PPT

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PPT

  1. 1. 8. Stocks, Stock Markets, and Market Efficiency <ul><li>Common stock </li></ul><ul><li>Stock market indexes </li></ul><ul><li>Stock valuation </li></ul><ul><li>Efficient Markets Theory </li></ul>
  2. 2. About common stock <ul><li>Share of firm’s ownship </li></ul><ul><li>A residual claimant </li></ul><ul><ul><li>Paid after all other creditors </li></ul></ul><ul><ul><li>“ last in line” </li></ul></ul><ul><li>Limited liability </li></ul><ul><ul><li>Shareholders cannot be liable beyond stock investment </li></ul></ul>
  3. 3. Measuring the Stock Market <ul><li>Stock market indexes </li></ul><ul><ul><li>Average price level in part/all of market </li></ul></ul><ul><ul><li>Benchmark for performance for money managers </li></ul></ul>
  4. 4. Dow Jones Industrial Average (DJIA) <ul><li>Stock prices of 30 of the largest U.S. companies </li></ul><ul><ul><li>Return to holding a portfolio of a single share of each stock </li></ul></ul><ul><ul><li>Adjusted for splits, firm changes </li></ul></ul><ul><li>Price-weighted average </li></ul><ul><ul><li>Greater wt. to higher priced stocks </li></ul></ul><ul><li>http:// www.djindexes.com/mdsidx/index.cfm?event = showAvgStats </li></ul>
  5. 8. The S&P 500 <ul><li>Value of 500 of the largest firms in U.S. economy </li></ul><ul><ul><li>At least $5 billion in market capitalization </li></ul></ul><ul><ul><li>At least 50% stock held by public </li></ul></ul><ul><li>Valued-weighted </li></ul><ul><ul><li>Weight to each stock price based on firms total market value </li></ul></ul><ul><ul><ul><li>Share price x (shares outstanding) </li></ul></ul></ul><ul><ul><li>Larger firms get more wt. </li></ul></ul><ul><li>http://www2.standardandpoors.com/spf/pdf/index/500factsheet.pdf </li></ul>
  6. 9. Correlation: 95%
  7. 10. Nasdaq Composite <ul><li>Over 3000 OTC traded companies </li></ul><ul><li>Value-weighted </li></ul><ul><li>Smaller, newer firms </li></ul><ul><li>$500 billion total market value </li></ul>
  8. 11. DJ Wilshire 5000 <ul><li>“ Total market index” </li></ul><ul><ul><li>All publicly traded stocks in U.S. with readily available price data </li></ul></ul><ul><li>Value-weighted </li></ul><ul><li>Over $15 trillion in total market capitalization </li></ul>
  9. 13. Correlation across indices: .8 - .99
  10. 14. Stock Valuation <ul><li>Recall: </li></ul><ul><ul><li>We value an asset based on the present value of the expected future cash flows </li></ul></ul><ul><ul><li>For stocks these are dividend payments, resale price </li></ul></ul>
  11. 15. <ul><li>D 0 = dividend today </li></ul><ul><li>g = annual dividend growth rate </li></ul><ul><li>P n = future resale price in year n </li></ul><ul><li>P = price today </li></ul><ul><li>i = discount rate </li></ul>
  12. 16. value of a stock today
  13. 17. <ul><li>but we do not know the future P…. </li></ul><ul><li>assume stock is held indefinitely, just paying dividends…. </li></ul>
  14. 18. Dividend-discount model
  15. 19. <ul><li>interest rate = risk free rate + risk premium </li></ul><ul><ul><li>i = rf + rp </li></ul></ul><ul><li>then </li></ul>
  16. 20. <ul><li>higher risk free rate, lower stock price </li></ul><ul><li>higher risk premium, lower stock price </li></ul><ul><li>higher dividends, higher stock price </li></ul><ul><li>higher dividend growth, higher stock price </li></ul>
  17. 21. example <ul><li>D = $2, g = 2%, rf = 3%, rp = 5% </li></ul><ul><li>P= $2/(.03+.05-.02) </li></ul><ul><li>P = $2/.06 = $33.33 </li></ul>
  18. 22. <ul><li>what if risk premium rises to 7%? </li></ul><ul><ul><li>P = $2/(.03+.07-.02) = $2/.08 = $12.50 </li></ul></ul><ul><li>what if risk premium falls to 3%? </li></ul><ul><ul><li>P = $2/(.03+.03-.02) = $2/.04 = $50 </li></ul></ul><ul><li>Dividend discount model shows us why stock prices are volatile </li></ul>
  19. 23. Theory of Efficient Markets <ul><li>efficient market hypothesis (EMH) </li></ul><ul><li>asset prices (stock prices) reflect all available information </li></ul><ul><ul><li>markets adjust immediately to new information </li></ul></ul><ul><ul><li>prices incorporate expectations about future </li></ul></ul>
  20. 24. example <ul><li>XYZ stock, $25 </li></ul><ul><ul><li>value of $25 based on </li></ul></ul><ul><ul><li>--past prices, profits, trading, litigation </li></ul></ul><ul><ul><li>--forecasts about future profits, litigation, market share </li></ul></ul><ul><ul><li>--relevant economic conditions </li></ul></ul>
  21. 25. <ul><li>not ALL buyers and sellers must act rationally for markets to be efficient </li></ul><ul><ul><li>just most of them </li></ul></ul>
  22. 26. implications <ul><li>IF stock market is efficient, </li></ul><ul><ul><li>THEN stock prices already reflect all relevant, available information </li></ul></ul><ul><ul><li>SO, using the same info to predict future prices will not work </li></ul></ul>
  23. 27. <ul><li>if future stock prices were predictable… </li></ul><ul><ul><li>Expect price to rise tomorrow, </li></ul></ul><ul><ul><li>Then you buy it today, </li></ul></ul><ul><ul><li>Price rises TODAY </li></ul></ul><ul><li>Stock price today reflects our expectations about future price movements </li></ul><ul><ul><li>Stock prices are close to a “random walk” </li></ul></ul>
