8. Stocks, Stock Markets, and Market Efficiency

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8. Stocks, Stock Markets, and Market Efficiency

• Common stock
• Stock market indexes
• Stock valuation
• Efficient Markets Theory

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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

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Measuring the Stock Market

• Stock market indexes
• Average price level in part/all of market
• Benchmark for performance for money managers

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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

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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

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Correlation 95
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Nasdaq Composite

• Over 3000 OTC traded companies
• Value-weighted
• Smaller, newer firms
• 500 billion total market value

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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

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Correlation across indices .8 - .99
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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

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

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value of a stock today
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• but we do not know the future P.
• assume stock is held indefinitely, just paying
  dividends.

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Dividend-discount model
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• interest rate risk free rate risk premium
• i rf rp
• then

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

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example

• D 2, g 2, rf 3, rp 5
• P 2/(.03.05-.02)
• P 2/.06 33.33

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• 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

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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

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example

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

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

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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

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• 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

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Are markets efficient?

• a lot of research on efficiency of U.S. stock
  market
• to test efficiency, must understand
  implications of efficiency

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• 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

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Evidence for efficiency

• do professionally managed mutual funds beat the
  market?
• no, on average

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• 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

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

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Technical analysis

• Chartists
• using past price patterns to predict future price
  patterns
• no evidence this technique beats the market

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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

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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

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Evidence against efficient markets

• certain return patterns out there
• anomalies
• should not exist if markets are fully efficient

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

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• 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)

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• 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

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

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

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• 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

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

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weight of evidence

• so efficiency is not perfect,
• but earning above-average returns is very
  difficult

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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

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conclusion

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