The stock market, rational expectations, efficient markets, and random walks The Economics of Money, Banking, and Financial Markets Mishkin, 7th ed. Chapter 7

Common stock Common stock - primary source of equity capital Owners have voting rights and are residual claimants (they receive whatever is left after all other claims are satisfied) Dividends are payments to stockholders, typically paid on a quarterly basis (if at all).

Computing the Price of Common Stock Basic Principle of Finance Value of Investment = Present Value of Future Cash Flows One-Period Valuation Model

Generalized dividend valuation model

General dividend Valuation model (long-term holding)

Gordon growth model Assumes constant dividend growth: Simplifying: Assuming the dividend growth rate is less than the required return on equity

Assumptions of the Gordon growth model Constant dividend growth Growth rate of dividends is less than the required return on equity

Stock price determinants Uncertainty plays an important role. An increase in risk results in a higher expected return on equity (lowering current stock prices)

Adaptive and rational expectations Adaptive expectations - based only on current and past realizations for the series being forecast Rational expectations - unbiased forecasts based on all available relevant information Arguments against rational expectations: effort needed to construct optimal forecasts may be too costly. people may be unaware of relevant information (the cost of acquiring the information may be too high).

Theory of Rational Expectations Rational expectation (RE) = expectation that is optimal forecast (best prediction of future) using all available information: i.e., RE  X e = X of 2 reasons expectation may not be rational 1. Not best prediction 2. Not using available information Rational expectation, although optimal prediction, may not be accurate Rational expectations makes sense because it is costly not to have optimal forecast Implications: 1.Change in way variable moves, way expectations are formed changes 2.Forecast errors on average = 0 and are not predictable

Efficient markets hypothesis Decisions concerning financial markets are based on rational expectations. Expected value of a variable equals the optimal forecast of the variable. It is argued that rational expectations are used in financial markets due to the strong financial incentive to have optimal forecasts.

Implications of the efficient markets hypothesis A change in the way a variable behaves will change the way in which expectations are formed Expected value of forecast error will be zero.

Efficient markets hypothesis - Implications The expected return on a security will equal the optimal forecast of the return. Current prices are set so that optimal forecast of a security’s return = security’s equilibrium return.

Efficient Markets Hypothesis Rational Expectations implies: P e t+1 = P of t+1  RET e = RET of (1) Market equilibrium RET e = RET*(2) Put (1) and (2) together: Efficient Markets Hypothesis RET of = RET* Why the Efficient Markets Hypothesis makes sense If RET of > RET*  P t , RET of  If RET of < RET*  P t , RET of  until RET of = RET* 1.All unexploited profit opportunities eliminated 2.Efficient Market holds even if are uninformed, irrational participants in market

Further implications In an efficient market, prices reflect the intrinsic value of a security (based on market fundamentals) Security prices reflect all available information concerning the equilibrium value of the security. Security prices reflect the cost of financial capital.

Evidence supporting efficient markets hypothesis Performance of investment analysts and mutual funds (e.g., “dartboard index”) Past performance is not a predictor of future performance for analysts and mutual funds Timing of new information releases and stock prices Random walk behavior of stock prices Technical analysis - technical analysts do not perform better than other analysts.

Evidence against the efficient markets hypothesis Small-firm effect – higher return for small firms, adjusting for risk. Possibly due to high information costs? Nonlinear risk-return functions? January effect - price rise December-January Tax issues - selling to realize capital losses (but why does it persist?) Market overreaction - initial overshooting of price when announcements are made Excessive volatility - fluctuations in stock prices are greater than would be expected based on changes in fundamental value Mean reversion - not a random walk? New information is not always immediately incorporated into stock prices

Implications for Investing 1.Published reports of financial analysts not very valuable 2.Should be skeptical of hot tips 3.Stock prices may fall on good news 4.Prescription for investor 1.Shouldn’t try to outguess market 2.Therefore, buy and hold 3.Diversify with no-load mutual fund Evidence on Rational Expectations in Other Markets 1.Bond markets appear efficient 2.Evidence with survey data is mixed; Skepticism about quality of data 3.Following implication is supported: change in way variable moves, way expectations are formed changes

Evidence in other markets Evidence in other financial markets (i.e., Bond) supports the efficient markets hypothesis Evidence with survey data is mixed; Skepticism about quality of data (such as inflation forecasts) There is evidence that a change in the way a variable moves will change the method of forecast formation

Speculative bubbles Rational bubble – prices differ from fundamental market value because people expect other people to pay more in the future.