Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ Stocks, Stock Markets, and Market Efficiency Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter Eight

8-2 Introduction By giving individuals a way to transfer risk, stocks supply a type of insurance enhancing our ability to take risk. Companies use stocks as a way to obtain financing. Stocks are a central link between the financial works and the real economy. Stocks tell us the real value of a company. Stocks allocate scarce resources.

8-3 Introduction During a week in 1929, the New York Stock Exchange lost more than 25 percent of its value. This marked the beginning of the Great Depression. In October 1927, prices fell nearly 30 percent in one week. In the 1990’s stock prices increased nearly fivefold, and we forgot about the black Octobers.

8-4 Introduction From January 2000 to the feel after the Sept. 11, 2001 terrorist attacks, the Dow Jones Industrial Average fell more than 30 percent. During the same period, the Nasdaq composite index fell 70 percent and has remained low ever since. This was dubbed the “Internet bubble”. The recent financial crisis lead to the stock market roughly halving in value by early from its 2007 value.

8-5 Introduction The subsequent rebound from the trough has been the sharpest since the Great Depression. However, despite all of this, stock prices tend to rise steadily and slowly, collapsing only on rare occasions when normal market mechanisms are out of alignment.

8-6 Introduction The goals of this chapter are: To try to make sense of the stock market. To show what fluctuations in stock value mean for individuals and for the economy as a whole. To look at a critical connection between the financial system and the real economy. Explain why we sometimes have bubbles and crashes.

8-7 The Essential Characteristics of Common Stock Stocks, also known as common stock or equity, are shares in a firm’s ownership. Stocks first appeared in the 16th century as a way to finance voyages of explorers. The idea was to spread the risk through joint-stock companies, organizations that issued stock and used the proceeds to finance several expeditions at once. In exchange for investing, stockholders received a share of the company’s profits.

8-8 The Essential Characteristics of Common Stock Shares were issued in small denominations, allowing investors to buy as little or as much as they wanted. Shares were transferable - an owner could sell them to someone else. Although one used to receive a stock certificate, most stockholders no longer do. Information is all computerized which is safer and makes it easier to transfer.

8-9 The Essential Characteristics of Common Stock The ownership of common stock conveys rights: A stockholder is entitled to participate in the profits of the enterprise. Stockholders are entitled to vote at the firm’s annual meeting.

8-10 The Essential Characteristics of Common Stock Although a stockholder is entitled to participate in the profits of the firm, they are merely a residual claimant. Stockholders are paid last, only after all other creditors have been paid. However, stockholders have limited liability in the firm. Even if a company fails completely, the maximum amount a shareholder can lose is their initial investment.

8-11 The Essential Characteristics of Common Stock The thriving market of stocks is possible because: An individual share is only a small faction of the company’s value. A large number of shares are outstanding. Prices of individual stocks are low. Stockholders are residual claimants. Stockholders have limited liability. Shareholders can replace managers who are doing a bad job.

8-12 When you buy a house You consume housing services. You should expect to get back the original purchase price. The average long-run real change in housing prices in the U.S. is 0.20%. Unlike other financial investments, you don’t get a place to live - that is your return on your investment.

8-13 Measuring the Level of the Stock Market We need to understand the dynamics of the stock market. What are the connections between stock values and economic conditions? We also need to be able to measure the level of fluctuation in all stock values. This concept is the value of the stock market. We will refer to its measures as stock-market indexes.

8-14 Measuring the Level of the Stock Market Stock indexes: Tell us how much the value of an average stock has changed, and Tell us how much total wealth has gone up or down. Provide benchmarks for performance of money managers. You can tell whether a money manager has done better or worse than “the market” as a whole.

8-15 The Dow Jones Industrial Average The DJIA Is the first and best known stock market index. Is based on the stock prices of 30 of the largest companies in the U.S. Measures the value of purchasing a single share of each of the stocks in the index. The percentage change in the DJIA over time is the percentage change in the sum of the 30 prices.

8-16 The Dow Jones Industrial Average The DJIA is a price-weighted average, which gives greater weight to shares with higher prices. The behavior of higher priced stocks dominates the movement of a price-weighted index.

8-17 The Standard and Poor’s 500 Index The S&P 500 is constructed from the prices of many more stocks than the DJIA. It is based on the value of 500 largest firms in the U.S. economy. It tracks the total value of owing the entirety of those firms. It uses a value-weighted index where larger firms carry more weight.

8-18 The Standard and Poor’s 500 Index If a firm is priced at $100 and has 10 million shares outstanding, its total market value or market capitalization, is worth $1 billion. A price weighted index gives more importance to stocks that have high prices. A value weighted index gives more importance to companies with a high market value. Price per se is irrelevant.

