returns,investors will sell the asset, forcing the price down to the current value. But if theasset’s price is less than the present value of its expected future returns, investors willbuy the asset, putting upward pressure on the price until it equals the current value.

Although investors and traders use rational expectations in their financial deci-sions, they cannot foretell the future. No one can predict exactly an asset’s future price.When market participants have rational expectations, the deviation of the expectedprice from the actual future price is not predictable. Using all available information,investors and traders arrive at a forecast price for tomorrow (time t � 1). Let Pt�1 rep-resent the actual price of a share tomorrow and let Pe

t�1 equal the expected price basedon the information available at time t. When market participants have rational expec-tations, the difference between the actual price and the expected price equals a random(unforecastable) error:✝✝

(10.1)

In other words, if you use the same information that other market participants use informulating their price forecast, you can’t predict their mistakes.

The Efficient Markets HypothesisMarket participants acting rationally will estimate a value for any asset—but how doesthis behavior translate into the prices we observe in markets, and how can we be sure thata market price equals an asset’s fundamental value? To answer these questions, let’s beginwith an analysis of the reasoning you might apply in deciding whether to purchase sharesof stock in Consolidated Instruments. Using all the information available today (time t)regarding the prospects of the company, the industry, and the economy, you determinethat Consolidated Instruments’ shares are worth more than their market price. Althoughthe stock is currently priced at $20 per share, your forecast of the present value of futurereturns, based on information you received today, suggests that the stock price should be$30 per share. This information prompts you (and other investors) to buy shares to real-ize the higher expected rate of return. In reaction to this surge of interest, the stock pricerises until it reaches the higher price of $30. By trading on the basis of your forecast, you

Pt�1 � Pet�1 � 1Unforecastable errort�1 2.

208 PART 3 Financial Markets

✝ John Muth, “Rational Expectations and the Theory of Price Movements,” Econometrica, 29:315–335,1961.

✝ ✝ An implication of market efficiency is that prices of financial assets should approximately follow a randomwalk, meaning that the change in price from one trading period to the next is not predictable. The reason is thatbecause the current market price in an efficient market incorporates all available information, any change inmarket price from one period to the next reflects new information.

profit from the ensuing increase in the price of shares in Consolidated Instruments. Ratio-nal expectations provide the incentive to profit when market prices are higher or lowerthan the forecasted value. In this way, the self-interested actions of major, informedtraders cause available information to be incorporated into market prices.

As long as the transactions costs of buying and selling financial instruments are low,the activities of traders and investors will tend to eliminate deviations from the price thatavailable information predicts. Individual investors may profit from spotting prices higheror lower than forecasts of underlying values, and those who invest in gathering new infor-mation may also earn a profit from forecasting value. However, over a reasonable lengthof time, market participants should allow no unexploited profit opportunities. In this case,everyone can look to the market price as the best available signal of value.

The efficient markets hypothesis is a theory of market pricing behavior that appliesrational expectations to the pricing of assets. According to the theory, when traders andinvestors use all available information in forming expectations of future rates of returnand when the cost of trading is low, the equilibrium price of the asset equals the market’soptimal forecast of fundamental value. The forecast of fundamental value in marketprices, in turn, offers market participants guidance in financial and economic decisions.Figure 10.1 illustrates this flow of information in an efficient financial market.

For now, our assessment of the role that expectations play in determining marketprices is based on the assumption that the same information is potentially available toall parties (borrowers, lenders, and traders). In Chapter 11, we identify problems aris-ing from asymmetric information—for example, when a borrower has informationabout prospects or risks not shared by other market participants.

By summarizing information in market prices, financial markets provide signals forlending, borrowing, and portfolio allocation.

Determining an Asset’s Expected Price

We know from the analysis of interest rate determination and the theory of portfolioallocation that the current market value of a financial instrument depends on its returns


Information

Rational expectations

Prices provide information about fundamentalvalue to market participants. Market efficiencyenhances liquidity and risk-sharing services of

financial markets.

Market

Participants

Efficient

Market

Flow of Information in an Efficient Financial MarketEfficient financial markets benefit both lenders and borrowers. When market prices reflect all available information, they guide decisions aboutlending, borrowing, and portfolio allocation.

FIGURE 10.1

relative to returns on other investments with similar risk, liquidity, and informationcharacteristics. Think of the income from a bond or shares of stock in two parts: a cur-rent return and the value of expected future returns. For a bond, your income comesfrom the coupon payments you receive while you hold the bond plus your expected futurecapital gain (or loss) when you redeem the bond. For shares of stock, your income comesfrom the dividends you receive while you hold the shares plus your expected future cap-ital gain (or loss) when you sell the shares. Thus Pt, the price of an asset at time t, equalsthe sum of the expected return on the asset, De, next period, t � 1, plus the expectedprice, Pe, of the asset at t � 1. To account for the asset’s risk, the expected return andthe expected price must be discounted by 1 plus the interest rate adjusted for risk, sothe asset’s current price equals the present value of future returns from holding it, or

(10.2)

where

price of financial assets at time t;

expected periodic return on the asset (coupon payment for a bond or adividend for a share of stock) for time t � 1;

interest rate, adjusted for the asset’s risk; and

expected price of the financial instrument at time t � 1.

In an efficient bond market, bonds with higher default risk have a lower price thandefault-risk-free bonds with the same returns. In an efficient stock market, a stock’sprice reflects the present value of expected future dividends. We can use Eq. (10.2) todetermine whether a financial asset has a high price or a low price in an efficient mar-ket. A financial asset will have a high price today if (1) it is expected to have highreturns (high De); (2) it is not very risky (low i); or (3) it is expected to rise in value inthe future (an expected capital gain, or high Pe).

Price Fluctuations

Although the efficient markets hypothesis says that the price of a financial instrumentis based on all available information, the prices of financial assets such as stocks andbonds can change. Because their prices reflect information about fundamental value,they constantly change to reflect news about changes in fundamental value. Theexpression for the price of a financial instrument in Eq. (10.2) suggests that prices

Pet�1 �

i �

Det�1 �

Pt �

Pt �De

t�1 � Pet�1

1 � i,


In China, stock markets were nonexistent under communist rule until the 1990s.Can you imagine some likely problems in developing stock markets further there?The value of financial markets in channeling funds from savers to borrowers and in pro-viding risk sharing for savers depends on market liquidity and the information contentof market prices. Initially, new stock markets are likely to lack liquidity and efficienttrading mechanisms for savers. Even more important, because little information aboutenterprises is available to market participants, market prices may not provide mean-ingful signals for saving and investment decisions. (Even if more information were avail-able, individual savers might not know what to do with it.) ♦

C H E C K P O I N T

change in reaction to changes in expected future returns or in risk, liquidity, or infor-mation costs associated with the instrument. This reaction occurs whether the instru-ment is a bond, shares of stock, a foreign exchange contract, a futures contract, anoptions contract, or any other financial instrument.

