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

2. Chapter 7 Preview
There is not a day that goes by that the stock market isn’t a major news item. In the past 20 years we have seen huge swings in the stock market. During the 1990’s the Dow Jones and S&P 500 indexes increased more than 400%, the NASDAQ 1000% (tech heavy).
Because so many people invest in the stock market and the price of stocks affects how we live and plan for retirement the market for stocks is the financial market that receives the most attention. This chapter will look at how it works.
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3. Chapter 7 Preview
We begin by looking at theories that determine the valuation of stocks, how they rise and fall. Once we learn methods for stock evaluation, we look at how expectations about the market affect its results. We will examine the theory or rational expectations. When this theory is applied to financial markets the outcome is the efficient market hypothesis.
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4. Computing the Price of Common Stock
Common stock is the principle way that corporations raise equity capital. As a stockholder you have ownership in a corporation and rights. The most important is the right to vote and to be the residual claimant of all funds flowing into the company (cash flows). Stockholders are paid dividends, payments made usually every quarter to stockholders. Stock-holders have the right to sell any time.
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5. Computing the Price of Common Stock
One basic principle of finance is that the value of any investment is found by computing the present value of all cash flows the investment will make over its life. The cash flows a stock might earn are dividends, the sale price or both.
For our purposes I will not be teaching any formulas but focus instead on the concepts using an illustration from the book.
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6. How the Market Sets Prices
The price is set by the buyer willing to pay the highest price
The market price will be set by the buyer who can take best advantage of the asset
Superior information about an asset can increase its value by reducing its risk
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7. Theory of Rational Expectations
Analysis of stock price evaluation depends on people’s expectations – especially cash flows. Expectations are critical in any sector of the economy but especially with the stock market so we need to know how they are formed. Getting “all” the information is crucial.
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8. Theory of Rational Expectations
So, the theory of rational expectations can be stated as follows: Expectations will be identical to optimal forecasts (the best guess of the future) using all available information.
What does this mean? Let’s use the example of Joe Commuter and the drive to work which really is more applicable for Americans but best illustrates this theory.
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9. The Example of Joe Commuter
When Joe travels to work not during rush hour it takes an average of 30 minutes, sometimes 35 or 25 but avg is 30 minutes.
During rush hour it takes him 10 minutes more. Thus during rush hour the optimal forecast is 40 minutes.
If Joe’s only information effecting his drive is that he goes during rush hour, what does the rational expectation theory allow you to predict about Joe’s driving time?
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10. The Example of Joe Commuter
Since Joe’s best guess with all his info is 40 minutes clearly an expectation of 35 is not rational because it does not equal his optimal forecast.
Suppose the next day, under the same conditions, the drive takes 45 minutes with a lot of red lights. The next day 35 with no red lights. Do these variations mean Joe’s 40 minutes is irrational? No, 40 is still a rational expectation. Either way, he is off
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11. The Example of Joe Commuter
by 5 minutes so the expectation has not been perfectly accurate. The forecast does not have to be perfectly accurate to be rational – only the best possible with the information available – the best correct on average. Thus the following point is made:
Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate.
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12. The Example of Joe Commuter
Now enter additional information: there is an accident that causes a 2 hour traffic jam. If Joe cannot get this information 40 minutes is still a rational expectation and he cannot enter that into his optimal forecast.
However, if there was a radio broadcast reporting the accident that Joe ignored, his 40 minute expectation is no longer rational. Based on this info his optimal forecast should have been 2 hours 40 min
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13. Theory of Rational Expectations
Expectations will be identical to optimal forecasts using all available information
Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate
It takes too much effort to make the expectation the best guess possible
Best guess will not be accurate because predictor is unaware of some relevant information
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14. Rationale behind the Theory
Why do people try to make their expectations match their best possible guess of the future using all available information? It is costly for people not to!
Joe has a strong reason to make his expectation of the time it takes to get to work as accurate as possible. If Joe is not accurate and doesn’t allow enough time to get to work he gets FIRED! If he allows too much time he loses SLEEP or LEISURE time.
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15. Rationale behind the Theory
This same principle applies to business or investing in the stock market.
For example, General Electric (GE), which manufactures appliances, knows that interest rate movements are important to the sale of appliances (refrigerators, ovens). If GE makes poor forecasts of interest rates, it will earn less profit, because it might produce too many or too few products. GE needs to acquire all the information it can about interest rates.
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16. Rationale behind the Theory
The advantage for matching expectations with optimal forecasts are vital for financial markets. People with better forecasts of the future make money. The application of this theory is called the efficient market hypothesis and is very helpful.
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17. Implications for the stock market and the entire economy
1. If there is a change in the way a variable moves, the way in which expectations of the variable are formed will change as well.
2. The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time.
Let’s look at these 2 points more closely:
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18. Implications for the stock market and the entire economy
1. Let’s say interest rates move in such a way that they return to a “normal” level in the future. If today’s rate is high relative to normal, an optimal forecast is that the rate will return to normal. Rational expectation theory would mean when today’s interest rate is high, the expectation is that it will fall in the future.
