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8. Stocks, Stock Markets, and Market Efficiency

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Title: 8. Stocks, Stock Markets, and Market Efficiency


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

2
About common stock
  • Share of firms 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
  • http//www.djindexes.com/mdsidx/index.cfm?eventsh
    owAvgStats

5
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8
The SP 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/500
    factsheet.pdf

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

12
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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)
  • P 2/.06 33.33

22
  • 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

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
  • SP 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

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
  • 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
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