1. 8. Stocks, Stock Markets, and Market Efficiency
Common stock
Stock market indexes
Stock valuation
Efficient Markets Theory

2. About 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

3. Measuring the Stock Market
Stock market indexes
Average price level in part/all of market
Benchmark for performance for money managers

4. 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

8. The 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.

9. Correlation: 95%

10. Nasdaq Composite Over 3000 OTC traded companies Value-weighted
Smaller, newer firms
$500 billion total market value

11. DJ 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

13. Correlation across indices: .8 - .99

14. Stock 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

15. D0 = dividend today
g = annual dividend growth rate
Pn= future resale price in year n
P = price today
i = discount rate

16. value of a stock today

17. but we do not know the future P….
assume stock is held indefinitely, just paying dividends….

18. Dividend-discount model

19. interest rate = risk free rate + risk premium
i = rf + rp
then

20. higher risk free rate, lower stock price
higher risk premium, lower stock price
higher dividends, higher stock price
higher dividend growth, higher stock price

21. example D = $2, g = 2%, rf = 3%, rp = 5% P= $2/(.03+.05-.02)

22. what if risk premium rises to 7%?
what if risk premium falls to 3%?
P = $2/( ) = $2/.04 = $50
Dividend discount model shows us why stock prices are volatile

23. Theory 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

24. example XYZ stock, $25 value of $25 based on
--past prices, profits, trading, litigation
--forecasts about future profits, litigation, market share
--relevant economic conditions

25. not ALL buyers and sellers must act rationally for markets to be efficient
just most of them

26. implications 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

27. 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”

28. Are markets efficient?
a lot of research on efficiency of U.S. stock market
to “test” efficiency, must understand implications of efficiency

29. 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

30. Evidence for efficiency
do professionally managed mutual funds beat the market?
no, on average

31. 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
, Wilshire 5000 outperformed 67% of equity funds

32. so if professionals have difficulty earning superior returns
then prices likely reflect public information

33. Technical analysis Chartists
using past price patterns to predict future price patterns
no evidence this technique beats the market

34. Fundamental 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

35. WSJ 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

36. Evidence against efficient markets
certain return patterns out there
“anomalies”
should not exist if markets are fully efficient

37. risk-adjusted returns of smaller firms higher over time
small-firm effect
risk-adjusted returns of smaller firms higher over time
Risk measure?
Survivorship bias
effect has become smaller over time

38. 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)

39. 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

40. “Dogs of the Dow”
Portfolio of 10 DJIA stocks with highest dividend yield (D/P)
Once strategy became widespread, it no longer worked.

41. other effects
day-of-the-week
weather
most anomalies are too small to allow a profit after trading costs

42. 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

43. Bubbles
Large gaps between actual asset price and fundamental value
Internet stock bubble of late 1990s
Housing bubble?
Eventually the bubble bursts!

44. weight of evidence so efficiency is not perfect,
but earning above-average returns is very difficult

45. Implications 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

46. conclusion stock market price behavior combines fundamentals
investor psychology
markets are not perfectly efficient
field of behavioral economics, finance