One source of price fluctuations in an efficient market is shifts in interest rates. Anincrease in market interest rates reduces the present value of future interest and princi-pal payments from a long-term bond. As a result, the price of a bond falls when yieldsrise. Similarly, an increase in expected future market interest rates raises long-termyields relative to short-term yields. Exchange rates also fluctuate in response to move-ments in interest rates at home and abroad. Finally, an increase in default risk increasesthe risk premium in a bond’s interest rate and lowers the bond’s price.

The financial news media tend to emphasize fluctuations in the stock market. Onereason is that price fluctuations for individual stocks can be large. For example, in asingle day, a share of stock might rise in price from $10 to $12, a 20% gain, or fallfrom $10 to $8, a 20% loss. Can such large fluctuations be consistent with an efficientfinancial market? The answer is yes. To find out why, let’s examine a change in the priceof a stock. Suppose that, using all currently available information, shareholders fore-cast dividends per share of Consolidated Industries (CI) stock to be $2.00 this year,$2.08 next year, and $2.16 two years from now. On the basis of their assessment ofprospects, market participants expect dividends to increase steadily at a rate of 4% peryear. The value of a share today is the present value of future dividends. Thus, if i is therisk-adjusted interest rate appropriate for CI, the present value PV of expected futuredividends is

PV of PV ofyear 1 year 2

dividend dividend

According to the efficient markets hypothesis, if the CI share price is greater than thisvalue, traders will sell shares, forcing the price down. Conversely, if the CI shares areundervalued, traders will buy shares, forcing the price to rise until the current value andthe market price are equal.

Changes in expected dividends for just one period are unlikely to have much effecton share price, which represents the present value of all expected future dividends.Therefore, in principle, the efficient markets hypothesis allows for large movements inshare prices. Let’s find out why. Using our assumption that the CI dividend per shareis expected to grow forever at a constant rate g (4% in this example), we can expressthe present value as

This equation restates the fundamental value, or price, of the share as the product ofthe current dividend per share (the first term on the right) and an expression includingthe risk-adjusted interest rate and the expected growth rate of dividends (the second termon the right). In other words, the equation says that a higher expected dividend growthrate increases value, whereas a higher risk-adjusted interest rate decreases the value ofexpected dividend returns.

PV � 1$2.00 2 a 1 � gi � g

b.

Present value �2.081 � i

� 2.1611 � i22 � . . . .


If we expect a constant growth rate of g � 0.04 and a risk-adjusted interest rate i � 0.10, the fundamental value of Consolidated Industries shares (and price per shareunder the efficient markets hypothesis) is

Suppose that bad news about the long-term growth prospects of CI’s industry causesthe expected growth rate of dividends g to fall to 2%. Then the share price falls to

a decline in value of 26%. Hence, although news about short-term fluctuations inprospects affects prices only slightly under the efficient markets hypothesis, largeswings in prices are possible in response to good or bad news about long-termprospects.

Investment Strategies

When prices of financial instruments summarize all information available to marketparticipants, savers and borrowers obtain the information necessary to make deci-sions at low cost, as Table 10.1 shows. For example, higher stock prices tell busi-nesses that investors expect profits to rise in the future and that the businesses shouldincrease their spending on new plant and equipment. Higher bond prices indicatethat market interest rates or risk premiums are falling, reducing returns to holdingbonds and the cost of funds for borrowers. Recall that an upward-sloping yield curveinforms borrowers of likely higher future real interest rates, or inflation. Wideningdifferences between domestic and foreign real interest rates reveal shifts in desiredinternational borrowing and lending and likely changes in exchange rates.

Understanding the efficient markets hypothesis allows you to formulate strategiesfor portfolio allocation, trading, assessing the value of financial analysis, and predict-ing changes in market prices of stocks, bonds, and other financial assets.

PV � $2.00 a 1.02

0.10 � 0.02b � $25.50,

PV � 1$2.00 2 a 1.04

0.10 � 0.04b � $34.67.


How Should 9/11 AffectU.S. Stock Prices?The New York Stock Exchange closedafter the September 11 attacks, asrescuers struggled to repair physicaldamage and restore essential tele-communications services to keepmarkets open. On the morning ofSeptember 17, as the markets re-opened, I published from the WhiteHouse an article in The Wall StreetJournal, cautioning against panic by

reminding investors of the fundamen-tals of valuation.

As terrible as the events of Septem-ber 11, 2001, were, most economistsquestioned whether they wouldreduce the growth rate of cash flowsin the corporate sector (g in the equa-tion on page 211). A more reasonableguess was that greater uncertaintyabout the global economy in the wakeof September 11 would increase therequired return on stocks (i in theequation on page 211). While stock

prices did drop as markets reopened,equity values rebounded in Octoberand November, as heads cooled inexamining valuation and the militarycampaign against the Taliban provedsuccessful.

Unfortunately for equity investors,corporate accounting scandals atEnron, WorldCom, and other largefirms occurred shortly thereafter,again leading investors to lower theirestimate of g and raise their estimateof i, depressing stock prices.

C O N S I D E R T H I S . . .

Web Site Suggestions:http://www.nyse.comFollow price move-ments under “MarketInformation.”

web_links212.html

Portfolio allocation. As long as all market participants have the same information,the efficient markets hypothesis predicts that all above-normal profit opportunities willbe exploited in the trading process. Hence you should not risk your savings in only oneasset without information superior to that generally available (known as insider infor-mation) about a company’s prospects. That is, investors should follow a strategy of hold-ing a diversified portfolio.

Many individuals diversify their investments by purchasing mutual funds, some ofwhich invest in broad market portfolios or index funds, such as S&P 500 stocks. Hir-ing an investment firm to manage your funds actively would cost many times morethan simply placing all your money in a mutual fund that holds a broad market port-folio. Large institutional investors are also placing larger portions of their equity invest-ments in these index funds because actively managed funds often provide lower ratesof return than broad market portfolio funds over long horizons.

