8. stocks, stock markets, and market efficiency common stock stock market indexes stock valuation...
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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