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Course 5 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis Slide 2 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-2 Review of the previous lecture: The risk and term structure of Interest Rates Bonds with the same maturity will have different interest rates because of the three factors: default risk liquidity and tax considerations. The greater a bonds default risk, the higher is interest rate relative to other bonds the greater a bonds liquidity the lower its interest rate; and bonds with tax-exempt status will have lower interest rates than they otherwise would. The relationship among interest rates on bonds with the same maturity risk structure of interest rates. Slide 3 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-3 4 theories of the term structure : explanations of how interest rates on bonds with different terms to maturity are related. -The expectations theory long term interest rates as equaling the average of future short term interest rates expected to occur over the life of the bond -The segmented markets theory treats the determination of interest rates for each bonds maturity as the outcome of supply and demand in that market only Neither of these theories by itself can explain the fact that interest rates and bonds on different maturities move together over time and that yield curves usually slope upward. Slide 4 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-4 The liquidity premium & preferred habitat theories They view the long-term interest rates as equaling the average of future short term interest rates expected to occur over the life of the bond + a liquidity premium. A steeply upward-sloping curve indicates that future short-term interest rates are expected to rise, a mildly upward-sloping curve indicates that short-term rates are expected to stay the same, a flat curve indicates that short-term rates are expected to decline slightly and an inverted yield curve indicates that a substantial decline in short-term rates is expected. Slide 5 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-5 Preview Because so many people invest in the stock market and the price of stocks affects the ability of people to retire comfortably, the market for stocks is undoubtly the financial market that receives the most attention and scrutiny. We begin by discussing the fundamental theories that underline the valuation of stocks. Once we have learned the methods for stock valuation we need to explore how expectations about the market affect its behavior. We do so by examining the theory of rational expectations. When this theory is applied to financial markets, the outcome is the efficient market hypothesis, which has some general implications for how markets in other securities besides stock operate. Slide 6 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-6 Computing the price of Common Stock Common stock is the principal way that corporations raise equity capital. Holders of common stock own an interest in the corporation consistent with the percentage of outstanding shares owned. This ownership interest gives stockholders those who hold stock in a corporation-a bundle of rights. to vote to be the residual claimant of all funds flowing into the firm (known as cash flows Stockholders are paid dividends from the net earnings of the corporation. To develop our theory of stock valuation, we begin with the simplest possible scenario: You buy the stock, hold it for one period to get the dividend, then sell the stock. We call this the one-period valuation model Slide 7 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-7 Suppose that you have some extra money to invest for one year. After one year, you will need to sell your investment to pay tuition. After watching CNBC or Wall Street Week on your TV, you decide that you want to buy Intel.Corp. stock. You call your broker and find that Intel is selling for $50 per share and pays $0.16 per year in dividends. The analyst on Wall Street predicts that the stock will be selling for $ 60 in one year. Should you buy this stock ? Slide 8 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-8 One-Period Valuation Model Slide 9 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-9 Suppose that after a careful consideration you decide that you would be satisfied to earn 12 % return on the investment. Based on your analysis you find that the present value of all cash flows from the stock is 53.71. Because the stock is priced at $50 per share, you would choose to buy it. However, you should be aware that the stock might be selling for less than $53.71, because other investors place a different risk on the cash flows or estimate the cash flows to be less than you do. Slide 10 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-10 Generalized Dividend Valuation Model Slide 11 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-11 Consider the implications of the previous generalized dividend model. It says that the price of stock is determined only by the present value of the dividends and that nothing else matters. Many stocks do not pay dividends, so how it is that these stocks have value ? Buyers of the stock expect that the firm will pay dividends some day. Most of the time a firm institutes dividends as soon as it has completed the rapid growth phase of its life cycle. Slide 12 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-12 Gordon Growth Model Slide 13 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-13 How the Market sets Stock Prices Suppose you go to an auto action. The cars are available for inspection before the action begins and you find a little Mazda Miata that you like. You test drive it in the parking lot and notice that it makes a few strange noises, but you decide that you will still like the car. You decide 5000 would be a fair price that would allow you to pay some repair bills should the noises turn out to be serious. You see that the action is ready to begin so you go in and wait for the Miata to enter. Suppose