Trading. Similarly, if prices reflect available information, buying and selling individ-ual assets regularly is not a profitable strategy. Lacking superior information, an investoris ill advised to constantly move funds from one asset to another, or churn, a portfolio.Therefore you should buy and hold a market portfolio over a long time horizon.

Financial analysis and hot tips. The efficient markets hypothesis suggests thatpredicting an individual asset’s price by focusing simply on past price data doesn’t givethe best possible forecast. Why? The reason is that these historical data do not reflectall available information. “Tips” published in leading commercial or financial publica-tions are equally unlikely to lead you to profitable trades. The news will already bereflected in the market price by informed traders who have learned about it before itspublication. By chance, some analysts may appear to outperform broad-based marketrates of return over an extended period of time. However, you should not expect to“beat the market” through forecasting gimmicks.

Do not conclude, however, that all financial analysis is worthless. The efficientmarkets hypothesis states that all available information is incorporated into the mar-ket price of a financial asset. If you can uncover new information that can change mar-ket prices, you may be able to profit.


Signals for Savers and Borrowers in an Efficient Market

An increase in . . . Signals that . . . Because of . . .

stock prices businesses should invest more greater investment opportunities

bond prices savers should lower their required lower default risk or lower overallrate of return and borrowers level of interest ratesshould increase investment

risk premiums savers should increase their required greater default risk, lower liquidity,rate of return and borrowers or higher information costsshould decrease investment

the upward slope of savers should require higher yields higher expected future inflation orthe term structure on long-term instruments relative real interest rates

to short-term instruments

the difference between savers should adjust their lending shifts in desired internationaldomestic and foreign to domestic and foreign borrowers lending and borrowingreal interest rates and exchange rates will shift

TABLE 10.1

Predicting price changes. Under the efficient markets hypothesis, today’s price ofan asset reflects all the information available today. But a price increase or decrease betweentoday and tomorrow is unforecastable. Why? Today’s market price is based on currentlyavailable information, and the only reason for a price change is tomorrow’s “news.”

Suppose that Microsoft announces that its earnings this year are 5% lower thanlast year’s. Will the price of a share of Microsoft fall? Not necessarily. Analysts fol-lowing Microsoft may have anticipated the decrease in earnings and incorporated thatdecrease into the share price. Only if the information of experts had differed fromMicrosoft’s announcement would the price change. For example, if analysts studyingMicrosoft had forecast a decrease in earnings of 15%, that pessimistic expectationwould have been incorporated previously into the price of Microsoft stock. Hence anearnings decrease of only 5% represents good news, and the share price may rise.Although the link between announcements and price movements may seem complex,the efficient markets hypothesis provides some simple guidance. Only the unexpectedcomponent of announcements (the true news) will affect the price.

Actual Efficiency in Financial MarketsMany economists believe that highly liquid markets in which information costs are low(such as those for U.S. Treasury securities, foreign-exchange contracts, financial futuresand options, some low-risk corporate bonds, mortgages, and commercial paper) are


Charting the Civil Warwith the Gold MarketThe efficient markets hypothesisexplains how well financial marketscommunicate available information inprices of financial assets. In a sense,asset prices represent opinions ofmarket participants about futureasset returns, based on the informa-tion available to them. Kristen Willardof Columbia University, Timothy Guin-nane of Yale University, and HarveyRosen of Princeton University usedthis insight to ask how the market for“greenbacks” in the early 1860sreflected turning points in the Ameri-can Civil War.✝

To cover wartime expenses, the Unionissued greenbacks, a legal tender cur-rency that was not immediately con-vertible into gold. Because greenbackscould be exchanged for gold in thefuture (after the war’s conclusion), mar-kets watched war events to judge thecost of the war for the Union and thelikelihood that the Union would prevailover the Confederacy. Events thatincreased costs to the Union decreasedthe chance that greenbacks would befully redeemed with gold and thereforereduced the gold price of greenbacks.

Willard, Guinnane, and Rosen foundthat the gold market concurred withthe later judgment by historians that

the Battle of Gettysburg was a majorturning point in the Civil War. They alsofound that some other events that arenot emphasized by historians—such asConfederate General Early’s retreatfrom Washington in 1864—wereviewed as major events by goldtraders. Using the logic of the efficientmarkets hypothesis, the authors stressthat the “opinion poll” that is implicit inprices in financial markets can help usto understand how contemporariesviewed major historical events.✝ Kristen L. Willard, Timothy W. Guinnane, andHarvey S. Rosen, “Turning Points in the Civil War:Views from the Greenback Market,” American Eco-nomic Review, 86, September 1996.

O T H E R T I M E S , O T H E R P L A C E S . . .

Your sister-in-law has told you that her specialized stock market fund has outper-formed the total market for the last three years by constantly churning funds fromone investment to another. Should you invest all your savings in her fund? No.The efficient markets hypothesis predicts that unless your sister-in-law has betterinformation than other market participants have, you should invest in a broad marketportfolio instead. ♦

C H E C K P O I N T

relatively efficient. Prices and returns determined in these markets appear to reflectavailable information about fundamental values. Early empirical work by EugeneFama of the University of Chicago and others corroborated the prediction of the effi-cient markets hypothesis that changes in stock prices are not predictable.✝

Other analysts—especially active traders and individuals giving investmentadvice—are more skeptical about whether the stock market is efficient. They point tothree differences between the theoretical behavior of financial markets and the actualbehavior that cause them to question the validity of the efficient markets hypothesis:

1. They cite pricing anomalies in the market that allow investors to earn consis-tently above-average profits. According to the efficient markets hypothesis,those profit opportunities should not exist—or at least should not exist veryoften or for very long.

2. They cite price changes that are predictable by using available information.According to the efficient markets hypothesis, investors should not be able topredict future price changes from past performance.

3. They cite price changes that appear larger than changes in fundamental value.According to the efficient markets hypothesis, prices should reflect the security’sfundamental value.

Pricing Anomalies

The efficient markets hypothesis predicts that an investor will not be able to earnabove-normal profits consistently from buying and selling individual stocks or groupsof stocks. However, analysts have found strategies by which stock trading can result inabove-normal returns. From the perspective of the efficient markets hypothesis, thesetrading opportunities are anomalies. Two such anomalies are the small-firm effect andthe January effect.

