MONEY AND BANKING
Prof. Ranjit Dighe
Lecture notes to accompany Cecchetti's Chapter 8 ("Stocks, Stock Markets, and Market Efficiency")
Revised 25-April-2008.

In these notes:
I. The stock market: An introduction
II. The valuation of stocks
III. The efficient-market theory of the stock market

I.  THE STOCK MARKET:  AN INTRODUCTION

Although the stock market is not central to either money or banking, it nevertheless occupies an important place in this course.   A big reason why stocks are always of interest is that they have the highest average return (about 10%) of any class of assets.   The valuation of stocks often draws a key course concept, present discounted value (PDV).  Finally, many of the financial institutions we'll be studying are involved in the stock market.

Stocks, as we learned earlier, are shares of ownership in a company.  A firm's stockholders are the firm's owners.  Stocks are riskier than bonds and other interest-bearing assets not only because their prices fluctuate a lot, but also for this reason:
Legally speaking, stockholders are residual claimants, which means they get paid last, after the firm's bondholders and other creditors, if the firm goes bankrupt.
-- On the other hand, owning stock in a company involves less risk than being the sole owner of a company (say, a small business), because stockholders have limited liability, which means that they cannot lose more than (100% of) their initial investment.  In other words, they cannot be sued or held legally responsible for the company's misconduct or incompetence.

Stocks are normally tracked through stock-market averages or indexes.
-- The Dow Jones Industrial Average is the best known, but far from the most useful.  It's a simple average of the stock prices of just 30 companies (adjusted for stock splits over time).
-- The Standard & Poor's 500 (S&P 500) average is more useful.  It's an average of the stock prices of 500 of the largest U.S. companies, each one weighted according to its market capitalization (value of total shares outstanding).
-- The Wilshire 5000 index, a weighted average of 5,000 U.S. companies (most of the market), is still more comprehensive.

II. THE VALUATION OF STOCKS 

Note well:  stocks do not pay interest.  The returns to stockholders come in the form of dividends (periodic distributions of the company's profits) and (especially these days) capital gains (the profit you make from selling a stock for more than you paid for it).

Stock prices are widely watched and change by the minute. Prices are set through the interactions among the many traders on the various stock exchanges. Because the stock market has a huge number of traders, each one too small relative to the market to influence the price, we can say that the stock market is a competitive market, and stock prices are determined by supply and demand. Traders buy and sell securities based on their estimated valuations of them. But where do those estimated valuations come from?

The value of a stock ultimately depends on the expected future profits of the company.  Profitable companies can pay bigger dividends. 

--> The traditional approach to valuing stocks is as the expected present-day value of the company's future stream of dividends or profits (per share).  Some guesswork is involved here, as we don't know how much those dividends will be in the future or even when (or if) they'll be paid. 

If stocks and bonds carry equal risk, then the PDV of any stock is the present-day value of all future dividend payments associated with the stock. According to fundamental analysis of stock prices (a technique that Warren Buffett says he swears by), the proper price for a stock is its estimated PDV (just as the proper price of a bond is the PDV of all the payments it will be making). The PDV of a stock's entire future dividends is often called the stock's intrinsic value.
-- Many of today's hottest stocks do not currently pay any dividends. If people expected them never to pay any dividends, not even in the distant future, then the PDV's, and hence the "proper" prices, of those stocks would be zero. The fact that stocks like Dell and Microsoft, which do not pay dividends, command high prices on the market suggests that people expect them to start paying dividends sometime in the future.  Then again, even if they pay no dividend or only a small dividend, a share of ownership in a profitable company is a good thing to have.

Using the standard PDV formulas to price stocks is fairly straightforward. The easiest case by far is when the company pays a dividend and is expected to pay that same dividend forever. (This may be a reasonable expectation for a very stable company, like a utility company.) In such cases, the appropriate PDV formula is the consol-bond formula, since a share of stock that pays the same yearly dividend forever is just like a bond that makes the same fixed yearly payment ($FP) forever.   (Recall:  In the consol bond formula -- number [3] on the PDV handout -- the PDV of getting that yearly fixed payment is $FP/i. The only thing different here is the notation -- instead of $FP, we use $D, for dividend.)
-- For a given interest rate i, the PDV (and appropriate price) of a constant-dividend ($D) stock is

$D/i.

To repeat an earlier example: Suppose Minnesota Power stock pays a $2 dividend that is expected to continue forever, and the interest rate is 5%.
--Q: What should the stock's price be?
--A : $2/.05 = $40.

