Chapter 8: Stocks, Stock Markets and Market Efficiency
The stock market is probably the most-watched financial market, with it trading activity and indices a part of newscasts every day. In this chapter we look measuring the level of the stock market and at the fundamentals behind the value of a stock along with the role of expectation in the stock market
Stocks are equity securities, meaning they represent shares in a firms ownership. This gives stock owners claims on the profits of the firm, but it also makes stockholders residual claimants, meaning stockholder receive nothing until all debt claims are paid. (In the case of bankruptcy, most stockholders lose their entire invesments.) Also important is the concept of limited liabilty. This means stockholders' losses are limited to their initial investment; i.e. they are not held personally responsible for the losses of the company. For example, stockholders in Enron lost their entire investment, but Enron's creditors cannot go after the stockholder houses or bank accounts. Finally, owners of common stock receive voting rights to choose the company's board of directors.
Measuring the Level of the Stock Market
Given the impact of the stock market performance on our wealth, it is important to measure the performance of the stock market as a whole over time, not just indiviual stocks. These changes in values are measured by stock market indexes. As the index moves up and down we have an indication of the percentages gains and losses, on average, in the stock market. Not only do indexes tell us how much the value of an average stock has changed, they serve as benchmarks for investment performance: Is your portfolio doing better or worse than the market average?
The Dow Jones Industrial Average (DJIA)
While this is the most commonly quoted index, it is also the most narrow, measuring the price changes of 30 stocks. Stocks selected for the DJIA are considered industry leaders in the most important industries in the U.S. economy. This includes retailers such as Wal Mart and Home Depot, technology firms such as Microsoft, and traditional manufacturers such as General Electric and Alcoa. (Go here for a full description of this indexes history and composition)
The DJIA is unique among indexes in that it is a price-weighted average. Higher-priced stocks are given greater weight in the index so any changes in the prices of these companies will have a greater impact on the index value.
After falling three years in a row (2000, 2001, 2002), the Dow has posted gains from 2003-06. Thusfar in 2007 (September), the Dow is up almost 11% from its value at the end of 2006.
The S&P 500 Index
The S&P 500 is a broader index than the DJIA, including stocks of the 500 leading companies in leading industries in the U.S. economy. This index is a value-weighted index. This means that the firm's market value (stock price x the number of shares outstanding) determines its weighting in the index, NOT its price. This distinction is important in what movements in the index tell us. The Dow tells us how a portfolio of one share of each Dow stock is faring, or average price movements. The S&P 500 tells us the return to a portfolio of stocks weighted by the size of the firm, thus telling us about changes in wealth rather than price.
Other Indexes
There are many other indexes out there measuring different areas of the stock market. The broadest index available is the Wilshire 5000, which includes all publicly traded stock in the U.S. (over 6500!). The Nasdaq is also a broad index (over 5000 stocks), but focuses on OTC stocks. Nasdaq firms tend to be smaller and newer than the stocks tracked in the DJIA and S&P 500. Both the Nasdaq and Wilshire indexes are value-weighted.
Despite all of the different indexes, we do find their behavior to be highly correlated: They move up and down together. As Table 8.2 (p. 184) in your text shows, 2001 was a bad year for stock markets around the work due to a worldwide recession.
Valuing Stock
Unlike bonds, which only guarantee the owner a fixed and finite cash flow, common stock is an equity security that gives stockholders ownership in the corporation. This ownership entitles stockholders to voting rights and to quarterly payments from earnings known as dividends. As with any financial asset, the value of the stock is the discounted value of expected future cash flows. For stock, this would be any dividends and the future sales price. This method of valuation gives us what is known at the fundamental value of a stock.
One-Period Model
This simplest model of valuation would be to assume a single holding period, such as one year, for the stock. In this case you purchase the stock for an initial price, P0, and at the end of the year receive a dividend, Div1, and sell the stock for price P1. So the current value of the stock is the discounted value of the dividend and the resale price:
Here the appropriate discount rate, ke, is the required return on equity (the minimally acceptable return given the risk/uncertainty surrounding the stock value) and not the interest rate. (Your book uses the interest rate, but the concept of k is more accurate, because k includes a risk premium for holding stocks. This risk premium is necessary since stock owners are residual claimants.)
So, for example, if you demand a 10% equity return on XYZ stock, expect a dividend of $ 0.20 per share for the year and a share price of $50 one year from now, then your current value of the stock would be
In other words, you would not be willing to pay more than $45.64 for a share of XYZ stock today.