Small-firm effect. Evidence from data collected since the mid-1920s indicatesthat savers could have earned above-normal profits by investing in the stocks of smallfirms—even after the greater risk associated with returns from those firms is taken intoaccount. Although the small-firm effect was less pronounced during the 1980s, its longexistence is inconsistent with the efficient markets hypothesis. However, some econo-mists believe that the relatively low liquidity of markets for stocks of small firms andthe relatively large information costs incurred by investors in evaluating those firmscould explain why returns appear to be high.

January effect. For a long period of time, rates of return on stocks were abnormallyhigh each January. Market participants often argue that the January effect results frominvestors seeking to minimize their tax liabilities: Investors sell stocks on which they


Web Site Suggestions:http://quote.yahoo.com/m1?uTrack movements instock and bond mar-kets in response tonews.

✝ Three types of tests have been conducted for stock price data. The first uses only past stock price data as“available information” (test of weak-form efficiency). The second expands the information set to include allpublicly available information (test of semistrong-form efficiency). The third type incorporates “insider infor-mation” known only to corporate managers in the information set (test of strong-form efficiency). Rejectionsof strong-form efficiency do not invalidate the intuition of the efficient markets hypothesis because the infor-mation is not available to traders and investors in financial markets. For a review of the early empirical work,see Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal ofFinance, 25:383–416, 1970.

web_links215.html

have lost money at the end of the year to deduct the losses against capital gains real-ized on other assets during the year. In January of the new year, buying pressuresemerge as investors rebalance their portfolios. Although this explanation seems logical,it is not consistent with the efficient markets hypothesis because institutional investors(such as private pension funds) are the largest market participants. These investors donot pay capital gains taxes and so should buy stock rather than sell stock in Decemberif prices are abnormally low. In the 1980s and 1990s, economists found that the Janu-ary effect diminished in importance except for shares of small firms.

Mean Reversion

Another prediction of the efficient markets hypothesis is that investors cannot relatechanges in asset prices, and thus returns, to currently available information—only newscan change prices and returns. The efficient markets hypothesis therefore is inconsis-tent with what is known as mean reversion. It is the tendency for stocks with highreturns today to experience low returns in the future and for stocks with low returnstoday to experience high returns in the future. Some economists have found evidenceconsistent with mean reversion and against the efficient markets hypothesis. Othereconomists have noted that results supporting mean reversion are strongest for small-firm stocks and for data from the period before World War II.✝ These observations sug-gest that lower liquidity and higher information costs could be responsible for theapparent inefficiency. Hence, for most traders and investors, the notion that changes instock prices are not predictable appears to be reasonable.

Excessive Volatility

The efficient markets hypothesis tells us that the price of an asset equals the market’sbest estimate of its fundamental value. Fluctuations in the actual market price thereforeshould be no greater than the fluctuations in the fundamental value. Robert Shiller ofYale University used actual data on dividends over a long period of time to calculate thefundamental value of the S&P 500 stocks.✝✝ He found that the actual market price fluc-tuated much more than his estimate of fluctuations in fundamental value, a rejection ofthe efficient markets hypothesis. Although some economists have criticized some ofShiller’s tests, many believe that those tests do cast some doubt on the validity of the effi-cient markets hypothesis as it applies to the stock market.

Statistical evidence from studies of financial markets generally confirms that stockprices reflect available information. However, examination of pricing anomalies, meanreversion, and excessive fluctuations in stock prices has generated controversy overwhether the observed price fluctuations reflect only changes in fundamental value.Much of this debate centers on explanations for the tremendous volatility of stockprices in the late 1980s, particularly that surrounding the stock market crash of Octo-ber 19, 1987.


✝ A good summary of the evidence for and against mean reversion in stock prices can be found in CharlesEngel and Charles S. Morris, “Challenges to Stock Market Efficiency: Evidence from Mean Reversion Stud-ies,” Federal Reserve Bank of Kansas City Economic Review (September–October):21–35, 1991.✝✝ Robert J. Shiller, “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?,”American Economic Review, 71:463–486, 1981.

Market Efficiency and the Crash of 1987

On Monday, October 19, 1987, the stock market crashed. The Dow Jones IndustrialAverage, the most often quoted stock index, fell by 508 points, losing nearly 23% ofits value in a single day! Trading volume was a record 600 million shares. The declinein the market value of equities was significantly greater than occurred in the famouscrash of October 28, 1929, when the Dow Jones Industrial Average fell by about 13%.

The 1980s had been a period of significant stock price increases—an unprecedent-edly strong bull market. Soaring above 2500 in October 1987, the Dow Jones Indus-trial Average had been at 1500 as recently as 1985 and at only 1000 in 1982. Althoughstock prices had declined the week before the crash, the downturn on “Black Monday”was breathtaking.

This highly visible episode caused many economists and financial analysts to ques-tion the efficient markets hypothesis. There was no clearly identifiable bad news thatday or during the previous weekend to suggest such a dramatic downward revaluationof the long-run profitability of U.S. business. Attempts to isolate particular bits of badnews—including congressional legislation that was thought to be harmful to equitymarkets and statements by policymakers in the United States and abroad—were unsuc-cessful. Economists then began trying to explain the crash on the basis of newapproaches to asset pricing that did not rely on the efficient markets hypothesis.

Noise traders and fads. One explanation for the 1987 crash points to relativelyuninformed traders called noise traders, who pursue trading strategies with no superiorinformation. Noise traders often pursue fads—that is, overreaction to good or bad newsabout an issue or a class of assets (say, stocks or bonds in general). For example, noisetraders may aggressively sell shares of stock or bonds of a company whose outlook isdescribed unfavorably in a leading business publication. Of course, the efficient marketshypothesis holds that information that is available to market participants will have beenreflected in the price long before the noise trader even removes the business publicationfrom the mailbox! Nonetheless, the selling pressure from noise traders can force the shareprice down by more than the decrease suggested by the change in fundamental value.

Can’t better-informed traders simply profit at the expense of noise traders? Notalways. Albert Kyle of Duke University has shown that the presence of a significantfringe of noise traders creates additional risk in the market. An investor who believes inthe efficient markets hypothesis has no assurance that a price will return to fundamen-tal value after noise traders overreact.