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19. Implications for the stock market and the entire economy
Suppose now the interest moves so that when it is high it stays high. The optimal forecast and thus the rational expectation is that it will stay high and there is not the expectation the rate will fall. Thus, when there is a change in the way the variable moves, the way in which expectations of this variable (change) is formed will change, too.
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20. Implications for the stock market and the entire economy
2. Back to the example of Joe, if his time on a certain day is 45 minutes and his expectation is 40 minutes, the forecast error is 5 minutes.
Suppose Joe’s forecast error is not equal to zero but now it equals 5 minutes. He can now correct his forecast by increasing it by 5 minutes to 45. When Joe has revised his forecast by 5 minutes on average, the forecast error will equal 0 so that it cannot be predicted ahead of time. Rational Expectations theory implies that errors of expectations cannot be predicted.
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21. Efficient Markets
Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return
In an efficient market, a security’s price fully reflects all available information
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22. Evidence in Favor of Market Efficiency
Having performed well in the past does not indicate that an investment advisor or a mutual fund will perform well in the future
If information is already publicly available, a positive announcement does not, on average, cause stock prices to rise
Stock prices follow a random walk which basically says that future changes in stock prices should, for all practical purposes, be unpredictable.
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23. Evidence in Favor of Market Efficiency
Technical analysis cannot successfully predict changes in stock prices
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24. Evidence Against Market Efficiency
Small-firm effect – small firms earn unusually high returns over long periods of time, even when the greater risk for these firms has been taken into account.
January Effect – due to tax issues, investors have an incentive to sell stocks before the end of the year because they can take losses of their tax return and reduce their tax liability.
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25. Evidence Against Market Efficiency
Market Overreaction – stock prices may overreact to news announcements and the pricing errors are only corrected slowly.
Excessive Volatility – extreme changes in prices.
Mean Reversion – stocks will tend to correct themselves.
New information is not always immediately incorporated into stock prices.
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26. Application Investing in the Stock Market
Recommendations from investment advisors cannot help us outperform the market
A hot tip is probably information already contained in the price of the stock
Stock prices respond to announcements only when the information is new and unexpected
A “buy and hold” strategy is the most sensible strategy for the small investor
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27. Behavioral Finance
The lack of short selling (causing over-priced stocks) may be explained by loss avoidance.
The large trading volume may be explained by investor overconfidence
Stock market bubbles may be explained by overconfidence and social contagion
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28. Summary of Chapter 7
1. The interaction among traders in the market is what actually sets prices on a day-to-day basis. The trader who values the security the most will be willing to pay the most. As new information is released, investors will either buy or sell depending on how the market price compares to their valuation. Because small changes result in large changes in price, it is not surprising that markets are often volatile.
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29. Summary of Chapter 7
2. The efficient market hypothesis states that current security prices will fully reflect all available information. 3. The evidence on the efficient market hypothesis is mixed. Evidence that new information is not always incorporated into stock prices suggests that the hypothesis may not always be correct. 4. The efficient market hypothesis indicates that hot tips, investment advisor
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30. Summary of Chapter 7
Recommendations and technical analysis cannot help an investor outperform the market. The best thing is for investors to pursue a buy-and-hold strategy – purchase stocks and hold them for long periods of time.
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31. Study Questions (number as in the book)
1. What basic principle of finance can be applied to the valuation of any investment asset?
6. “Forecaster’s predictions of inflation are mostly inaccurate, so their expectations of inflation cannot be rational.” Is this statement true or false. Explain.
10. Suppose that increases in the money supply lead to a rise in stock market prices. Does this mean that when you see the money supply have an increase in the past week, you should go out and buy stocks? Why or why not?
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32. Study Questions (number as in the book)
7. “Whenever it is snowing when Joe Commuter gets up in the morning, he misjudges (is wrong) how long it will take him to drive to work. Other-wise, his expectations of the driving time are perfectly accurate. Considering that it snows only once in every 10 years where Joe lives, Joe’s expectations are almost always perfectly accurate. Are Joe’s expectations rational? Why or why not? 13. If your broker has been right in her 5 previous buy and sell recommendations, should you continue listening to her advice?
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33. Study Questions (number as in the book)
11. If the public expects a corporation to lose $5 per share this quarter & it actually loses $4, which is still the largest loss in it’s history, what does the efficient market hypothesis say will happen to the price of the stock when the $4 loss is announced? 17. If higher money growth is associated with higher inflation, & if announced money growth turns out to be extremely high but is still less than the market expected, what do you think would happen to long term bond prices?
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34. Study Questions (number as in the book)
12. If you read in the Wall Street Journal (newspaper) that the “smart money” article on Wall Street expects stock prices to fall, should you follow that advice and sell all your stocks? 14. Can a person with rational expectations expect the price of a share of Google to rise by 10% in the next month? 16. An efficient market is one in which no one ever profits from having better information than the rest. Is this statement true, false or uncertain. Explain your answer.
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