(We can rearrange that equation into another common financial statistic, the price-dividend ratio:
--> (PDVstock )/(Dividend) = 1/i (i.e., price-dividend ratio is 1/i).
-- In the Minnesota Power example, the price-dividend ratio is $40/$2 = $20, which is also equal to 1/i = 1/.05 = $20.)

Other cases are more complex, and different models have been developed to price stocks in those situations.

-- One case that's only a little bit more complex is a stock which pays dividends that are not constant but which grow at a constant annual rate (e.g., 1% per year).  Such a stock will be worth more than just the current dividend payment divided by i, because the total amount of payments is larger.  Fortunately, the sum of the PDV's of those payments converges to a geometric sum:

---- For a given interest rate i, a stock currently paying a dividend of $D, which is expected to grow at an annual rate of g, has an expected PDV (and appropriate price) of

$D*(1+g) / (i - g)

Which of the many interest rates in the economy should we use for i in this case?  This question is important because stocks are a lot riskier than most bonds.  Because people are risk-averse, they generally require a higher return if they are to hold stocks instead of bonds.  That higher return is known as the risk premium on stocks, or the equity premium.
-- So i in these formulas should be either (a) the interest rate on a bond that's just as risky as stocks or (b) a more normal interest rate, like the Treasury bond rate, plus the risk premium for stocks.

Q: Why might the PDV/ intrinsic value approach not be such a good way to price stocks?
A: Because nobody knows for sure what a company's future earnings and future dividends will be. The PDV of a share of a stock, or of any asset whose future returns are not known with precision, is just an estimate, and so the intrinsic value approach is only useful if you can accurately predict the company's future earnings. Most of us can't do that very well ("I don't have a crystal ball.")
-- Additional caveats about the PDV approach to stock pricing:
---- Stocks and bonds do not carry equal risk.  Stocks are riskier, because the amount of the future dividend payments is not fixed (unlike the interest and principal payments on a bond) and because in the event of bankruptcy the firm must pay off its bondholders and other creditors before it can divide up its assets among its stockholders.
---- Even if you know a stock's price is way in excess of its PDV (and hence the stock is overpriced), there is still the possibility of selling the stock at a profit, if you can sell it before the stock-market bubble bursts.  That approach to the market is often called noise trading.  (It's potentially the way to get rich the fastest in the stock market, but it's also very risky, and many more people get burned by this strategy than get rich by it.  A "buy-and-hold" strategy is much safer.)

Although stocks don't pay interest, stock prices are strongly, and negatively, affected by changes in interest rates.  Two roughly equivalent reasons why:
(1)  Stocks and bonds are substitutes. When people look to invest their money, they look at the expected returns of different assets, including stocks and bonds. If the interest rate (i) goes up, then more people will want to buy new bonds that pay those higher interest rates. So more people will buy bonds, and fewer people will buy stocks.  (Stated more properly, an increase in i means that the return on stocks worsens relative to the return on new bonds, so the demand for stocks will decrease, and stock prices will fall.)
(2)  In the long term the appropriate price of a share of stock is the PDV of the company's future stream of earnings per share, and since a rise in i lowers the PDV of any and all future payments, then it lowers the PDV of all stocks.  (This reason may look totally different from [1], but it isn't, since the market interest rate i in the denominator of the PDV formula represents the interest you could be earning.  For stocks and other investments, that interest rate is like your opportunity cost.)

Summing up:  How changes in interest rates affect stock prices

Stock prices, like old bond prices, are negatively related to the current interest rate.
 
If i goes up -> more people buy new bonds; demand for stocks falls -> stock prices fall.
If i goes down -> fewer people buy new bonds; demand for stocks rises -> stock prices rise.

Since stocks are typically sold at some point rather than held forever, there are valuation models that include the stock's expected sale price at some later date.

-- If the stock is to be sold at the end of the year, then its price now would be the PDV of dividends in the first year, plus the expected resale price of the stock at the end of the year.
-- If the stock is to be sold n years from now, then its price now would be the PDV of dividends in the first n years, plus the PDV of the stock's expected resale price n years from now.

Whichever model one uses to estimate appropriate valuations of stocks, those estimates will tend to be volatile, because they will change whenever the interest rate (i, part of the denominator in every PDV term) changes or as new information that would affect future dividends or earnings becomes available. Small changes in interest rates or estimated profit growth can mean large changes in stock valuations, and hence prices. Even day to day, then, the stock market is often volatile.

