Lecture 7 - Stock Market and EMF
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The document discusses the efficient market hypothesis (EMH), which states that current stock prices fully reflect all available information. Under EMH, it is impossible for investors to consistently outperform the market because stock prices adjust rapidly to new information. However, some evidence suggests markets are not always efficient, as seen in crashes not explained by economic changes. While published reports may be reflected in prices already, the EMH remains useful as a benchmark for understanding market behavior.
Lecture 7 - Stock Market and EMF
- 2. Preview • In this chapter, we examine the theory of rational expectations. When this theory is applied to financial markets, the outcome is the efficient market hypothesis, which has some general implications for how markets in other securities besides stocks operate.
- 3. Computing the Price of Common Stock • The One-Period Valuation Model: 1 1 0 0 1 1 (1 ) (1 ) = the current price of the stock = the dividend paid at the end of year 1 = the required return on investment in equity = the sale price of the stock at the end of the e e e Div P P k k P Div k P first period
- 4. Computing the Price of Common Stock • The Generalized Dividend Valuation Model: 1 2 0 1 2 0 0 1 The value of stock today is the present value of all future cash flows ... (1 ) (1 ) (1 ) (1 ) If is far in the future, it will not affect (1 ) The price of the n n n n e e e e n t t t e D PD D P k k k k P P D P k stock is determined only by the present value of the future dividend stream
- 5. Computing the Price of Common Stock • The Gordon Growth Model: P0 D0 (1 g) (ke g) D1 (ke g) D0 = the most recent dividend paid g = the expected constant growth rate in dividends ke = the required return on an investment in equity Dividends are assumed to continue growing at a constant rate forever The growth rate is assumed to be less than the required return on equity
- 6. How the Market Sets Stock Prices • The price is set by the buyer willing to pay the highest price. • The market price will be set by the buyer who can take best advantage of the asset. • Superior information about an asset can increase its value by reducing its perceived risk.
- 7. How the Market Sets Stock Prices • Information is important for individuals to value each asset. • When new information is released about a firm, expectations and prices change. • Market participants constantly receive information and revise their expectations, so stock prices change frequently.
- 8. Application: Monetary Policy and Stock Prices • Monetary policy can affect stock prices in two ways. First, when the Fed lowers interest rates, the return on bonds (an alternative asset to stocks) declines, and investors are likely to accept a lower required rate of return on an investment in equity. The resulting decline lowers the denominator in the Gordon growth model (Equation 5) and raises stock prices.
- 9. Application: Monetary Policy and Stock Prices • Furthermore, a lowering of interest rates is likely to stimulate the economy, so the growth rate in dividends, g, is likely to be somewhat higher. This rise in g also causes the denominator in Equation 5 to decrease, which also leads to a rise in stock prices.
- 10. Application: The Global Financial Crisis and the Stock Market • The financial crisis that started in August 2007 led to one of the worst bear markets in 50 years. • Downward revision of growth prospects: ↓g • Increased uncertainty: ↑ke • Gordon model predicts a drop in stock prices.
- 11. The Theory of Rational Expectations • Adaptive expectations: – Expectations are formed from past experience only. – Changes in expectations will occur slowly over time as data changes. – However, people use more than just past data to form their expectations and sometimes change their expectations quickly.
- 12. The Theory of Rational Expectations • Expectations will be identical to optimal forecasts using all available information. • Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate. – It takes too much effort to make their expectation the best guess possible. – The best guess will not be accurate because the predictor is unaware of some relevant information.
- 13. Formal Statement of the Theory expectation of the variable that is being forecast = optimal forecast using all available information e of e of X X X X
- 14. Rationale Behind the Theory • The incentives for equating expectations with optimal forecasts are especially strong in financial markets. In these markets, people with better forecasts of the future get rich. • The application of the theory of rational expectations to financial markets (where it is called the efficient market hypothesis or the theory of efficient capital markets) is thus particularly useful.
- 15. Implications of the Theory • If there is a change in the way a variable moves, the way in which expectations of the variable are formed will change as well. – Changes in the conduct of monetary policy (e.g., target the federal funds rate) • The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time.
- 16. The Efficient Market Hypothesis: Rational Expectations in Financial Markets • Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return. • In an efficient market, a security’s price fully reflects all available information.
- 17. Rationale Behind the Hypothesis Rof R* Pt Rof Rof R* Pt Rof until Rof R* In an efficient market, all unexploited profit opportunities will be eliminated
- 18. How Valuable Are Published Reports by Investment Advisors? • Information in newspapers and in the published reports of investment advisers is readily available to many market participants and is already reflected in market prices. • Acting on this information will not yield abnormally high returns, on average. • The empirical evidence for the most part confirms that recommendations from investment advisers cannot help us outperform the general market.
- 19. Efficient Market Prescription for the Investor • Recommendations from investment advisors cannot help us outperform the market. • A hot tip is probably information already contained in the price of the stock. • Stock prices respond to announcements only when the information is new and unexpected. • A “buy and hold” strategy is the most sensible strategy for the small investor.
- 20. Stock Market Crash and Market Efficiency • Nothing in efficient markets theory rules out large changes in stock prices. A large change in stock prices can result from new information that produces a dramatic decline in optimal forecasts of the future valuation of firms. However, economists are hard pressed to find fundamental changes in the economy that would have caused the Black Monday and tech crashes. One lesson from these crashes is that factors other than market fundamentals may have an effect on asset prices.
- 21. Does EMH Imply that Financial Markets Are Efficient • Some financial economists believe all prices are always correct and reflect market fundamentals (items that have a direct impact on future income streams of the securities) and so financial markets are efficient. • However, prices in markets like the stock market are unpredictable. This casts serious doubt on the stronger view that financial markets are efficient.
- 22. Behavioral Finance • The lack of short selling (causing over-priced stocks) may be explained by loss aversion. • The large trading volume may be explained by investor overconfidence. • Stock market bubbles may be explained by overconfidence and social contagion.
- 23. EMH - Pandemic • We’ve seen excessive volatility in the markets as people digest information around the pandemic (consistent with EMH). • We’ve seen strong departures from economic fundamentals (inconsistent with EMH) • Are online platforms responsible for irrational behavior (Robinhood) – What’s the story with Hertz (yes, the rental car company).