Stocks, Stock Markets, and Market Efficiency

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Chapter 8

• Stocks, Stock Markets, and Market Efficiency

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Stocks and Stock MarketsThe Big Questions

• What are stocks?
• How are stocks valued?
• How risky are stocks?

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StocksImportant Characteristics

• Also known as common stock or equity
• Shareholders own the company
• can elect/remove the firms managers and board of
  directors
• Issued in small denominations and large number of
  shares outstanding
• Priced so that small investments possible

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StocksImportant Characteristics

• Stockholders are residual claimants
• Stockholders are paid after everyone else.
• Since they are paid last, they never know for
  sure how much their return will be.
• Stockholders have Limited liability
• Maximum loss is the amount invested
• If firm owes money to Workers, Suppliers, and
  Bondholders
• Stockholders are not liable for it

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Measuring the Stock MarketIndices

• Uses of a Stock Market Index
• Provides a measure of overall market performance.
• Provides a benchmark against which to measure the
  performance of
• Individual stocks
• Various investment strategies

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Measuring the Stock MarketIndices

• Dow Jones Industrial Average
• Price-weighted
• Measures the return to holding one share of each
• The return to holding a typical stock
• Standard Poors Composite 500
• Value-weighted
• Measures the return to owning all 500 companies
  (a portfolio with weights equal to the value of
  each)
• Assume DJIA decreases to 7500 from 8000.
• What is the percentage change in the index?
• What percentage increase is required for the
  stock price to return to 8000?

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Valuing Stocks

• Why do stocks have value?
• Are they risky? If yes, why?

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Valuing StocksDividend-Discount Model

• Present Value of Dividend Flows

Dn dividend payment in period n i
interest rate to discount the dividend stream
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Valuing StocksDividend-Discount Model

• If the growth rate, g, of future dividends is
  constant, then
• Impact of risk
• Required Stock Return (i)
• Risk-free Return (rf) Risk Premium (rp)

.
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Valuing Stocks

• Implications of the Dividend-Discount Model with
  Risk Stock Prices are High When
• Current dividends are high/low
• Dividends are expected to grow/decrease quickly
• The risk-free rate is high/low
• The risk premium on equity is high/low
• The required rate of return is high/low

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Investing in Stocks For the Long Run
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Investing in Stocks For the Long Run

• Professor Jeremy Siegel of the University of
  Pennsylvanias Wharton School wrote a book titled
  Stocks for the Long Run
• investing in stocks is risky only if you hold
  them for a short time. But if you buy them and
  hold them for long enough, they really are not
  very risky.

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Theory of Efficient Markets

• Prices reflect all available information
• Implies stock price movements are unpredictable

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Efficient Market Hypothesis

• Securities are normally in equilibrium and are
  fairly priced.
• Investors cannot beat the market except through
  better information
• 3 forms of the EMH
• Weak-form EMH
• Semistrong-form EMH
• Strong-form EMH

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Efficient Market Hypothesis

• Weak-form EMH
• Current share prices reflect all information
  contained in past patterns of prices
• Past share prices cannot be used to predict
  future returns
• Adjusted for risk, investors cannot earn excess
  returns by developing trading rules on historical
  price information (Technical analysis)
• If technical rules worked, everyone would use
  them. As a result they would not work anymore.
• A recent decline is no reason to think stocks
  will go up (or down) in the future.
• Evidence supports weak-form EMH

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Efficient Market Hypothesis

• Semi-strong-form EMH
• Implies all the conditions of weak-form and
• Current share prices reflect all publicly
  available information
• new public information is priced immediately,
  before it can be traded on
• Adjusted for risk, investors cannot earn excess
  returns by trading published or common
  knowledge information.
• It doesnt pay to pore over info looking for
  undervalued stocks
• Largely true, but superior analysts can still
  profit by finding and using new information

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Semi-Strong Form Efficiency

• Implications
• Market reacts to information about companies
  fundamentals
• Macroeconomic news.
• News on earnings.
• Price adjustments are fast and appropriate no
  systematic under/overshooting after announcement.
• Tests
• Event studies of price reactions to news
  announcements.
• Announcements.
• Leading economic indicators.
• Mergers and acquisitions.

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Reaction to Macroeconomic Announcements

• Question
• How quickly do markets absorb information? Is
  the reaction appropriate?
• Results
• Almost all the price adjustment takes place in
  the first minute after the announcement
• CPI between 8.30 and 8.31.
• Later adjustments cannot be predicted from
  earlier reactions
• No systematic over or underreaction
• No profitable trading on news.

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Efficient Market Hypothesis

• Strong-form EMH
• Implies all the conditions of semi-strong form
  and
• Current share prices reflect all information,
  both public and private.
• No investor can earn excess returns, including
  those with insider information
• Not true--insiders can gain by trading on the
  basis of insider information, but thats illegal.

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Can excess returns be earned?

• Q Where do you think markets are in term of
  efficiency?
• A We can never know for sure since it is
  impossible to measure, but
• 1. Evidence exists that insiders CAN earn excess
  return on inside information, so few experts
  believe that markets are strong-form efficient
• 2. There is no definitive evidence that investors
  can earn excess returns by studying past prices
  and implementing trading rules.
• Paradox ? If such a trading rule existed, and it
  were known, then investors without wealth
  constraints would trade on it until such time
  that it no longer existed.
• It is well known that it is difficult to beat
  an index if you are a professional fund manager
• 90 of all funds under perform a passive index

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How efficient are financial markets?