Ch. 10: Some Lessons from Capital Market History

1. Ch. 10: Some Lessons from Capital Market History • Historic Returns • Observations from History • Average Returns: The First Lesson • Variability of Returns: The Second Lesson • Capital Market Efficiency • Securities Fraud, Insider Trading

2. Historic Returns • Ibbotson Associates 1926-99 data • Large Co. Stocks: S&P 500 • Small Co. Stocks: smallest 20% NYSE • L-T Government Bonds: 20 years to maturity • Treasury Bills: 3-month maturity • Inflation: Consumer Price Index • Return for 1 year = (P1 + D1 - P0)/P0, where P0 is the price at year’s beginning, P1 is at year-end, and D1 is any dividends paid (assume at year-end) • Capital gains yield, dividend yield

3. Wealth Building • Graph $1 invested in each series, from end of 1925, reinvesting dividends & coupons, no taxes, no transaction costs • HP-10B: P/YR=1, PV=-1, FV=6640.79, N=74 imply I/YR= ?? (geometric mean) • Geometric mean is the constant annual growth rate causing $1 to grow to $6,640.79 over 74 years

4. Observations from History • Observations (and lessons) from the graph • until 1943; until 1962, 1973 • See Concept Questions, p. 280 • Why buy anything besides small co. stocks? • The S&P 500 gained 37% in 1995, 23% in 1996, 33% in 1997, 27% in 1998, 21% in 1999. What has usually happened after two years of >20% growth for large co. stocks? (see pp. 284-5)

5. Observations Continued • The maximum return for large & small co. stocks was in 1933 (54% and 143%), the same year the unemployment rate peaked at 25% in the Depression. • The maximum return for bonds was in 1982 (40% on long-term Treasuries), the year the inflation of the 1970s dropped to 4% and interest rates fell. • “Treasury bill returns track inflation.” Why? • Do large & small co. stocks move together? • Do bonds & stocks move together?

6. Average Returns: The First Lesson • Arithmetic Mean: add the 1926-99 data and divide by 74 • Average nominal and real rates • Risk premiums over T-bills • The first lesson

7. Variability of Returns: The Second Lesson • Frequency distributions • Variance • Standard Deviation • Normal Distribution (p. 291) • What are the 68% and 95% Confidence Intervals for Large Company Stock Returns? • Concept Q. 10.4c, p. 294 • The Second Lesson

8. Capital Market Efficiency • Efficient capital market • Price behavior • Efficient Markets Hypothesis • Evidence

9. Efficient Markets Hypothesis • EMH Weak-Form: a stock’s price reflects its own past prices. • EMH Semistrong-Form: a stock’s price reflects all public information. • EMH Strong-Form: a stock’s price reflects all information. • ~100,000 full-time professional analysts & traders, ~3,000 major stocks. If each follows 30 stocks, then ~1,000 full-time professionals per stock. • What are the implications for investors?

10. Securities Fraud • Securities and Exchange Act of 1934 §10(b) and SEC Rule 10b-5 prohibit fraudulent or deceptive devices or schemes in securities trading. • They also prohibit untrue statements or omissions of material facts which mislead buyers or sellers of securities.

11. Insider Trading • In U.S., it is illegal for anyone to transact a security if based on inside information not available to others involved in the transaction. • “Disclose or Abstain” • U.S. vs. O’Hagan, Sup. Court Decision, 1997 • Insiders (officers, directors, major stockholders) of publicly traded corporations are required to report transactions in their firm’s shares.

12. Recommended Practice • Questions 1-3, 5, 6, 9, 10 pp. 300-1 • Problems on pp. 301-3: 1, 2, 9-11,17, 23, 25 (most answers are on p. 548-9)