8-19 The Standard and Poor’s 500 Index The two types of index simply answer different questions. Changes in a price-weighted index tells us the change in the price of a typical stock. Changes in the value-weighted index accurately mirror changes in the economy's overall wealth.

8-20 The financial pages report on the major stock- market indexes. Some indexes cover a particular sector or industry, or a set of certain sized firms. When you encounter a new index, make sure you understand both how it is constructed and what it is designed to measure.

8-21 Other U.S. Stock Market Indexes The Nasdaq Composite Index and the Wilshire 5000 are the next largest indexes in the U.S. Nasdaq is a value-weighted index of over 5000 companies traded on the over-the-counter (OTC) market. Nasdaq is mainly composed of smaller, newer firms and has recently been dominated by technology and Internet companies. The Wilshire 5000 is the most broadly based index in use; it covers all publicly traded stocks in the U.S. Wilshire is value-weighted and is the best measure of overall market wealth.

8-22 World Stock Indexes About a third of all the countries in the world have a stock market and each has an index. Most are value-weighted indexes. Table 8.2 gives behavior of these in early The percentage change in these indexes is the most important as their stated number does not mean much without comparison. Investors view global stock markets as a means to diversify risk away from domestic markets. However, there is now increased correlation of global markets.

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8-24 Valuing Stocks People differ on how stocks should be valued. Some believe they can predict changes by looking at patterns or past movements - chartists. Some estimate the value of stocks based on their perceptions of investor psychology and behavior - behavioralists. Others estimate stock based on both its current assets and on estimates of future profitability - the fundamentals.

8-25 Valuing Stocks The fundamental value of a stock is based on the timing and uncertainty of the returns it brings. We can use the information we have already studied to compute the fundamental value of stocks. Chartists and behavioralists question the usefulness of fundamentals in understanding the level and movement of stock prices.

8-26 Fundamental Value and the Dividend- Discount Model A stock represents a promise to make monetary payments on future dates, under certain circumstances. The payments are usually in the form of dividends: Distributions made to the owners of a company when the company makes a profit. If a company is sold, the stockholders receive a final distribution that represents their share of the purchase price.

8-27 Valuing Stocks: Dividend-Discount Model The current price is the present value of next years price plus the dividend: Expanding over an investment horizon of n years:

8-28 Valuing Stocks: Dividend-Discount Model The price today is the present value of the sum of the dividends plus the present value of the price at the time the stock is sold n years from now. What if a company does not pay dividends? We estimate when the company will start paying dividends and use the present-value framework. We must know something more about annual dividend payments.

8-29 Valuing Stocks: Dividend-Discount Model Assume that dividends grow at a constant rate of g per year so: As long as growth remains constant, we can do this for n year from now:.

8-30 Valuing Stocks: Dividend-Discount Model We can rewrite the price equation as: But we don’t know the price in n years, so we assume firm pays dividends forever turning the stock into something like a consol. We can then covert the above into:.

8-31 Valuing Stocks: Dividend-Discount Model This relationship is the dividend-discount model. The model tells us that stock prices should be high when dividends are high (D today ), dividend growth is rapid (g is large), or the interest rate (i) is low. Although this model is simple, we have ignored risk in deriving it.

8-32 Why Stocks are Risky When you buy stocks, it is as if you put up your wealth to buy the firm and borrow the rest. Stockholders get part of the profits, but only after everyone else is paid, including bondholders. The borrowing creates leverage, and leverage creates risk. The more debt, the more leverage and the greater the owners’ risk.

8-33 Imagine a firm that only needs a $1000 computer. Once installed, the firm will have equal probability of earnings: $80 in bad times. $160 in good times. Financing can be part equity (stock) & part debt (bonds). Debt can be obtained at a 10% interest rate. Why Stocks are Risky

8-34 Return to Debt & Equity Holders for Different Financing Assumptions

8-35 Why Stocks are Risky Stocks are risky because shareholders are residual claimants. They never know for sure how much their return will be. In contrast, bond holders receive fixed nominal payments and are paid before stockholders in the event of bankruptcy.

8-36 Sometimes investment reports imply that you can evaluate a fund’s performance simply by adding the percentage loss and gain over a period to get a total percent change. This is not the case. If a firm has a loss of 75%, an increase of 300% is required to return to initial level. In general, the percentage required to return to original value =, where d is initial decline.