another buyer also spots the Miata. He test-drives the car and recognizes that the noises are simply the result of worn brake pads that he can fix himself at no cost. He decides that the car is worth 7000. He also goes in and waits for the Miata to come up for the auction. Slide 14 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-14 Who will buy the car and for how much ? Suppose only the two of you are interested in the Miata. You begin the bidding at 4000. Your competitor ups the bid to 4500. You bid your top price of 5000. He counters with 5100. The price is now higher than you are willing to pay, so you stop bidding. The car is sold to the more informed buyer for 5100. Slide 15 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-15 This simple example raises a number of points. First, the price is set by the buyer willing to pay the highest price. The price is not necessarily the highest price the asset could fetch, but it is incrementally greater than what any other buyer is willing to pay. Second, the market price will be set by the buyer who can take best advantage of the asset. The buyer who purchased the car knew that he could fix the noise easily and cheaply. The same concept holds for other assets. For example, a price of property or a building will sell to the buyer who can put the asset to the most productive use. Finally the example shows the role played by information in asset pricing. Superior information about an asset can increase its value by reducing its risk. Slide 16 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-16 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 When new information is released about a firm, expectations change and with them, price change. New information can cause changes in expectations about the level of future dividends or the risk of those dividends. Because market participants are constantly receiving new information and revising their expectations, it is reasonable that stock prices are constantly changing as well. Slide 17 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-17 Monetary Policy and Stock Prices According to the Gordon growth model, monetary policy can affect stock prices in two ways. First, when the Fed lowers interest rates, the return on bonds (an alternative asset to stocks) declines and investors are likely to accept a lower required rate of return on an investment in equity (k e ). The resulting decline in k e would lower the denominator in the Gordon growth model, lead to a higher value of P 0 and raise the stock prices. Furthermore, a lowering of interest rates is likely to stimulate the economy, so that the growth rate in dividends, g, is likely to be somewhat higher. This rise in g also causes the denominator to decrease, which also leads to a higher P 0 and a rise in stock prices. As we will see later on, the impact of monetary policy on stock prices is one of the key ways in which monetary policy affects the economy. Slide 18 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-18 The analysis of stock price evaluation depends on peoples expectations-especially of cash flows. It is difficult to think of any sector in economy in which expectations are not crucial. The most widely used theory to describe the formation of business and consumer expectations is the theory of rational expectations. Slide 19 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-19 In the 1950 and 1960 economists regularly viewed expectations as being formed from past experience only. Expectations on inflation, for example, were typically viewed as being an average of past inflation rates. The view of expectation formation, called adaptive expectations, suggests that changes in expectation will occur slowly over time as past data change. Adaptive expectations have been faulted on the grounds that people use more information than just past data on a single variable to form their expectations of that variable. Their expectations of inflation will almost sure be affected by their predictions of future monetary policy as well as by current and past monetary policy. In addition, people often change their expectations quickly in the light of new information. To meet these objectives to adaptive expectations, John Muth developed an alternative theory of expectations, called rational expectations, which can be stated as follows: Expectations will be identical to optimal forecasts (the best guess of the future) using all available information. Slide 20 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-20 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 Nonetheless, it is important to recognize that if an additional factor is important but information about is not available, an expectation theory that does not take account of it can still be rational. Slide 21 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-21 Formal Statement of the Theory Slide 22 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-22 Rationale Behind the Theory Why do people try to make their expectations match their best guess of the future using all available information ? The simplest explanation is that it is costly for them not to do so The incentives for equating expectations with optimal forecasts are especially strong in financial markets. In these markets, people with better forecasts of the future get rich. The same principle applies to business. Suppose that an appliance manufacturer-say, General electric- knows that interest-rate movements are important to the sale of appliances. If GE makes poor forecasts of interest rates, it will earn less profit, because it might produce either too many appliances or too few. There are strong incentives for GE to acquire all available information to help it forecast interest rates and use the information to make the best possible guess of future interest rates movements. Slide 23 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-23 Implications of the Theory 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 Suppose that interest rates move in such a way that they