Download presentation
1
8. Stocks, Stock Markets, and Market Efficiency
Common stock Stock market indexes Stock valuation Efficient Markets Theory
2
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
3
Measuring the Stock Market
Stock market indexes Average price level in part/all of market Benchmark for performance for money managers
4
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
8
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.
9
Correlation: 95%
10
Nasdaq Composite Over 3000 OTC traded companies Value-weighted
Smaller, newer firms $500 billion total market value
11
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
13
Correlation across indices: .8 - .99
14
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
15
D0 = dividend today g = annual dividend growth rate Pn= future resale price in year n P = price today i = discount rate
16
value of a stock today
17
but we do not know the future P….
assume stock is held indefinitely, just paying dividends….
18
Dividend-discount model
19
interest rate = risk free rate + risk premium
i = rf + rp then
20
higher risk free rate, lower stock price
higher risk premium, lower stock price higher dividends, higher stock price higher dividend growth, higher stock price
21
example D = $2, g = 2%, rf = 3%, rp = 5% P= $2/(.03+.05-.02)
22
what if risk premium rises to 7%?
what if risk premium falls to 3%? P = $2/( ) = $2/.04 = $50 Dividend discount model shows us why stock prices are volatile
23
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
24
example XYZ stock, $25 value of $25 based on
--past prices, profits, trading, litigation --forecasts about future profits, litigation, market share --relevant economic conditions
25
not ALL buyers and sellers must act rationally for markets to be efficient
just most of them
26
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
27
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”
28
Are markets efficient? a lot of research on efficiency of U.S. stock market to “test” efficiency, must understand implications of efficiency
29
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
30
Evidence for efficiency
do professionally managed mutual funds beat the market? no, on average
31
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 , Wilshire 5000 outperformed 67% of equity funds
32
so if professionals have difficulty earning superior returns
then prices likely reflect public information
33
Technical analysis Chartists
using past price patterns to predict future price patterns no evidence this technique beats the market
34
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
35
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
36
Evidence against efficient markets
certain return patterns out there “anomalies” should not exist if markets are fully efficient
37
risk-adjusted returns of smaller firms higher over time
small-firm effect risk-adjusted returns of smaller firms higher over time Risk measure? Survivorship bias effect has become smaller over time
38
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)
39
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
40
“Dogs of the Dow” Portfolio of 10 DJIA stocks with highest dividend yield (D/P) Once strategy became widespread, it no longer worked.
41
other effects day-of-the-week weather most anomalies are too small to allow a profit after trading costs
42
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
43
Bubbles Large gaps between actual asset price and fundamental value Internet stock bubble of late 1990s Housing bubble? Eventually the bubble bursts!
44
weight of evidence so efficiency is not perfect,
but earning above-average returns is very difficult
45
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
46
conclusion stock market price behavior combines fundamentals
investor psychology markets are not perfectly efficient field of behavioral economics, finance
Similar presentations
© 2025 SlidePlayer.com. Inc.
All rights reserved.