8.
Stocks, Stock Markets, and
Market Efficiency
• Common stock
• Stock market indexes
• Stock valuation
• Efficient Markets Theory
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
Measuring the Stock Market
• Stock market indexes
• Average price level in part/all of
market
• Benchmark for performance for
money managers
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?event =
showAvgStats
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.
• http://www2.standardandpoors.com/spf/pdf/index/500factsheet.pd
f
Correlation: 95%
Nasdaq Composite
• Over 3000 OTC traded companies
• Value-weighted
• Smaller, newer firms
• $500 billion total market value
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
Correlation across indices: .8 - .99
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
• D0 = dividend today
• g = annual dividend growth rate
• Pn= future resale price in year n
• P = price today
• i = discount rate
value of a stock today
D0 (1 g ) D0 (1 g ) 2
D0 (1 g ) n
Pn
P ...
(1 i ) (1 i ) 2
(1 i ) n
(1 i ) n
• but we do not know the future P….
• assume stock is held indefinitely,
just paying dividends….
Dividend-discount model
D0
P
ig
• interest rate = risk
free rate + risk
premium
• i = rf + rp
• then
D0
P
rf rp g
D0
P
rf rp g
• higher risk free rate, lower stock
price
• higher risk premium, lower stock
price
• higher dividends, higher stock price
• higher dividend growth, higher stock
price
example
• D = $2, g = 2%, rf = 3%, rp = 5%
• P= $2/(.03+.05-.02)
• P = $2/.06 = $33.33
• 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
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
example
• XYZ stock, $25
• value of $25 based on
--past prices, profits, trading,
litigation
--forecasts about future profits,
litigation, market share
--relevant economic conditions
• not ALL buyers and sellers must act
rationally for markets to be efficient
• just most of them
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
• 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”
Are markets efficient?
• a lot of research on efficiency of U.S.
stock market
• to “test” efficiency, must understand
implications of efficiency
• 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
Evidence for efficiency
• do professionally managed mutual
funds beat the market?
• no, on average
• 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
• 1973-98, Wilshire 5000 outperformed
67% of equity funds
• so if professionals have difficulty
earning superior returns
• then prices likely reflect public
information
Technical analysis
• Chartists
• using past price patterns to predict
future price patterns
• no evidence this technique beats
the market
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
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
Evidence against efficient markets
• certain return patterns out there
• “anomalies”
• should not exist if markets are fully
efficient
• small-firm effect
• risk-adjusted returns of smaller
firms higher over time
• Risk measure?
• Survivorship bias
• effect has become smaller over
time
• 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)
• 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
• “Dogs of the Dow”
• Portfolio of 10 DJIA stocks with
highest dividend yield (D/P)
• Once strategy became widespread,
it no longer worked.
• other effects
• day-of-the-week
• weather
• most anomalies are too small to
allow a profit after trading costs
• 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
• Bubbles
• Large gaps between actual asset
price and fundamental value
• Internet stock bubble of late 1990s
• Housing bubble?
• Eventually the bubble bursts!
weight of evidence
• so efficiency is not perfect,
• but earning above-average returns is
very difficult
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
conclusion
• stock market price behavior
combines
• fundamentals
• investor psychology
• markets are not perfectly efficient
• field of behavioral economics,
finance