  24. 28. Are markets efficient? <ul><li>a lot of research on efficiency of U.S. stock market </li></ul><ul><li>to “test” efficiency, must understand implications of efficiency </li></ul>
  25. 29. <ul><li>it should be almost impossible to </li></ul><ul><li>“ beat the market” </li></ul><ul><li>(to earn above-average stock market returns over time) </li></ul><ul><li>Is this true? </li></ul><ul><li>-- most evidence says yes </li></ul><ul><li>-- some evidence suggests that some price inefficiencies do </li></ul><ul><li> exist </li></ul>
  26. 30. Evidence for efficiency <ul><li>do professionally managed mutual funds beat the market? </li></ul><ul><ul><li>no, on average </li></ul></ul>
  27. 31. <ul><li>S&P 500 outperformed 72% of all actively managed large-cap funds in the past 5 years </li></ul><ul><li>funds that do well in one year do not do well in subsequent year </li></ul><ul><li>1973-98, Wilshire 5000 outperformed 67% of equity funds </li></ul>
  28. 32. <ul><li>so if professionals have difficulty earning superior returns </li></ul><ul><ul><li>then prices likely reflect public information </li></ul></ul>
  29. 33. <ul><li>Chartists </li></ul><ul><li>using past price patterns to predict future price patterns </li></ul><ul><ul><li>no evidence this technique beats the market </li></ul></ul>Technical analysis
  30. 34. Fundamental Analysis <ul><li>Use available data to determine proper value of stock </li></ul><ul><ul><li>Which may or may not match price </li></ul></ul><ul><li>Again, we see no evidence that this earns above-average return in the long run </li></ul>
  31. 35. WSJ Dartboard contest <ul><li>1988-2001 </li></ul><ul><li>Over 6-month period </li></ul><ul><ul><li>4 professionals pick 1 stock each </li></ul></ul><ul><ul><li>4 dartboard stocks </li></ul></ul><ul><ul><li>Price appreciation of each portfolio </li></ul></ul><ul><li>Dartboard won about 40% of the time </li></ul><ul><ul><li>Even the deck stacked in favor of professionals </li></ul></ul>
  32. 36. Evidence against efficient markets <ul><li>certain return patterns out there </li></ul><ul><ul><li>“ anomalies” </li></ul></ul><ul><ul><li>should not exist if markets are fully efficient </li></ul></ul>
  33. 37. <ul><li>small-firm effect </li></ul><ul><ul><li>risk-adjusted returns of smaller firms higher over time </li></ul></ul><ul><ul><ul><li>Risk measure? </li></ul></ul></ul><ul><ul><ul><li>Survivorship bias </li></ul></ul></ul><ul><ul><li>effect has become smaller over time </li></ul></ul>
  34. 38. <ul><li>January effect </li></ul><ul><ul><li>stocks post larger returns in January </li></ul></ul><ul><ul><li>(December sell-offs for taxes) </li></ul></ul><ul><ul><li>should disappear as tax-exempt pension funds attempt to profit, </li></ul></ul><ul><ul><li>but still exists (but smaller) </li></ul></ul>
  35. 39. <ul><li>P/E effect </li></ul><ul><ul><li>Stocks with low P/E do better over time </li></ul></ul><ul><ul><li>Not consistent over time </li></ul></ul><ul><li>Price-to-book value </li></ul><ul><ul><li>Value investing (Buffet) </li></ul></ul><ul><ul><li>Not consistent, survivorship </li></ul></ul>
  36. 40. <ul><li>“ Dogs of the Dow” </li></ul><ul><ul><li>Portfolio of 10 DJIA stocks with highest dividend yield (D/P) </li></ul></ul><ul><ul><li>Once strategy became widespread, it no longer worked. </li></ul></ul>
  37. 41. <ul><li>other effects </li></ul><ul><ul><li>day-of-the-week </li></ul></ul><ul><ul><li>weather </li></ul></ul><ul><li>most anomalies are too small to allow a profit after trading costs </li></ul>
  38. 42. <ul><li>stock price over-reaction </li></ul><ul><ul><li>prices fall/rise too much with bad/good news </li></ul></ul><ul><ul><li>A “contrarian” strategy might produce superior returns </li></ul></ul><ul><li>excess volatility </li></ul><ul><ul><li>stock prices fluctuate more than their fundamentals </li></ul></ul>
  39. 43. <ul><li>Bubbles </li></ul><ul><ul><li>Large gaps between actual asset price and fundamental value </li></ul></ul><ul><ul><li>Internet stock bubble of late 1990s </li></ul></ul><ul><ul><li>Housing bubble? </li></ul></ul><ul><li>Eventually the bubble bursts! </li></ul>
  40. 44. weight of evidence <ul><li>so efficiency is not perfect, </li></ul><ul><li>but earning above-average returns is very difficult </li></ul>
  41. 45. Implications of efficiency evidence <ul><li>very difficult for average person to beat the market </li></ul><ul><ul><li>trying to do so generates trading costs </li></ul></ul><ul><li>the alternative </li></ul><ul><ul><li>buy-and-hold diversified portfolio </li></ul></ul><ul><ul><li>indexing </li></ul></ul>
  42. 46. conclusion <ul><li>stock market price behavior combines </li></ul><ul><ul><li>fundamentals </li></ul></ul><ul><ul><li>investor psychology </li></ul></ul><ul><li>markets are not perfectly efficient </li></ul><ul><ul><li>field of behavioral economics, finance </li></ul></ul>

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