Bubbles. Another explanation for the 1987 crash focuses on speculative episodesin the mid-1980s. When the price of an asset is more than its fundamental value, theprice is said to contain a bubble. In those years of frantic stock market activity, someinvestors bought assets not to hold them but to resell them quickly at a profit, eventhough they knew that prices were greater than fundamental values.✝

With a bubble, the “greater fool” theory comes into play: An investor is not a foolto buy the asset as long as there is a greater fool to buy it later for a still higher price.In other words, some investors might buy at inflated prices if they believe that they cansell to someone else for substantially more money. For example, suppose that you


✝ For an interesting discussion of financial bubbles in history and the present time, see Robert Shiller, Irra-tional Exuberance, Princeton, NJ: Princeton University Press, 2000.


C A S E S T U D Y

What Goes Up . . .Plunging stock prices in Japan in the 1990s caused many market analysts and economists to believe

that a bubble in Japanese equities was bursting. As of May 2003, the Japanese Nikkei stock index hadfallen by 79% from its all-time high at the end of 1989. If the collapse in Japanese stock prices wasindeed a bubble bursting, historical episodes of bubbles suggest that the decline was about right.

Bubbles are nothing new, as the accompanying table shows. The “tulipmania” in Holland in the sev-enteenth century is considered the original bubble, followed by a bubble in the price of shares in a firmdeveloping French holdings in what is now the United States. Even Sir Isaac Newton discovered gravityin the bubble when he invested in the shares of South Sea Company in the early eighteenth century. Inthe twentieth century, U.S. markets experienced bubbles in stocks in the Roaring Twenties and in silverin the early 1980s. Stock markets in Mexico, Hong Kong, and Taiwan all suffered through the burstingof bubbles in recent years. The fear that Japanese stock prices had a bubble led many investors to selltheir Japanese shares at a loss in the 1990s. The boom in the late 1990s, then bust, in NASDAQ-tradedtechnology stocks shared elements of a bubble. NASDAQ shares plummeted 70 percent from their 2000peak before recovering somewhat.

Booms and Busts

Length of % Decline Length of% Rise up phase peak to down phase

bull phase (months) trough (months)

TulipsHolland (1634–37) +5900% 36 –93% 10

Mississippi sharesFrance (1719–21) +6200% 13 –99% 13

South Sea sharesGreat Britain (1719–20) +1000% 18 –84% 6

U.S. stocksUnited States (1921–32) +497% 95 –87% 33

Mexican stocksMexico (1978–81) +785% 30 –73% 18

SilverUnited States (1979–82) +710% 12 –88% 24

Hong Kong stocksHong Kong (1970–74) +1200% 28 –92% 20

Taiwan stocksTaiwan (1986–90) +1168% 40 –80% 12

Japanese stocksJapan (1965–?) +3720% 288 * *

* –67% from December 29, 1989, peak to the October 1998 trough (a trough hit again in December 2000).

Source: “When Bears Run Wild,” April 4, 1992, from The Economist Newspaper. Copyright © 1992 The Economist Newspaper Group, Inc. Reprinted by permis-sion. Further reproduction prohibited. www.economist.com

C A S E S T U D Y

strongly suspect that the shares of Biogenetics, Inc., selling for $10, will never pay adividend; that is, the stock has no fundamental value. However, knowing that theindustry is “hot,” you might still expect to find someone who will pay $12 per sharenext year. The stock will be a profitable investment for you as a buy-and-sell trader, aslong as the risk-adjusted interest rate is less than 20%.

As long as the bubble grows at a slower pace than the economy as a whole,informed investors can profit by buying and selling the asset at prices greater than fun-damental value. However, if the bubble grows at a faster rate than the economy as awhole, it will eventually absorb all the wealth in the market. Hence, at some point, thebubble must burst. Some observers believe that the prices in the Japanese stock marketin the late 1980s, certain U.S. urban real estate markets in the late 1980s, and in high-technology stocks in the United States in 1999 and early 2000 all contained bubbles.

Trading mechanisms. Rather than disputing the efficient markets hypothesis,some economists instead have examined the role of trading mechanisms in fueling thedownturn during the 1987 crash. Commissioned by President Reagan, this researchwas performed by a group chaired by Nicholas Brady, later Secretary of the Treasury.The Brady Task Force identified several weak links in the trading mechanism as expla-nations for the crash, rather than irrationality of market participants or fundamentalimbalances in the economy as a whole.

First, the Task Force identified the way in which trades are executed on the NewYork Stock Exchange (NYSE) as one of the weak links. The large volume of sell ordersearly on October 19, 1987, overwhelmed the market makers known as specialists. Spe-cialists have inventories of stock and will buy and sell the stock of companies in whichthey specialize to match buy and sell orders in individual stocks. On October 19, spe-cialists’ losses mounted, eroding their equity capital during the day, and their financialstability began to be questioned. If specialists lack the necessary capital to make the mar-ket in their stocks, they are unable to function, the liquidity of stocks is reduced, and theability of market prices to communicate information is curtailed. In response to theCommission’s findings, the NYSE increased the minimum equity capital required of spe-cialists and the minimum level of inventory of shares they would be required to main-tain. Even with these changes, the specialists may not be able to cope much better todayduring such events.

Second, the Task Force suggested ways to avoid failure of the market trading mech-anism. It recommended circuit breakers, or interventions designed to restore orderlymarkets. When prices or order volumes reach certain levels, trading will be halted. Staffeconomists argued that halts based on large price movements might unnecessarily blockthe flow of information contained in market prices to participants. They did, however,endorse trading halts based on large imbalances between buy and sell orders. One pro-posal suggested that during a trading halt, specialists would open their order books totake nonbinding orders and announce what they believe to be the market-clearing price.After a few rounds of such open-order periods, the market could be reopened. Theincentive to participate could be provided by executing first the orders of those traderswho participated in the open-order period.

Following the publication of the Task Force report, the Working Group on Finan-cial Markets (composed of officials from the Treasury Department, the FederalReserve, the Commodity Futures Trading Commission, and the Securities andExchange Commission) recommended trading halts after major declines in stock mar-ket indexes. The Working Group composed a report recommending open-order periods


during a trading halt. These recommendations were adopted, and the circuit breakersare still in place (though the circuit breakers were made less restrictive in April 1998by switching to a system in which percentage decline triggered trading halts).