8-37 Risk and the Value of Stocks Stockholders require compensation for risk. The higher the risk, the higher the compensation. An investor will buy a stock with the idea of obtaining a certain return, which includes compensation for the stock’s risk. We know the return to holding stock for one year

8-38 We can think of the required return as the sum of the risk-free return and the risk premium (equity risk premium). We can write this as: Required Stock Return (i) = Risk-free Return (rf) + Risk Premium (rp) Rewrite dividend-discount model: Risk and the Value of Stocks

8-39 Risk and the Value of Stocks We can summarize as follows from this equation:

8-40 The Theory of Efficient Markets The basis for the theory of efficient markets is the notion that the prices of all financial instruments reflect all available information. Markets adjust immediately and continuously to changes in fundamental values. This implies that stock price movements are unpredictable. Any prediction that causes people to buy or sell the stock, thereby changes the price through simple supply and demand.

8-41 The Theory of Efficient Markets This means active portfolio management will not yield a higher return than of the broad stock-market index, year after year. Evidence suggests both that: Prices are unpredictable, and Professional money managers cannot beat an index like the S&P 500 regularly. Their returns are 2% lower on average.

8-42 The Theory of Efficient Markets But we do see managers who claim to exceed the market. How? They have inside information, which is illegal. They are taking on risk and are compensated as such. They are lucky. Markets aren’t efficient. This means that high or low investment returns could simply be a result of chance.

8-43 The Theory of Efficient Markets Suppose 225 million people start with a dollar and pair off to flip a coin once. The winner takes the $2 and moves on to next round. Do this over and over again. After 20 flips, there will be 215 people left with over $1 million each. Did the winners know anything special? As is true in the stock market, the number of people who “win” is about the same number as we would expect to be lucky.

8-44 There 2 stock exchanges in China. Shanghai (east coast) Shenzhen (near Hong Kong) Each firm issues 2 types of shares. A-shares (only Chinese investors until 2001) B-shares (only foreigners) Prices on A-shares were 4 times prices on B-shares. But they are the same stock - why so different? Problem was that there was a shortage of A-shares created by the government. Shortage drove up price and when released, prices fell more than 50 percent from their peak.

8-45 Investing in Stocks For the Long Run Stocks appear to be risky, but people hold a substantial proportion of their portfolio in stock. Either stocks are not that risky or people are not that risk averse. What is the case?

8-46 Investing in Stocks For the Long Run Figure 8.2 plots the one-year real return of the S&P 500 for 140 years. The average real return was 8% per year. In the past 50 years: The minimum return was -34% (in 2008). The maximum return was +31% (in 1996). Professor Jeremy Siegel suggested that investing in stocks is risky only if you hold them for a short time.

8-47 Investing in Stocks For the Long Run If you hold stocks long enough, they are not that risky. If we look at holding stocks for 25 years instead of one year. The minimum average annual real return was 2.5%. The maximum average annual real return was 11.3%. Between 1871 and 1992 there were no 30-year periods where bonds outperformed stocks. When held long enough, stocks are less risky than bonds.

8-48 Investing in Stocks For the Long Run

8-49 Prepackaged mutual funds are a great way to buy stocks. Mutual funds offer Affordability: small initial investment Liquidity: can withdraw quickly Diversification: portfolio of stocks Management: professionals Cost: look for low management fees

8-50 Markets may use available information efficiently and still face large setbacks if the information is incomplete or incorrect. An important source of the financial crisis of was the failure to understand and manage risks in the U.S. housing market. The efficient market hypothesis does not rule out large swings in market prices when new information becomes widely available.

8-51 The Stock Market’s Role in the Economy The prices determined in the stock market tell us the market value of companies. This guides the allocation of resources. If stock prices accurately reflect fundamental values, the resource allocation mechanism works well. However, stock prices sometimes deviate significantly from the fundamentals.

8-52 The Stock Market’s Role in the Economy Both euphoria and depression are contagious When investors become unjustifiably exuberant, prices rise regardless of the fundamentals. This creates bubbles, persistent and expanding gaps between actual stock prices and those warranted by the fundamentals. Bubbles lead to crashes. This explains the very jagged pattern in annual stock returns.

8-53 The Stock Market’s Role in the Economy Bubbles affect everyone because they distort economic decisions that companies and consumers make. Companies sell shares for prices that are too high. Companies then invest too much. Those not in the euphoria invest too little. People think they are wealthier than they are and spend too much.

8-54 The Stock Market’s Role in the Economy Crashes do the opposite. The shift from over-optimism to excessive pessimism causes a collapse in investment and economic growth. Large stock market swings alter economic prospects even if grounded in fundamentals. The recent financial crisis, the incentive to pull back on investment intensified helping to amplify the recessions of

8-55 The Nasdaq is composed of numerous small start-ups and large information technology firms. It doubled in value from September 1999 to March 2000 and then it fell by 70% over the next year. This did change how companies could gain financing - directly from capital markets instead of relying on venture capitalists. Downside were large losses to investors and warped investors’ decisions.

Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ Stocks, Stock Markets, and Market Efficiency Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin End of Chapter Eight