The fundamental-analysis (or intrinsic-value) approach is not the only approach to stock valuation.
-- Technical analysis involves trying to identify trends and patterns in the market and then take advantage of them.  (It doesn't seem to have a great track record.)
-- The behavioral approach to investing focuses on investor psychology, especially as it may relate to irrational waves of optimism and pessimism that may sweep the market.  "Noise traders" who can recognize psychology-driven market fluctuations can make out quite well.  A good example seems to be John Maynard Keynes, the founding father of macroeconomics.

III.  THE EFFICIENT-MARKET THEORY OF THE STOCK MARKET

The efficient-market hypothesis (or theory) says the stock market as a whole does the best job possible in valuing and pricing stocks. The market acts rationally, says the theory, using all available, relevant information and leaving no profit opportunity unexploited. This would imply that strategic stock picking is pointless, because the market has already priced every stock appropriately, given the current information.

The efficient-market theory is an application of a theory that has been extremely influential in macroeconomics over the past thirty years, namely--

The theory of rational expectations: Expectations will be identical to optimal forecasts (the best guess of the future) using all available information.
--Example: Your expectations of today's weather (which inform your choice of what to wear, etc.) are not rational if they're based on the guess that today's weather will be like yesterday's, or a hasty look outside. Rational expectations of the weather would involve listening to or reading a top-quality forecast by a professional meteorologist.
---- (If you didn't have time to listen to the weather on the radio this morning, it might have been a rational decision, if you had something better to do, but you will not have rational expectations of the weather. This goes to a key reason why people do not always have rational expectations - obtaining all the relevant, available information can be costly or inconvenient.)

In financial markets, people want to get rich, so they should follow all the relevant economic and financial series, read the company reports, and do whatever else is necessary to maximize one's (risk-adjusted) returns in the market. If enough traders in the stock market do this, then every stock's price will be rationally determined, and the prices of stronger stocks will be bid up and the prices of weaker stocks bid down, to the point where the expected return on every stock will be the same! At that point, a person looking for stocks to buy need not do any research of his own; he can just free ride on the wisdom of the other traders. In fact, he might as well make his picks by throwing darts at the newspaper stock listings...

News flash (a true story):
A Swedish newspaper gave $1,250 each to five stock analysts and a chimpanzee named Ola, to test who could make the most money on the market in a one-month period. Ola the chimp, who made his choice of purchases by throwing darts at the names of companies listed on the Stockholm exchange, won the competition.

A fluke? Maybe, maybe not.
-- For years, the Wall Street Journal did this every month, enlisting four Wall Street stock experts to pick one stock apiece, and then having someone throw darts four times at the paper's stock listings. After six months they'd compare the average returns on the four stocks the experts picked versus the four stocks the darts hit. Very often, the "dartboard portfolio" won; almost always it beat at least one or two of the pros' picks.

These kinds of studies are often conducted and reviewed by economists, too, somewhat more systematicallly.

The EFFICIENT-MARKET THEORY OF THE STOCK MARKET:  Stock prices reflect all available, relevant information.  When it comes to prices, the stock market is efficient in that "you get what you pay for" -- stock prices of the companies with the best prospects will be bid up to high levels, and stock prices of companies with weak prospects will be bid down to low levels.  Because the return on a stock is inversely related to what one pays for it, the returns on different companies will tend to be the same.  Corollaries:
-- You can't outguess the market.
-- Systematically "beating the market" (outperforming the market averages) is practically impossible.

According to the efficient-market theory, you'd be best advised to follow a PASSIVE INVESTMENT STRATEGY: Switch to index funds (mutual funds that simply track a stock-market average, rather than being actively managed), and hold them over a very long time period (a buy-and-hold, not buy-and-sell, strategy).

Q: Is the efficient-market theory of the stock market just a silly theory?
A: NO! It's supported by hundreds of empirical studies.  (Caveat:  some other studies go against it.  More on them later.)
-- FACT: The S&P 500 index outperformed over 2/3 of professionally managed portfolios for the decades of 1970s, 1980s, and 1990s. In nine of 13 years (1984-96), the S&P 500 index outperformed the majority of mutual funds. Over the 1990s, the S&P index has had a total return of 312 percent -- one-fourth greater than the average domestic stock fund.
---- Notably, the indexes have outperformed the managed portfolios both when the market was doing poorly (the '70s) and when the market was doing great (the '80s and '90s.)

Q: Why do most mutual funds do so badly relative to the market? They're run by smart people, aren't they?
A:
(1) Capital gains taxes -- when a mutual fund sells stock at a profit, it gets taxed on those gains; if you buy stock and just hold it as its price appreciates, you don't pay taxes.
(2) Transactions costs -- Buying and selling stocks means incurring brokerage or trading fees. Buying and holding stocks does not involve any transactions costs.
(3) Over-managing, due to perverse incentives? -- pressures for short-term successes and to "look busy" in order to justify their fees. Also, since every managed fund wants to "beat the market," they often try to time the market -- i.e., be in when the market's soaring, be out when it's stagnant or hurting -- and it's much easier to lose money than to make money that way. Peter Lynch: "Far more money has been lost by investors preparing for corrections than has been lost in the corrections themselves."