tend to return to a normal level in future. If todays interest rate is high relative to the normal level, an optimal forecast of the interest rate in the future is that it will decline to the normal level. Rational expectations theory would imply that when todays interest rate is high, the expectations is that it will fall in the future. The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time Slide 24 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-24 While the theory of rational expectations was being developed by monetary economists, financial economists were developing a parallel theory of expectations formation in financial markets. It led to the same conclusion as that of the rational expectation theorists: Expectations in the financial markets are equal to optimal forecasts using all available information. Although financial economists gave their theory another name, calling it the efficient market hypothesis, in fact their theory is just an application of rational expectations to the pricing of stocks and also other securities. The efficient market hypothesis is based on the assumption that prices of securities in financial markets fully reflect all available information. Slide 25 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-25 Efficient Markets Application of Rational Expectations Slide 26 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-26 Efficient Markets (contd) Slide 27 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-27 Efficient Markets Current prices in a financial market will be set so that the optimal forecast of a securitys return using all available information equals the securitys equilibrium return In an efficient market, a securitys price fully reflects all available information Slide 28 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-28 Rationale Slide 29 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-29 Stronger Version of the Efficient Market Hypothesis In an efficient market, all prices are always correct and reflect market fundamentals-items that have a direct impact on future income streams of the securities. This stronger view of market efficiency has several implications in the academic field of finance: -one investment is good as any other because the securities prices are correct. -the securitys price reflect all available information about the intrinsic value of the security. -securities can be used by managers of both financial and nonfinancial firms to asses their cost of capital (cost of financing their investments) accurately and hence the security prices can be used to help them make the correct decisions about whether a specific investment is worth making. Slide 30 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-30 Slide 31 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-31 It is a fact that our brains would not be able to operate without shortcuts. The first thinker who figured it out was Herbert Simon, an interesting fellow in intellectual history. He started out as a political scientist; he was an artificial-intelligence pioneer, taught computer science and psychology, did research in cognitive science, philosophy and applied mathematics and received the Bank of Sweden Prize for Economics in honor of Alfred Nobel. Slide 32 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-32 His idea is that if we were to optimize at every step in life, then it would cost us an infinite amount of time and energy. Accordingly, there has to be in us an approximation process that stops somewhere. You stop when you get a near satisfactory solution. Other way it may take you an eternity to reach the smallest conclusion or perform the smallest act. We are therefore rational, but in a limited way: bounded rational. He believed that our brains were a large optimizing machine that had built-in rules to stop somewhere. Slide 33 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-33 Not quite so, perhaps. It may be not just a rough approximation. For two initially Israeli researchers on human nature, how we behave seemed to be a completely different process from the optimizing machine presented by Simon. The two sat down introspecting in Jerusalem looking at aspects of their own thinking, compared it to rational models, and noticed qualitative differences. Whenever they both seemed to make the same mistake of reasoning they ran empirical tests on subjects, mostly students, and discovered very surprising results on the relation between thinking and rationality. It is to their discovery that we turn next. Slide 34 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-34 Who has exerted the most influence on economic thinking over the past two centuries ? Its not John Maynard Keynes, not Alfred Marshall, not Paul Samuelson and certainly not Milton Friedman. The answer is two non-economists. Daniel Kahneman and Amos Tversky, the two Israeli introspectors and their specialty was to uncover areas where human beings are not endowed with rational probabilistic thinking and optimal behavior under uncertainty. Strangely, economists studied uncertainty for a long time and did not figure out much-if anything, they though they knew something and were fooled by it. Aside from some penetrating minds like Keynes, Knight and Schackle economists did not even figure out that they had no clue about uncertainty-the discussions on risk by their idols show that they did not know how much they dont know. Slide 35 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-35 Psychologists, on the other hand, looked at the problem and came out with solid results. Note that, unlike economists, they conducted experiments, true controlled experiments of a repeatable nature that can be repeated tomorrow if necessary. Conventional economics do not have this luxury as they observe the past and make lengthy and mathematical comments, then bicker with each other about them. Slide 36 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-36 Khaneman and Tversky went in a completely different direction than Simon and stared figuring out rules