Note that even in this simple example, the valuation of stock is more uncertain that a Treasury bond. For the bond, the future cash flows are known and considered certain. But with the stock the future price and dividends are not known
Generalized Dividend Model
Now we can extend the one-period model to multiple periods. For n periods, the value of the stock would be
if the stock is held forever, then the sales price Pn is not an issue, and the model is rewritten as
Gordon Growth Model
Now let's make one more assumption: suppose dividends grow at a constant rate each year, g, and that g < ke. Then the stock value equation becomes
Using some rules about infinite series (see the footnote on page 188 or just trust me) this equation simplifies to
k, as the required equity return is really the sum of two components: the risk free return, rf, and the risk premium for holding stock, rp:
k = rf + rp
Yes, I know what you are thinking....
"So, Dr. Liz, what does this mathematical nightmare tell us about stock pricing?"
There are a couple of points to take from this exercise here:
- Current stock prices depend on current dividends and their expected growth. An increase in either will lead to an increase in the value of the stock. So, for example, a poor economy reduces expected dividend growth and causes stock prices to fall.
- The current stock price is also related to the required equity return. So if events cause investors to perceive stocks as riskier than before (like scandals involving financial statement fraud), then k will rise because investors want a higher return to compensate for higher risk. According to our model, an increase in k will cause stock prices to fall.
How the Market Sets a Stock Price
Stocks in the larger companies are sold on exchanges and electronic networks, where buyers and sellers are matched based on the prices they are willing to accept. So the market price of Microsoft stock is determined by the interaction of buyers and seller trading the stock around the world.
How much is a buyer willing to pay? How much is the seller willing to accept? This depends on how they assess the stock's value, which in turn depends on expectations about the stock's dividend growth, future value and risk. An new information becomes available, investors update their value assessment and stock prices respond.
This is why stock prices fluctuate with economic news, earnings announcements, and world events. This is also why releases of information occur at pre-designated times (so no investors have an unfair information advantage), and why the stock trading of those with inside information (like CEOs) is monitored and limited.
The Efficient Markets Theory
The efficient markets theory assumes that asset prices (particularly stock prices) reflect all available information.
For example, Microsoft's stock price on 8/6/2003 was about $26 . Under the efficient markets theory, the share price of $26 reflects all past relevant info about Microsoft (such as their profits, sales, litigation, etc) as well as forecasts about future earnings, sales, market share, new products, etc. People who buy and sell Microsoft stock have an incentive to use all of this information to make a profit, so the price set by buyers and sellers will reflect this information.
Furthermore, under the efficient markets theory, a security's return always reverts to some equilibrium return that reflects its fundamental value, its expected future earnings and risks. Why? Well, if Microsoft stock is earning an abnormally high return, people will buy the stock, bidding up the price. The higher price will drive down the return to some equilibrium level. If Microsoft stock is earning an abnormally low return, people will sell the stock, driving down its price. The lower price causes the return to rise to some equilibrium level.
Keep in mind that not everyone needs to use all available information to price a security for this to work. If enough buyers and sellers are behaving rationally, then the security price will reflect that.
Evidence on Efficient Markets
One key implication of the efficients markets theory is that over time it will be impossible to "beat the market." This means that we should not see any one group or person earning returns in the stock market that are consistently above average stock returns (the market return). Since prices already reflect all available information, using this information to predict stock prices will be worthless, so investment advisors using fancy formulas to forecast future stock prices should do no better than average over time. Is this true?
Evidence in favor of efficient markets
The is a large body of research that examines the returns of stock mutual funds over time to see if these expertly managed portfolios outperform the market. Well, they do not. In any given year over half of all mutual fund returns will be below the average stock return. Over time investors are better off trying to match the market average. This suggests that professional management does not give anyone an "edge" in trying to get superior returns. This is what we would expect if stock prices already reflect all available information. Furthermore, mutual funds that do well in one year typically do not do well in subsequent years. There are exceptions, but overall mutual funds may get lucky in one year, but the luck does not hold out in later years. In fact, we would expect a top-rated mutual fund in 2006 to get an influx of cash from new investors in 2007, which will drag down its returns.
If stock prices reflect all available information, then there is nothing to use to predict future stock prices. That is, if markets are efficient, stock prices are unpredictable or a random walk in statistical terms. So look for past price patterns to predict future prices should be a worthless exercise. Using past prices to predict future prices is known as technical analysis or chartists. Studies of technical analysts consistently show that over time they do not outperform the market. In fact they often do worse because they are constantly trading stocks, which generates costly commissions.
