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7. Stock Market Valuation & the EMH Role of Expectations Rational Expectations Efficient Markets Theory Role of Expectations Rational Expectations Efficient.

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Presentation on theme: "7. Stock Market Valuation & the EMH Role of Expectations Rational Expectations Efficient Markets Theory Role of Expectations Rational Expectations Efficient."— Presentation transcript:

1 7. Stock Market Valuation & the EMH Role of Expectations Rational Expectations Efficient Markets Theory Role of Expectations Rational Expectations Efficient Markets Theory

2 Role 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

3 Rational 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

4 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

5 A 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

6 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

7 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

8 If most expectations are rational, then changes in the behavior of a variable changes in how we forecast this variable

9 examplesexamples 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

10 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

11 also,also, forecast errors = actual value - predicted value will average zero over time forecast errors = actual value - predicted value will average zero over time

12 Efficient 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

13 exampleexample 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

14 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

15 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

16 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

17 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

18 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

19 implicationsimplications 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

20 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

21 Evidence 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

22 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

23 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

24 Evidence 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

25 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

26 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

27 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

28 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

29 weight 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

30 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 very difficult for average person to beat the market trying to do so generates trading costs the alternative buy-and-hold diversified portfolio indexing

31 Crash 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?

32 causescauses 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

33 conclusionconclusion 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


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