1 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis Chapter 7

2 Theory of Stock Valuation One period stock valuation Generalized dividend valuation If n is fairly large, then If the stock doesn’t pay dividends, t starts when dividends start.

3 Theory of Stock Valuation Gordon Growth Model To simplify, multiply both sides by and subtract the original equation from both sides

4 Informed Buyer Bids Up the Price If two people both knew next period’s dividend and the growth rate, but one has more information about the future of the firm, the knowledgeable one will require a smaller k and pay a higher price. If two people both knew next period’s dividend and the growth rate, but one has more information about the future of the firm, the knowledgeable one will require a smaller k and pay a higher price. The uncertainty for the less informed shows up as higher k. The uncertainty for the less informed shows up as higher k.

5 Examples Fed lowers interest rates => price of bonds rise => demand shifts to substitute: stocks => price of stocks rise Fed lowers interest rates => price of bonds rise => demand shifts to substitute: stocks => price of stocks rise Subprime crisis => g down, k up => P 0 down Subprime crisis => g down, k up => P 0 down

6 Expectations Static: expectations don’t change Static: expectations don’t change Past has no trend Past has no trend Adaptive: expectations are adjusted according to past with recent past having higher weight Adaptive: expectations are adjusted according to past with recent past having higher weight Slope is small Slope is small Rational: expectations are forward looking Rational: expectations are forward looking Slope is very discernable Slope is very discernable

7 Rational Expectations Approximate guesses impose high costs Approximate guesses impose high costs Optimal forecasts can reduce costs Optimal forecasts can reduce costs Predictions are on average accurate Predictions are on average accurate Errors add up to zero: no trend Errors add up to zero: no trend

8 Efficient Market Hypothesis Rational Expectations in Financial Markets Investors decide on stock purchases according to expected returns. Investors decide on stock purchases according to expected returns. Expected returns rely on expected price in the future. Expected returns rely on expected price in the future. Expected price is the optimal forecast price. Expected price is the optimal forecast price. Information on the variables affecting the supply and demand allow optimal forecast of returns to be the same as equilibrium return. Information on the variables affecting the supply and demand allow optimal forecast of returns to be the same as equilibrium return.

9 Efficient Markets Hypothesis Markets with extreme price flexibility adjust instantaneously to any shift in supply and demand. Markets with extreme price flexibility adjust instantaneously to any shift in supply and demand. Optimal forecast equals the equilibrium value. Optimal forecast equals the equilibrium value. Any deviation will immediately be recognized and allow arbitrage. Any deviation will immediately be recognized and allow arbitrage. There cannot be any profit opportunities. There cannot be any profit opportunities.

10 Efficient Market Hypothesis Those who profit from the efficient market are the smart ones because the “dumb” ones make stupid choices. Those who profit from the efficient market are the smart ones because the “dumb” ones make stupid choices. Prices are always right; they embody all the relevant information. Prices are always right; they embody all the relevant information. Pangloss! Pangloss!

11 Efficient Market Hypothesis Random walk, throwing darts do as well as professional picks. Random walk, throwing darts do as well as professional picks. Hot tips are already passé. Hot tips are already passé. Beware of the managers with high fees. Beware of the managers with high fees.

12 Efficient Market Hypothesis If there is market psychology, herd behavior, EMH is suspect. If there is market psychology, herd behavior, EMH is suspect. Bubbles question EMH. Bubbles question EMH. Animal Spirits (R. Shiller and G. Akerlof) won the 2009 TIAA-CREF Samuelson award. Animal Spirits (R. Shiller and G. Akerlof) won the 2009 TIAA-CREF Samuelson award.