One of the more entertaining pieces of evidence about stock market efficiency is the "Investment Dartboard" contest run by the Wall Street Journal from 1988 to 2002. For a 6-month period, the paper chooses a portfolio of 4 stocks using a dartboard and puts this randomly-selected portfolio up againsts one picking by 4 stock analysts. These analysts are chosen based on past success in stock picking, yet the dartboard. With over 100 contests the pros beat the dartboard about 60% of the time. While this is more than the 50-50 balance predicted by efficient markets, this still means that a dartboard did better than highly paid professionals 40% of the time! Even more interesting is that the pros beat the Dow Jones Industrial Average only 51% of the time.
Evidence against efficient markets
Starting in the 1970s, researchers discovered some return patterns in the stock market that are inconsistent with efficiency. These inconsistencies are referred to as anomalies, and provide some evidence that the stock market is not perfectly efficient.
The small-firm effect literature has found that small firm stocks have earned higher returns over long periods of time, even when adjusted for risk. Many explanations for this have been offered, but none are truly satisfactory. In the late 1990s, large firm stocks actually did much better than small firm stocks. This size effect has become smaller over time, but if markets are efficient, it should have disappeared very quickly as investors tried to profit from this information.
The January effect is the tendency for stocks to post large returns in January for long periods of time. While this can be explained by sell-offs in December for tax reasons, this effect should have disappeared as tax-exempt institutions (like pension funds) tried to profit from this anomaly. This effect has gotten smaller over time, but it has persisted too long to be consistent with efficient prices.
There are actually many other effects out there: day-of-the-week effect (better returns on Friday, worse on Monday), a weather effect (better returns on sunny days), and more. All of them have been too persistent to be consistent with efficiency.
There is also a body of research above the over-reaction of stock prices to news (good or bad) and the excess volatility of the stock market. Studies show the stock prices pluge in response to bad earnings reports, only to creep back upward the following week. Stock prices fluctuate much more than the fundamentals behind them fluctuate.
Sometimes psychology dominates the fundamentals and prices rises even if this is not justified by the fundamentals. This escalation is known as a bubble. Between 1999-2000 there is strong evidence of a bubble in the pricing of technology stocks (see page 198). Today economists debate whether a bubble exists in housing markets across the U.S. Eventually bubbles burst, and the resulting crash has damaging implications for the climate for business financing and the wealth of households.
So there is evidence against perfect efficiency, but let's keep some perspective. The overwhelming weight of evidence suggests that consistently earning above-average returns is very difficult. Even with some of the anonmalies mentioned, the potential to profit from these anomalies is very small.
Implications for investment strategy
The chief implication from efficient markets is to stop trying to beat the market. It does not work and you just generate a lot of trading costs that drag down your returns. Even if markets are not perfectly efficient, they are close enough so that it is very difficult for the average person or even financial advisors to generate above-average returns over time. Yes there are exceptions, but in any time period, some investors will be lucky and some unlucky.
So what's a stock market investor to do? The best time-proven strategy is to buy-and-hold a well-diversified portfolio to minimize taxes, trading costs, and achieve the long-run average return for the stock market. One way to do this is with the index mutual funds out there. Index funds seek to match the return of a stock market index (like the S&P 500) by holding a portfolio identical to the index. The Vanguard 500 was the first index fund, started back in 1976. At the time many made fun of the objective "to be average," but the fund has been a consistent performer and now there are hundreds of S&P 500 index funds along with index funds using other stock market indexes.
The lesson: by earning average returns over time you will do better than most mutual funds out there in the long run.
FYI: Related Links
Multiple Choice Quiz for Chapter 8 An interactive quiz from the textbook website.
The EMH on Trial: A Survey This online paper looks at some of the empirical evidence against the EMH.
The Folly of "Cheap and "Expensive" stocks In this Slate article a former (and famous) Wall Street analyst talks about stock valuation in a very accessible way.
Psychology and Behavior Finance This looks at the field of thought that directly challenges the accuracy of the EMH
Revisiting the Efficient Market Hypothesis A pragmatic look at the EMH in light of fairly recent (July 2003) stock market behavior
A Random Walk Down Wall Street by Burton Malkiel. This links you to the book's site on Amazon.com. This easy-to-read book is a classic that covers investing approaches and academic theories on the efficient market hypothesis. The author makes a compelling case for stock market efficiency, laying out the evidence and addressing his critics. This book was written by a former Princeton Prof. who also invests and advises in the market. It's a bestseller, written for the public and available in paperback.
The Wall Street Journal Dartboard Contest A discussion and summary of the Dartboard contest history and results
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