in humans that did not make them rational-but things went beyond the shortcut. For them, this rules, which are called heuristics, were not merely a simplification of rational models, but were different in methodology and category. They called them quick and dirty heuristics. There is a dirty part: these shortcuts come with side effects, these effects being the biases. This started an empirical research traditionally called heuristics and biases tradition that attempted to catalogue them-it is impressive because of its empiricism and experimental aspects of the methods used. Slide 37 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-37 Since the Kahneman and Tversky results, an entire discipline called behavioral economics and finance has flourished. It is in open contradiction with the orthodox so-called neoclassical economics taught in business schools and economics departments under the normative names of efficient markets, rational expectations and other such concepts. The literature in behavior economics is extremely readable for someone outside psychology, unlike papers in conventional economics and finance. Slide 38 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-38 Economists were not at the time interested in hearing these stories of irrationality: Homo economicus as we said is a normative concept. While they could easily buy the Simon argument that we are not perfectly rational and that life implies approximations, particularly when stakes are not large enough, they were not willing to accept that people were flawed rather than imperfect. But they are. Kahneman and Tversky showed that these biases do not disappear when there are incentives, which means that they are not necessarily cost saving. They were a different form of reasoning, and one where the probabilistic reasoning was weak. Slide 39 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-39 If your mind operates by series of different disconnected rules, these may not be necessarily consistent with each other, and if they may still do the job locally, they will not necessarily do so globally. Consider them stored as a rulebook of sorts. Consider that your brain reacts differently to the same situation depending on which chapter you open to. The absence of a central processing system makes us engage in decisions that can be in conflict with each other. You may prefer apples to oranges, oranges to pears, but pears to apples-it depends on how the choices are presented to you. The fact that your mind cannot retain and use everything you know at once is the cause of such biases. One central aspect of a heuristic is that it is blind to reasoning Slide 40 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-40 Conditions for perfect competition Homogeneous (identical) products - i.e. the presence of perfect substitutes. No firm with a cost advantage - i.e. all firms have identical cost curves. A very large number of suppliers - thus no single producer by varying its output can perceptibly affect the total market output and hence the market price. Free entry into and exit from the industry - ensuring that competition is sustained over time. No transport and distribution costs to distort competition. Suppliers and consumers who are fully informed about profits, prices and the characteristics of products in the market - hence ignorance or 'incomplete information' does not distort competition. Slide 41 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-41 Why are perfectly competitive markets desirable ? In long run firms only make normal profits Firms are allocatively efficient because they produce where the extra benefit of a unit represented by the price the consumers are willing to pay for it---equals the extra cost, P=AC Firms are productively efficient, this is firms produce at the minimum of the average cost curvethis is the lowest possible cost per unit If a firm becomes more efficient than the others it can earn abnormal profit in the short run; there is an incentive for firms to innovate and become more efficient Slide 42 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-42 But Firms may not be able to afford research and development because they do not earn abnormal profits in the long run There is a lack of variety for consumers because the products are not differentiated Slide 43 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-43 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 Technical analysis cannot successfully predict changes in stock prices Slide 44 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-44 Evidence Against Market Efficiency Small-firm effect January Effect Market Overreaction Excessive Volatility Mean Reversion New information is not always immediately incorporated into stock prices Slide 45 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-45 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 Slide 46 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-46 For a long time traders (in financial markets) were totally ignorant of the behavioral research and saw situations were there was with strange regularity a wedge between the simple probabilistic reasoning and peoples perception of things. There were wearing names like I am as good as my last trade effect, the sound-bite effect, the Monday morning quarterback heuristic, and the It was obvious after the fact effect. It was both vindicating for traders pride and disappointing to discover that they existed in heuristics literature as the anchoring, the affect heuristic and the hindsight bias (it makes feel like trading is true, experimental scientific research). The correspondence between the two worlds is shown in the next table. Slide 47 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-47 Slide 48 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 7-48 The lack of short selling (causing over-priced stocks) may be explained by loss aversion The large trading volume may be explained by investor overconfidence Stock market bubbles may be explained by overconfidence and social contagion