What most of the mutual-fund houses have to say about index funds:
(1) They're un-American. Trying to "beat the market" is the "American dream." (Huh?)
(2) They point to the success of the funds that did beat the market.

[At about this point in the lecture I conducted the Eco 340 coin-tossing competition. It was inspired by a metaphor that efficient-market-theorist Burton Malkiel proposed for the following metaphor for the great mutual-fund success stories:]
-- Imagine a coin-tossing contest with 1000 people. "The contest begins, and [they all] flip coins. Just as would be expected by chance, 500 of them flip heads, and these winners advance to the second stage of the contest and flip again. As might be expected, 250 flip heads. Operating under the laws of chance, there will be 125 winners in the third round, 62 in the 4th, 31 in the 5th, 16 in the 6th, and 8 in the 7th.
-- By this time, crowds start to gather to witness the surprising ability of these expert coin tossers. The winners are overwhelmed with adulation. They are celebrated as geniuses in the art of coin tossing -- their biographies are written, and people urgently seek their advice. After all, there were 1,000 contestants, and only eight could consistently flip heads."
----> POINT/ANALOGY: The big stock-market success stories are perfectly consistent with the laws of chance.
Are today's mutual fund managers who beat the market several years in a row geniuses, or just lucky?  Given the thousands of mutual funds out there, luck surely explains many, if not all, of those success stories.

Moreover, even the most successful ones always issue the disclaimer, "Past performance is no guarantee of future performance." In fact, empirical tests of the efficient-market hypothesis typically find the top-ranked funds from one period generally earn only average returns in the next period. So market-beating funds have a tendency to fall to earth.

One objection:  Just because the repeated success of a (very) few individuals is consistent with the laws of chance doesn't mean it's explained by the laws of chance. Coincidence ain't causality. Talent might plausibly be the explanation, too; and it virtually has to be the explanation for such giants as Peter Lynch (Wall Street legend who ran Fidelity's Magellan Fund for the 20-plus years that it did beat the market and everybody else) and Warren Buffett, who still runs Berkshire Hathaway.
-- On the other hand, Peter Lynch has retired (at age 47!) from active fund management, as have many of the other giants of the 1980s; and Berkshire Hathaway is a closed-end fund whose shares tend to sell for a big markup over their Net Asset Value (and they are priced so that a single share costs tens of thousands of dollars!).

Evidence in favor of the efficient market hypothesis:  A summing up:

Evidence against the efficient-market hypothesis

Although hundreds of empirical studies have been supportive of the efficient-market theory, most were largely conducted fairly early in the life of the theory (1970s, 1980s, early 1990s). More recent studies have been somewhat less favorable.  The recent studies do not prove that the stock market is usually inefficient, but they do reveal several anomalies in stock-price behavior that seem inconsistent with the efficient-market theory:
 Taking stock of the efficient-market hypothesis

Clearly this evidence is mixed and the studies are controversial, but the efficient-market theory still seems "a good starting point" for understanding stock prices. At heart, the theory isn't too different from the PDV-based approaches to valuing stocks at the beginning of this unit. But there are too many exceptions, most notably the market's excessive volatility, to make the efficient-market theory the last word in understanding stock prices. Perhaps the stock investors with rational expectations don't control enough shares to drive all stock prices to their appropriate levels?
-- (Of note: For the bond market, the efficient-market theory looks very convincing.  There's much less uncertainty in the bond market than in the stock market.)

The impact of the efficient-market view is also mixed, but has been on the rise since at least the early 1990s. The tech boom and bust may have derailed it a bit, but index funds are still very popular.  Clearly the investing public has gradually become fond of index funds:  Vanguard's S&P-500 index fund became the country's second-largest mututal fund in the late 1990s.  The largest mutual fund company (Fidelity) introduced several index funds in the 1990s, in order to keep up with the competition, and numerous other mutual-fund houses introduced index funds of their own. 

Application: Practical guide to investing in the stock market
-- How valuable are published reports by investment advisers? Not.
-- Should you be skeptical of hot tips? Yes.
-- In three words, what should a smart investor do?  Buy and hold.
(All three of these answers follow straight from the efficient-market theory, which is, of course, controversial. But, empirically speaking, they all seem to work.)