7. stock market valuation
TRANSCRIPT
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7. Stock Market Valuation & 7. Stock Market Valuation & the EMHthe EMH
7. Stock Market Valuation & 7. Stock Market Valuation & the EMHthe EMH
• Role of Expectations
• Rational Expectations
• Efficient Markets Theory
• Role of Expectations
• Rational Expectations
• Efficient Markets Theory
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Role of ExpectationsRole of ExpectationsRole of ExpectationsRole of Expectations
• expectations have played a role in several topics studied this semester• bond market• interest rates• inflation• profits
• expectations have played a role in several topics studied this semester• bond market• interest rates• inflation• profits
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Rational ExpectationsRational ExpectationsRational ExpectationsRational Expectations
• prior to 1960s, economists assumed adaptive expectations• forecast of inflation based on past
values of inflation• expectations change slowly over
time
• prior to 1960s, economists assumed adaptive expectations• forecast of inflation based on past
values of inflation• expectations change slowly over
time
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• problems with adaptive expectations• inflation is affected by many
variables• not just past values
• if economy changes• expectations should change
quickly, not slowly
• problems with adaptive expectations• inflation is affected by many
variables• not just past values
• if economy changes• expectations should change
quickly, not slowly
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A better model of expectationsA better model of expectationsA better model of expectationsA better model of expectations
• rational expectations• use all available information to
make best forecast• not exact, but best possible
• rational expectations• use all available information to
make best forecast• not exact, but best possible
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why rational expectations?why rational expectations?why rational expectations?why rational expectations?
• better forecasts mean better decisions• firms make more profits• consumers better off• Federal Reserve is better at
achieving goals
• better forecasts mean better decisions• firms make more profits• consumers better off• Federal Reserve is better at
achieving goals
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why not rational?why not rational?why not rational?why not rational?
• people do not take time to look at all relevant info in making decisions
• people not aware of all of the relevant info
• people do not take time to look at all relevant info in making decisions
• people not aware of all of the relevant info
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If most expectations are rational, If most expectations are rational, thenthenIf most expectations are rational, If most expectations are rational, thenthen
changes in the behaviorof a variable
changes in howwe forecast this variable
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examplesexamplesexamplesexamples
• yield curve usually slopes up
• but now suppose it starts being flat most of the time
• predictions about yield curve will use this
• yield curve usually slopes up
• but now suppose it starts being flat most of the time
• predictions about yield curve will use this
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• your professor NEVER offers extra credit
• your professor starts offering extra credit after exams
• you start going to class after an exam to get extra credit
• your professor NEVER offers extra credit
• your professor starts offering extra credit after exams
• you start going to class after an exam to get extra credit
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also,also,also,also,
• forecast errors
= actual value - predicted value• will average zero over time
• forecast errors
= actual value - predicted value• will average zero over time
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Efficient Markets HypothesisEfficient Markets HypothesisEfficient Markets HypothesisEfficient Markets Hypothesis
• apply rational expectations to financial markets• stock market
• asset prices (stock prices) reflect all available information
• apply rational expectations to financial markets• stock market
• asset prices (stock prices) reflect all available information
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exampleexampleexampleexample
• Microsoft stock, $25• value of $25 based on
--past prices, profits, trading, litigation
--forecasts about future profits, litigation, market share
--relevant economic conditions
• Microsoft 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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• buyers & sellers of Microsoft stock,• trying to profits from trading• use all info that will help them
arrive at true value of stock
• buyers & sellers of Microsoft stock,• trying to profits from trading• use all info that will help them
arrive at true value of stock
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• return on microsoft stock always reverts to some level that reflects• expected future earnings• risk
• why?
• recall
• return on microsoft stock always reverts to some level that reflects• expected future earnings• risk
• why?
• recall
return =future price - purchase price + cash flow
purchase price
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• if returns are high relative to equil.• people buy stock• stock price rises• return falls
• if returns are low relative to equil.• people sell stock• stock price falls• return rises
• if returns are high relative to equil.• people buy stock• stock price rises• return falls
• if returns are low relative to equil.• people sell stock• stock price falls• return rises
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• not ALL buyers and sellers must act rationally for markets to be efficient• just most of them
• not ALL buyers and sellers must act rationally for markets to be efficient• just most of them
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Are markets efficient?Are markets efficient?Are markets efficient?Are markets efficient?
• a lot of research on efficiency of U.S. stock market
• to “test” efficiency, must understand implications of efficiency
• a lot of research on efficiency of U.S. stock market
• to “test” efficiency, must understand implications of efficiency
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implicationsimplicationsimplicationsimplications
• 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 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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• 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
• 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 efficiencyEvidence for efficiencyEvidence for efficiencyEvidence for efficiency
• do professionally managed mutual funds beat the market?• no, on average• over 50% will have below-average
returns in a given year• funds that do well in one year do
not do well in subsequent year
• do professionally managed mutual funds beat the market?• no, on average• over 50% will have below-average
returns in a given year• funds that do well in one year do
not do well in subsequent year
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• so if professionals have difficulty earning superior returns• then prices likely reflect public
information
• so if professionals have difficulty earning superior returns• then prices likely reflect public
information
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• technical analysis• using past price patterns to predict
future price patterns • no evidence this technique beats
the market
• technical analysis• using past price patterns to predict
future price patterns • no evidence this technique beats
the market
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Evidence against efficient marketsEvidence against efficient marketsEvidence against efficient marketsEvidence against efficient markets
• certain return patterns out there• “anomalies”• should not exist if markets are fully
efficient
• 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• effect has become smaller over
time
• small-firm effect• risk-adjusted returns of smaller
firms higher over time• 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
• 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
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• other effects• day-of-the-week• weather• most anomalies are too small to
allow a profit after trading costs
• 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
• excess volatility• stock prices fluctuate more than
their fundamentals
• stock price over-reaction• prices fall/rise too much with
bad/good news
• excess volatility• stock prices fluctuate more than
their fundamentals
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weight of evidenceweight of evidenceweight of evidenceweight of evidence
• so efficiency is not perfect,
• but earning above-average returns is very difficult
• so efficiency is not perfect,
• but earning above-average returns is very difficult
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Implications of efficiency evidenceImplications of efficiency evidenceImplications of efficiency evidenceImplications 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
• 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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Crash of 1987Crash of 1987Crash of 1987Crash of 1987
• October 19, 1987• Dow lost 500 points (20%)• is such a large loss in 1 day
consistent with efficiency?
• October 19, 1987• Dow lost 500 points (20%)• is such a large loss in 1 day
consistent with efficiency?
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causescausescausescauses
• rising federal budget deficit
• rising trade deficit
• anti-corporate legislation
• rising inflation
• falling $
• but none had a dramatic 1-day change
• rising federal budget deficit
• rising trade deficit
• anti-corporate legislation
• rising inflation
• falling $
• but none had a dramatic 1-day change
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conclusionconclusionconclusionconclusion
• stock market price behavior combines• fundamentals• investor psychology
• markets are not perfectly efficient• field of behavioral finance
• stock market price behavior combines• fundamentals• investor psychology
• markets are not perfectly efficient• field of behavioral finance