The effectiveness of these proposals was tested almost exactly two years after the1987 crash, when the Dow Jones Industrial Average dropped 190 points on October13, 1989. Trading was not halted on the New York Stock Exchange, but price-basedcircuit breakers were in place in futures and options markets. Problems in the tradingmechanism between the markets caused concern, suggesting that, to be most effective,the use of circuit breakers should be coordinated among the markets. Since 1988, thecircuit breaker system has been triggered only once, on October 27, 1997, at the heightof the Asian financial crisis. Analysts and policymakers braced for the worst when theNew York Stock Exchange reopened on September 17, 2001, after the September 11tragedy, but the day was orderly.

A third factor identified by some observers as a reason for the 1987 crash iscomputer-based, or program, trading. In computer-generated orders to buy or sellmany stocks at the same time cause rapid adjustments of institutional portfolios. Thelarge volume of sell orders generated by program trading during the crash met withNYSE disapproval. However, no solid evidence links program trading to stock pricevolatility. In 2003, program trading accounted for a much larger share of daily tradingvolume than a decade ago.

Value Investing versus Efficient Markets

Despite the efficient markets hypothesis’ intuitive appeal, some very successful largeinvestors (such as Warren Buffett) have earned enormous returns from valueinvesting—buying stocks with low prices relative to earnings, dividends, historicalprices, or other measures of value. Originally the subject of research by Columbia Uni-versity professors Benjamin Graham and David Dodd in the 1930s, the strategies werestudied with renewed vigor by economists in the 1980s and 1990s. In both the UnitedStates and Japan, it appears that stocks with low market values of equity relative to his-torical prices outperform the market.

Josef Lakonishok of the University of Illinois, Andrei Shleifer of Harvard Univer-sity, and Robert Vishny of the University of Chicago considered the success of variousinvestment strategies over the period from 1968 to 1990.✝ They found that value stocksoutperformed glamour stocks (those with high past growth) over this period by morethan 10% per year. The authors emphasized that many investors likely have shortertime horizons than those required to obtain a payoff from value investing. They arguedthat whether such returns were likely to continue depends on the extent to which insti-tutional investors, such as mutual fund or pension fund managers, rely more in thefuture on quantitative investment strategies that are designed to identify value stocks.

The results of Lakonishok, Shleifer, and Vishny raise a question about whether thehigh returns from value investing represent greater risk being assumed by investors.This is an important ongoing topic of research on the extent to which the stock mar-ket is efficient.


✝ Josef Lakonishok, Andrei Shleifer, and Robert W. Vishny, “Contrarian Investment, Extrapolation, and Risk,”Journal of Finance, 49:1541–1578, 1994.

Costs of Inefficiency in Financial MarketsThe arguments for and against the efficient markets hypothesis are not merely academicdisagreements. Market efficiency provides an information service to the financial sys-tem, and a lack of efficiency is a cost to the economy and society. In this section, wedetail what those costs are and demonstrate how the economy benefits when thosecosts can be reduced. We focus on two potential costs to the economy from financialmarket inefficiency: (1) those arising from excessive fluctuations in asset prices and (2)those arising from inefficiency caused by high information costs.

Costs of Excessive Price Fluctuations

When changes in prices of financial assets, such as stocks and bonds, do not reflect shiftsin fundamental value, market prices contain less information. As a result, financial mar-kets fail to send the appropriate signals for lending, borrowing, and portfolio allocationdecisions. In addition, if prices are more volatile than fundamental values, stock andbond markets are not effectively providing risk-sharing services. At the same time thatfinancial assets become less useful for risk sharing, trading volume may decline, makingfinancial assets less liquid. Although these costs exist, there is no reliable way to meas-ure them.

More recently, financial analysts and policymakers have worried that excessivefluctuations in the stock market could cause excessively volatile economic activity.They focus on the links between the financial system and the economy through lend-ing and borrowing. For example, would household consumption and business invest-ment increase and decrease as stock prices fluctuate, even if those price movementswere the result of a fad or bubble? Evidence from the U.S. economy after the stock mar-ket crash of 1987 suggests that household consumption and business investment didn’tdecline immediately, although segments of the securities industry were hit hard withsharply reduced profits and layoffs. Rather, research indicates that consumers and busi-nesses pay more attention to long-run movements than to short-term shifts in assetprices.

Despite the lack of evidence linking volatility in the stock market with fluctuationsin economic activity, some policymakers have proposed regulatory interventions. Inaddition to the circuit breakers suggested by the Brady Task Force, legislators have pro-posed transaction taxes and changes in margin requirements.

If conducting transactions costs very little, bubbles might stimulate too much trad-ing, contributing to excessive volatility. One proposal for preventing this situation is tocharge a transaction tax for each market transaction. This tax would effectively raisethe cost of trading and decrease trading activity. The tax has appeal, but it also createstwo problems. First, decreasing trading volume can reduce liquidity in the stock mar-ket. Second, if the tax raises trading costs in the United States, stock trading activitiesalong with revenue and jobs in the securities industry might move overseas. Thesedrawbacks have caused Germany, the United Kingdom, the Netherlands, and Swedento reduce or eliminate transaction taxes.

In the United States, the Federal Reserve Board sets a margin requirement, which isthe minimum proportion of the purchase price of shares that an investor must supplyfrom nonborrowed funds. An investor can borrow from a broker only the amount of thepurchase price above the margin requirement. Some analysts claim that buying shares oncredit encourages speculation and generates greater swings in gains and losses. One


proposed reform is to raise margin requirements to discourage speculation. There is noclear evidence, however, that stock price volatility declines when margin requirements areincreased, or vice versa. Moreover, as with transaction taxes, an additional cost of rais-ing margin requirements to reduce trading is that it might reduce liquidity.

To summarize, while excessive price fluctuations can be costly, arguments for gov-ernment intervention to reduce stock price volatility outside of periods of market crisisare weak.

Information Costs

When financial markets are inefficient, savers and borrowers face higher informationcosts—and the economy suffers because scarce resources (investment dollars) aren’tallocated efficiently. Some of these costs are offset by other participants in the financialsystem. If information is not readily available to participants, market prices may notrepresent fundamental value—even if the prices reflect all publicly available informa-tion. To obtain the missing information, savers and borrowers must incur research andmonitoring costs. Such expenses are unnecessary for individual savers and borrowerswhen market prices represent the best estimate of fundamental value.

