© 2008 Pearson Education Canada7.1

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

© 2008 Pearson Education Canada7.2

Common StockCommon Stock

• Common stock is the principal way that corporations raise equity capital.

• Stockholders have the right to vote and be the residual claimants of all funds flowing to the firm.

• Dividends are payments made periodically, usually every quarter, to stockholders.

Three Methods of Three Methods of Valuation/PredictionValuation/Prediction

• 1. Technical Analysis

• 2. Fundamental Analysis

• 3.Rational Expectations Analysis

I. Technical AnalysisI. Technical Analysis

:”Charting” technique

• Trying to identify “deterministic” pattern in historical stock prices

• Stock prices are believed to go through this ‘deterministic’ life cycles

Technical Analysis in the Technical Analysis in the real worldreal world

• What are they? How do they work?http://stockcharts.com/education/TradingStrategies/index.html

• Do they make an economic sense?

- A higher profit with TA than without it.

- At what cost? -Practicality Issue http://www.recognia.com/about/news/2003_01_27.htm

II. Fundamental AnalysisII. Fundamental Analysis

“Accounting” Method1. Basic Premise:

Price-Earnings Ratio gravitates towards a certain Benchmark Value.

The Benchmark Value is just like a Long-Run equilibrium value in economics.

# Does it exist?

2. Investment Strategy 2. Investment Strategy of Fundamental Analysisof Fundamental Analysis

“Pick up Undervalued Stocks”(1) Simplest Method• If P/E ratio < Benchmark P/E, the stock is undervalued: “Buy”• If P/E ratio < Benchmark P/E, the stock is overvalued: “Sell”

(2) Most Complex(Obscure) Methods• John Templeton’s strategy• Warren Buffett’s strategy http://www.investopedia.com/articles/01/071801.asp

3. Stock Price 3. Stock Price

The Gordon Growth Model

P = D/ (r – g)

P: ‘fair’ Stock PriceD: Annual Dividends

r: Discount Rate (=Interest Rate from alternative investment)

g: (Expected) Annual Growth rate of Dividends

4. Price-Earnings Ratio4. Price-Earnings Ratio

P/E Ratio

= Price / Earnings

= (Dividends/Earnings) / (r - g)

* * Numerical ExampleNumerical Example

(Question) Would you buy or sell the following stock?

Actual Price of a Stock = $55Dividends = $1Interest Rate = 5%Annual Growth Rate of Dividends = 3%(Solution) What is the ‘fair price’ of this stock?

Is the actual market price higher or lower?

III. Rational Expectations III. Rational Expectations AnalysisAnalysis

• “There is no mis-priced stock in the market”

• “No known information or deterministic information is useful in predicting a future price change”

• Financial Market is Efficient in Utilizing Information

• All known/expected information has been already reflected in the current price through immediate market actions possibly by those close to information sources: The current price of an asset is the result of market actions based on the known/expected information. No chance for an average investor with public information to make profits

1. Why?: Efficient Market Theorem1. Why?: Efficient Market Theorem

2. Three Versions of 2. Three Versions of Efficient Market TheoremEfficient Market Theorem

Weak Version: past price has no ‘informational’ value, and does not help you predict a future price change

- History does not help predict the future

- Technical analysis is useless

Semi-strong Version: Public information is useless.

Strong Version: No information is helpful

3. What does the Rational 3. What does the Rational Expectations Theory say Expectations Theory say

about the Stock Prices over about the Stock Prices over time?time?

• Current Stock Prices have already incorporated all expected information.

• Any even that has been anticipated does not affect the stock price again.

• Only the event that has not been anticipated affects the stock price.

• Stock Prices respond only to “News” or “Surprise”• News are random, and thus Changes in Stock Price are

Random Walk (not denying the trend of stock price itself).

4. Implications for Investment Strategy4. Implications for Investment Strategy• Long-Term Buy and Hold:

• Short-Term Unpredictability:

You cannot beat the market

“Timing the market” is a bad idea

© 2008 Pearson Education Canada7.16

5. Evidence Against 5. Evidence Against Market EfficiencyMarket Efficiency

• Small-firm effect• January Effect• Market Overreaction• Excessive Volatility• Mean Reversion• New information is not always immediately

incorporated into stock prices

• Chaos and fractals• Inside Trading

Advanced DiscussionAdvanced Discussion“Insider Trading”“Insider Trading”

• According to the EMH, there is no other way of persistently leaping excess returns in the financial market than having access to Inside Information. Trading based on Inside Information is called Insider Trading.

click here for Advanced Discussion

7.17