The Theory of Capital Markets Rational Expectations and Efficient Markets

Adaptive Expectations Expectations depend on past experience only. Expectations are a weighted average of past experiences. Expectations change slowly over time.

Rational Expectations The theory of rational expectations states that expectations will not differ from optimal forecasts using all available information. It is reasonable to assume that people act rationally because it is is costly not to have the best forecast of the future.

Rational Expectations Rational expectations mean that expectations will be identical to optimal forecasts (the best guess of the future) using all available information, but….. It should be noted that even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate.

“Non-rational” Expectations? There are two reasons why an expectation may fail to be rational: People might be aware of all available information but find it takes too much effort to make their expectation the best guess possible. People might be unaware of some available relevant information, so their best guess of the future will not be accurate.

Rational Expectations: Implications If there is a change in the way a variable moves, there will be a change in the way expectations of this variable are formed. The forecast errors of expectations will on average be zero and cannot be predicted ahead of time. The forecast errors of expectations are unpredictable.

Summary Statistics (1926 - 2000) Compound Annual Return 11.2% 12.4% 5.3% 3.8% 3.1% Arithmetic Annual Return Risk (Standard Deviation) Distribution of Annual Returns Large Company Stocks 13.2% 20.3% Small Company Stocks 17.4% 33.8% Gov’t Bonds 5.7% 9.2% Cash 3.8% 3.2% Inflation 3.2% 4.5%

Tulipmania Holland, 1630s. Peter Garber, Famous First Bubbles Mosaic virus, random-walk look Free press began in Holland then.

Dot Com Bubble Toys.com: Had disadvantage relative to bricks & mortar retailers starting web sites Lastminute.com: travel agency, sales in fourth quarter of 1999 were $650,000, market value in IPO ins March 2000 was $1 billion.

Efficient Markets Efficient markets theory is the application of rational expectations to the pricing of securities in financial markets. Current security prices will fully reflect all available information because in an efficient market all unexploited profit opportunities are eliminated. The elimination of all unexploited profit opportunities does not require that all market participants be well informed or have rational expectations.

Definition of Efficient Markets (cont.) Professor Eugene Fama, who coined the phrase “efficient markets”, defined market efficiency as follows: "In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value." Fama, Eugene, "Random Walks in Stock Market Prices,” Financial Analysts Journal , 1965.

The Efficient Markets Hypothesis The Efficient Markets Hypothesis (EMH) is made up of three progressively stronger forms: Weak Form Semi-strong Form Strong Form

The EMH Graphically All historical prices and returns In this diagram, the circles represent the amount of information that each form of the EMH includes. Note that the weak form covers the least amount of information, and the strong form covers all information. Also note that each successive form includes the previous ones. All public information All information, public and private

Efficient Markets Theory: Example Assume you own a stock that has an equilibrium return of 10%. Also assume that the price of this stock has fallen such that the return currently is 50%. Demand for this stock would rise, pushing its price up, and yield down.

Efficient Markets Theory Weak Version All information contained in past price movements is fully reflected in current market prices. In this case, information about recent trends in stock prices would be of no use in selecting stocks. “Tape watchers” and “chartists” are wasting their time.

Efficient Markets Theory Semi- Strong Version Current market prices reflect all publicly available information. In this case, it does no good to pore over annual reports or other published data because market prices will have adjusted to any good or bad news contained in those reports as soon as they came out. Insiders, however, can make abnormal returns on their own companies’ stocks.

Efficient Markets Theory Strong Version Current market prices reflect all pertinent information, whether publicly available or privately held. In an efficient capital market, a security’s price reflects all available information about the intrinsic value of the security. Security prices can be used by managers of both financial and non-financial firms to assess their cost of capital accurately.

Efficient Markets: Strong Version Security prices can be used to help make correct decisions about whether a specific investment is worth making. In this case, even insiders would find it impossible to earn abnormal returns in the market. Scandals involving insiders who profited handsomely from insider trading helped to disprove this version of the efficient markets hypothesis.

The Crash of 1987 The stock market crash of 1987 convinced many financial economists that the stronger version of the efficient markets theory is not correct. It appears that factors other than market fundamentals may have had an effect on stock prices. This means that asset prices did not reflect their true fundamental values.

The Crash of 1987 But, the crash has not convinced these financial economists that rational expectations was incorrect. Rational Bubbles A bubble exists when the price of an asset differs from its fundamental market value. In a rational bubble, investors can have rational expectations that a bubble is occurring, but continue to hold the asset anyway. They think they can get a higher price in the future.

Efficient Markets: Evidence Pro: Performance of Investment Analysts and Mutual Funds Generally, investment advisors and mutual funds do not “beat the market” just as the efficient markets theory would predict. The theory of efficient markets argues that abnormally high returns are not possible.

Efficient Markets: Evidence Pro: Random Walk Future changes in stock prices should be unpredictable. Examination of stock market records to see if changes in stock prices are systematically related to past changes and hence could have been predicted indicates that there is no relationship. Studies to determine if other publicly available information could have been used to predict stock prices also indicate that stock prices are not predictable.

Efficient Markets: Evidence Pro: Technical Analysis The theory of efficient markets suggests that technical analysis cannot work if past stock prices cannot predict future stock prices. Technical analysts predict no better than other analysts. Technical rules applied to new data do not result in consistent profits.

Efficient Markets: Evidence Con: Small Firm Effect Many empirical studies show that small firms have earned abnormally high returns over long periods. January Effect Over a long period, stock prices have tended to experience an abnormal price rise from December to January that is predictable.

Efficient Markets: Evidence Con: Market Overreaction Recent research indicates that stock prices may overreact to news announcements and that the pricing errors are corrected only slowly. Excessive Volatility Stock prices appear to exhibit fluctuations that are greater than what is warranted by fluctuations in their fundamental values.

Efficient Markets: Evidence Con: Mean Reversion Stocks with low values today tend to have high values in the future. Stocks with high values today tend to have low values in the future. The implication is that stock prices are predictable and, therefore, not a random walk.

Efficient Markets Theory: Implications Hot tips cannot help an investor outperform the market. The information is already priced into the stock. Hot tip is helpful only if you are the first to get the information. Stock prices respond to announcements only when the information being announced is new and unexpected.

Behavioural Finance The lack of short selling (causing over-priced stocks) may be explained by loss aversion The large trading volume may be explained by investor overconfidence Stock market bubbles may be explained by overconfidence and social contagion

Conclusions: The theory of rational expectations states that expectations will not differ from optimal forecasts using all available information. Efficient markets theory is the application of rational expectations to the pricing of securities in financial markets.

Conclusions: The evidence on efficient markets theory is mixed, but the theory suggests that hot tips, investment advisers’ published recommendations, and technical analysis cannot help an investor outperform the market. The 1987 crash convinced many economists that the strong version of the efficient markets hypothesis was not correct.