In practice, businesses raise most of their funds from current and accumulatedprofits, not from financial markets. Savers and borrowers reduce actual informationcosts by channeling funds through intermediaries (particularly banks, but also mutualfunds, pension funds, and insurance companies) instead of through markets. In fact, thelargest participants in markets for bonds, stocks, and other financial instruments in theUnited States and other industrialized countries are not individual savers and borrow-ers, but financial intermediaries (Chapter 3). As we will see in Part 4, intermediariesboth reduce information costs for many savers and borrowers and contribute to liq-uidity and efficiency of financial markets. As a result, policymakers in many countriesare often more concerned about the stability of financial intermediaries than aboutvolatility in financial markets.

SUMMARY

1. Market prices for financial instruments containimportant information for lending, borrowing, andportfolio allocation decisions. When traders andinvestors have rational expectations, they use allavailable information in forming their expectations offuture returns. In this case, the equilibrium price of afinancial instrument is equal to the optimal forecastof fundamental value.

2. Under the efficient markets hypothesis, changes in theprice of a financial instrument reflect news aboutchanges in fundamental value and are not fore-

castable. Security prices fluctuate in an efficient mar-ket as fundamental value increases or decreases.

3. Although statistical evidence suggests that prices ofliquid assets traded in financial markets reflect avail-able information about fundamental value, stockprices appear to be more volatile than the efficientmarkets hypothesis suggests. For example, no appar-ent “fundamental” factor can explain the precipitousdrop in stock prices during the stock market crash ofOctober 19, 1987.


KEY TERMS AND CONCEPTS

Bubble

Circuit breakers

Efficient markets hypothesis

Fads

Fundamental value

Noise traders

Program trading

Rational expectations

gloss222.html


SUMMARY

4. Potential costs to the economy from inefficient finan-cial markets arise from excessive fluctuations of assetprices relative to fundamental values and from highinformation costs. Most economists believe that

information costs resulting from the lack of substan-tial amounts of information are especially severe.These costs help to explain the relative unimportanceof financial markets in raising funds for businesses.

REVIEW QUESTIONS

1. Define rational expectations. In a market in whichinvestors and traders have rational expectations,what should the price of an asset equal?

2. Is there a connection between market liquidity andmarket efficiency? Why or why not?

3. Give a concise definition of the efficient marketshypothesis. What assumptions does it require aboutliquidity and information?

4. If you believe that the stock market is an efficientmarket, why would an investment strategy of “buyand hold” be a good idea?

5. Suppose that the price of a stock rises only becausepeople believe that it will rise, not because the corpo-ration is likely to earn higher profits. What is this sit-uation called? What is likely to happen to the pricesometime in the future? Has it ever happened to anentire market?

6. Suppose that you believe that General Motors’ earn-ings will rise by 20% this year, compared to only10% last year. Should you buy GM stock?

7. If you are an informed trader, would you be happy tosee numerous noise traders in the market?

8. State whether each of the following statements is trueor false and, using the efficient markets hypothesis,briefly explain why.

a. Stock prices do not change.

b. Stock prices go up with published good news anddown with published bad news.

c. Stock prices reflect true underlying (fundamental)value.

9. Why are fads inconsistent with the predictions of theefficient markets hypothesis?

10. What is program trading? Does it play a significantrole in increasing market volatility?

11. “They make money the old-fashioned way. Theychurn it.” Why might someone who believes in mar-ket efficiency make this statement?

12. Jeremy Siegel and Richard Thaler argue that if theequity premium just reflects the increased risk of equi-ties, then equities should be attractive to investors whoare less risk averse than the marginal investor. If theequity premium is too large to be justified by theincreased risk of equities, then it may reflect, in part,investors’ “mistakes and fears.” Siegel and Thaler statethat: “[M]ost economists we know have a high propor-tion of their retirement wealth invested in equities. . . .”If true, what would be the implications of this fact foreconomists’ views of the workings of the stock market?

13. Suppose that in looking at data on stock marketreturns, you find that returns are higher than averagein January but below average during the rest of theyear. Is this consistent with market efficiency? Why or

why not? What could an investor do to take advan-tage of this situation?

14. Suppose you find that, after accounting for differences inrisk, liquidity, and information costs, some stocks areoverpriced (Pt � 1 � 1.1Pe

t � 1 � Errort � 1) and others areunderpriced (Pt� 1 � 0.9Pe

t� 1 � Errort � 1). Are the mar-kets efficient? What should you do to make expectedprofits?

15. According to the efficient markets hypothesis, wouldyou be better off paying someone 5% of your savingsto pick stocks for you or picking your own stocks bythrowing darts at the stock pages of the newspaper?Why?

16. Suppose that you are shopping and find a wonderfulnew product that you think will be a big seller. Itshould increase tremendously the profits of the com-pany that sells it. Should you buy shares in that com-pany? Why or why not?

ANALYTICAL PROBLEMS

QUIZ

QUIZ

ap_quiz223.html

rq_quiz223.html


. . . With so much stockmarket gloom around, itmay seem odd that eco-nomics is still struggling toexplain why equities haveproduced such high invest-ment returns. But the fig-ures are clear: over longperiods of 40 years ormore, equities have signifi-cantly outperformed otherinvestments.

Estimates vary butwhatever long time period,measuring technique orcountry you choose, thetotal return on equities farexceeds that of a risklessasset, such as a governmentbond. Perhaps the mostcareful analysis, by ElroyDimson, Paul Marsh andMike Staunton,* calculatesthat this equity risk pre-mium was 4.9 percentagepoints globally.

The power of com-pound interest over verylong periods implies thateven though equity marketshave roughly halved overthe past three years, calcu-lated equity risk premiumsremain high. The U.S. pre-mium since 1900, for exam-ple, would still be wellabove 4 percentage points.

What has surprisedeconomists since the mid-

1980s is not that equitieshave higher returns—theyare riskier assets than bonds

so investors requirehigher returns—but that

the size of the equity riskpremium cannot be justifiedby the additional risk.

One of the authors ofthe original 1980s work,Rajnish Mehra of the Uni-versity of California, hasrecently published a paperexamining whether eco-nomic theory has been ablesatisfactorily to explain the“equity premium puzzle” inthe 20 years since it becamewidely discussed.**

Since equities andbonds perform similarly invarious economic scenarios,

he calculates that equitiesshould command only a 1

percentage point annualpremium over risklessassets.

His answer is that noneof the theoretical explana-tions adequately explainsthe discrepancy. Some aca-demics have constructedmodels that mirror the databut their assumptions abouthuman behaviour, especiallyregarding risk aversion andprudence, “become improb-ably large.” A potentialupward bias in the equity

return data because the USmarket has survived thepast century also failsbecause government bondsare as vulnerable to finan-cial implosion owing to waror revolution. . . .

