The Stock Market and Stock Prices

1. Reading: Siklos Chapter 14 The Stock Market and Stock Prices

2. Overview • Basics of Stock Markets • Explaining Stock Price Behaviour: • Efficient Markets & Fundamentalists • Stock Market Volatility • The Home-bias in Stock Purchases • International Stock Price Linkages

3. Notation Note that many stocks do not pay dividends. Buyers of the stock expect that the firm will pay dividends some day.

4. Computing the Price of Common Stock • Basic Principle of Finance Value of Investment = Present Value of Future Cash Flows • One-Period Valuation Model (1)

5. Exercise 1 Intel Share Price 12% return is required on equity 16 cent dividend to be paid next year. $10 share price forecasted for next year

6. Generalized Dividend Valuation Model • Since last term of the equation is small, Equation 2 can be written as (2) (3)

7. Theory of Rational Expectations Rational expectation (RE) = expectation that is optimal forecast (best prediction of future) using all available information: i.e., RE  Xe = Xof 2 reasons an expectation may not be rational 1. Not best prediction 2. Not using available information

8. Rational expectation, although optimal prediction, may not be accurate • Rational expectations makes sense because it is costly not to have optimal forecast Implications: 1. Change in way variable moves, changes the way expectations are formed 2. Forecast errors on average = 0 and are not predictable (i.e. forecasters do not make persistent mistakes and they learn from previous mistakes immediately)

9. Theories of Stock Price Determination • Efficient Markets Hypothesis – an application of rational expectations theory. • Expectations about stock prices will be identical to optimal forecast using all available information. • Three forms (vary based on definition of “all available information”): • weak form, semi-strong form, strong form

10. Notation

11. Efficient Markets Hypothesis:Weak form Investors have an “information set” on which “expectations” of future stock prices are formed E(Pt+1| Pt, Pt-1,…)=Pt If the past history of stock prices is known then E(Pt+1) = Pt so that Pt+1=Pt+Ut giving rise to the random walk of stock prices

12. The Random Walk of Stock Prices

13. The Random Walk of Stock Prices

14. Efficient Markets Hypothesis (cont’d) • Semi-strong form expands the Information set to include other fundamental macroeconomic variables such as interest rates, inflation, money growth,….) • The strong form would incorporate private or insider information. This would most severely limit the profitable opportunities from changes in stock price behaviour

15. Interest Rates and Stock Prices R R LF1 LFs R P LF0 LF 2 Stock Price LF

16. Efficient Markets Hypothesis Pt+1 – Pt + C RET = Pt Pet+1 – Pt + C RETe = Pt Rational Expectations implies: Pet+1 = Poft+1RETe = RETof (1) Market equilibrium RETe = RET* (2) Put (1) and (2) together: Efficient Markets Hypothesis RETof = RET*

17. Why the Efficient Markets Hypothesis makes sense If RETof > RET* Pt, RETof If RETof < RET* Pt, RETof until RETof = RET* 1. All unexploited profit opportunities eliminated 2. Efficient Market holds even if there are uninformed, irrational participants in the market

18. Evidence on Efficient Markets Hypothesis Favorable Evidence 1. Investment analysts and mutual funds don’t beat the market 2. Stock prices reflect publicly available information: anticipated announcements don’t affect stock price 3. Stock prices and exchange rates close to random walk 4. Technical analysis does not outperform market

19. Unfavorable Evidence 1. Small-firm effect: small firms have abnormally high returns 2. January effect: high returns in January 3. Market overreaction 4. Excessive volatility 5. Mean reversion 6. New information is not always immediately incorporated into stock prices Overview Reasonable starting point but not whole story

20. Implications for Investing 1. Published reports of financial analysts not very valuable 2. Should be skeptical of hot tips 3. Stock prices may fall on good news 4. Prescription for investor 1. Shouldn’t try to outguess market 2. Therefore, buy and hold 3. Diversify with no-load mutual fund

21. A Different but Compatible View:The Fundamentalist Approach • Related to Gordon Growth Model • Stock prices should reflect expectations about the flow of future dividends • Assume that dividends reflect profits of the firm • Assume a constant opportunity cost of holding money, R. • Assume a constant growth rate of dividends, g • Assume that dividends paid out forever

22. Gordon Growth Model • Assuming dividend growth is constant, Equation 3 can be written as • Assuming the growth rate is less than the required return on equity, Equation 4 can be written as (4) (5)

23. Exercise 2 Intel Share Price 12% return is required on equity 16 cent was last dividend paid. 10% dividend growth rate expected.

24. The Fundamentalist Approach Assumption: the required return on equity, ke, is equal to the market interest rate, R. Rewriting equation (5), (6)

25. Anomalies and Other features of stock price behaviour • Volatility and its Measurement • Price-Earnings Ratio • January & other calendar effects • Bubbles (South Sea, Mississippi, Tulipmania) • International Linkages

26. What Causes “Noise” in Stock Markets Case 1: Market dominated by Informed Traders Noisy Traders  LOW VOLATILITY Inf. Traders Noisy Traders Informed Traders Case 2: Market dominated by Uninformed traders HIGH VOLATILITY

27. Stock Market Volume

28. International Stock Price Behaviour

29. Summary • Stock market behaviour is governed by the efficient markets hypothesis which comes in the weak, semi-strong and strong forms • The Fundamentalist approach explains the determination of stock prices according to the flow of dividends generated by a stock • Stock price behaviour is also subject to a number of anomalies and there are a number of other interesting aspects about stock prices