The good news forequity investors is that if the“normal” level of the equitypremium is lower, currentmarket values can be betterjustified by dividend levelsand their likely growth. Butthe bad news is that equitiesare unlikely to perform aswell in the current centuryas in the last.

If Prof. Mehra is rightand the historic 5 percent-age point equity premium ishere to stay over the verylong term, the prospects for equity investors seembrighter. But the crucialphrase is “over the verylong term.” Right now, aprospective higher risk pre-mium suggests U.S. equitiesremain overvalued becauseonly with lower stock pricescould equities start to yieldthe required 5 percentagepoint premium over gov-ernment bonds.

* Triumph of the Optimists, Princeton University Press.

** The Equity Premium: Why Is It a Puzzle?www.nber.org/papers/w9512.

FINANCIAL TIMES MARCH 19, 2003

Are Stocks a Good Deal?

a

b

c

M O V I N G F R O M T H E O R Y T O P R A C T I C E . . .M O V I N G F R O M T H E O R Y T O P R A C T I C E . . .


The efficient markets hypothesis saysthat the prices of financial assets suchas stocks reflect available informationabout expected returns. That informa-tion can provide valuable guidance tosavers and borrowers. Although mostanalysts would not dispute the notionthat available information works itsway into asset prices, many commen-tators have expressed concern thatU.S. stocks were overvalued in 1999and 2000 before equity prices fellsharply. That is, at the end of the1990s and continuing into the newcentury, a vigorous debate took placeabout whether current market pricesof equities exceeded underlying funda-mental value. Our description of valua-tion in an efficient market can be usedto shed light on this debate.

We can go back to the simplevaluation model presented on

page 210, in which the fundamentalvalue of a stock depends on its divi-dend, the growth rate of dividends andearnings, and the appropriate discountrate. Low interest rates (discountrates) and continued profitability (divi-dends and earnings growth) wouldclearly be good news for stock values.

If stocks are riskier than bonds, theywill have a higher discount rate. To theextent that the gap between stock andbond returns exceeds the premium forrisk, stocks offer positive risk-adjustedreturns over the long haul.

From the valuation expressionwe derived on page 210, the

return on stocks can be thought of asthe sum of the dividend–price ratio(dividend yield) and the expectedgrowth rate of dividends. The authorsnote that this return on stocks has his-torically been much greater than thereturn on Treasury bonds. One sourceof difference is the risk of stocks rela-tive to the risk of Treasury bonds.

If no “equity risk premium” existed forstock returns, stock prices should riseuntil the dividend–price ratio plus thegrowth rate of earnings equals theexpected rate of return on bonds. Sucha price increase would be significant.

Should you rush headlong intostocks? Not necessarily. To the

extent that changes in the relative risk-iness of stock and bond returns arealready captured in market prices,stock returns may be lower going for-

ward. In addition, analysts’ bullishnessabout future earnings may be overlyoptimistic. More generally, an analysisof the vanishing equity premium(appealing to, perhaps, changinginvestor attitudes, investor composi-tion, or transactions costs) is in order.A difficult task remains: in an efficientmarket, one needs an explanation ofwhy the equity risk premium took solong to shrink. One possibility is that agradual decline in transactions costsfor equities reduced the risk premium.

For further thought . . .

How might reductions in transactionscosts for equities relative to bondsaffect the equity risk premium? Whatdoes your answer imply about the linkbetween market liquidity and marketefficiency?

Source: Excerpted from Chris Giles, “A Puzzle at the Heart of Equi-ties,” Financial Times, March 19, 2003. Copyright © 2003 FinancialTimes. Reprinted with permission.

a

b

c

A N A L Y Z I N G T H E N E W S . . .A N A L Y Z I N G T H E N E W S . . .


17. Suppose that Bigbucks Company pays a dividend thisyear of $7 per share. You expect the dividend to growby 2% per year, so you discount Bigbucks’s dividendsat 4%. What is the most you would be willing to payfor a share of stock in Bigbucks? Suppose instead thatyou discount Bigbucks’s dividends at 3%. Now howmuch would you be willing to pay per share? If Big-bucks’s dividends grow only 1% per year instead of2% (using 4% as the discount rate again), how muchwould you be willing to pay per share?

18. What do you think caused the stock market crash ofOctober 19, 1987? Why? What do you think iswrong, if anything, with the other explanations pre-sented in the text?

19. Suppose that people generally overreact to news.That is, when good news arrives, the prices of a com-pany’s stocks and bonds increase too much, and afterbad news arrives, the prices decline too much. Howcan you profit from this knowledge?

DATA QUESTIONS

20. Find the most recent Economic Report of the Presi-dent in your library. Table B-91 in the back of thereport lists common stock prices and yields. The next-to-last column of the table reports the “dividend–priceratio,” which is defined as the average ratio of divi-dends to price for the S&P 500 stocks. An increase inthe dividend–price ratio over time implies that divi-dends are growing more rapidly than market prices.A decrease in the dividend–price ratio over timeimplies that dividends are growing more slowly thanmarket prices. What happened to the dividend–priceratio over the decade of the 1990s? If you believe thatthe stock market is efficient, how would you explainthis pattern?

21. The New York Stock Exchange’s “Market Informa-tion” section of its Web site (http://www.nyse.com) isan excellent place to study price movements. Go tothis section and look at the one-year price movementsof the NYSE Composite Index. Based on the general

movement of this index during this period of time,what would you expect the index to be one year fromnow? Estimate the percentage increase or decrease invalue, and then calculate the present value of theindex today. According to the efficient marketshypothesis, will traders buy or sell shares that com-prise the index?

22. The efficient markets hypothesis predicts that allinformation available today about a firm will alreadybe incorporated into a stock price. Yahoo! Finance’sMarket Update page (http://finance.yahoo.com/mo)is an excellent resource for checking recent corporateearnings reports. Go to this site and look at the firmslisted under earnings. Does the earnings report corre-late with movements of each firm’s stock price overthe past 5 days? Over the past three months? Wouldthe efficient markets hypothesis suggest a change in the stock prices in the future based on the earningsreports listed? Explain.

web_links226.html

CHAPTER 10 Information and Financial Market...

Documents

Transcript of CHAPTER 10 Information and Financial Market...