Stock Markets and Stock Price Determination PDF

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Professor: Mike Shannon...

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Stock Markets and Stock Price Determination Source:

Mishkin and Serletis, Ch. 7 including the Web Appendix on the Efficient Market Hypothesis.

- Common stock: - A share in the ownership of the firm. - Gives owner a claim on profits (shareholders: residual claimants) - entitled to any dividends paid out. - Limited liability: shareholder is not liable for firm's losses (beyond the value they have invested in the stock) - Shareholder has the right to sell the stock; voting rights. - Issuing stock: a way for a business to raise money. - Origins of joint stock companies: pooling savings to finance large capital investments (Dutch sailing ships). - small denominations aid pooling. - Business is borrowing by giving up a ‘share’ of the company. - Investment in stock is equity investment (“equities”).

- Individual investors as stock owners: - can buy individual stocks - can buy shares in an investment fund: fund constructs a portfolio (e.g., mutual funds, ETFs) - Stock prices determined by what the highest bidder will pay. - most transactions are of already issued stock (secondary market).

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The Price (Value) of a Stock: Stocks as Assets - Valuing assets (see Overhead Set 5, textbook Ch. 4): - Assets give a claim to a stream of payments: - Price: P

A1, A2, ...An

(D in earlier overheads)

- equilibrium price:

the level which gives the same return as on other similar assets (i).

e.g. similar riskiness, liquidity, etc. - it is the present value of the stream of payments (discounted by i): 2

1+i¿ ¿ 3 1+i¿ ¿ N 1+i ¿ ¿ ¿ ¿ A A1 + 2 P= (1+i) ¿

- flows of lending between this asset and substitute assets ensures this holds. e.g., Price below the equilibrium level? - the yield is then higher than on similar assets (i) - more people buy the asset (demand rises) - P will rise until it is at the equilibrium level. - Businesses as assets: what is the value of a business to its owner? - Present value of the stream of returns the firm generates. - Returns?

Profits 2

- Define: Profiti = profit in period i.

- Then the value of the firm (call it V): V=

Profit1 + Profit2 + Profit3 + …+ Profitn (1+i) (1+i)2 (1+i)3 (1+i)n

where: - “n” is the last period of the firm’s existence. - “i” is an appropriate return (discount rate), i.e. return on similar assets. - future profits are uncertain: equation is based on expected profits. - “i” will include a risk premium to account for this uncertainty. - Value of a Share: - A share gives part ownership in the firm. - one share means you own: 1/(Total no. of shares) of the firm. e.g. if 1 million shares, own 1 millionth of the firm. - Value (price) of a share (S): S = V/ (Total number of shares)

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- Share pricing discussions often the focus is on “dividends” as the stream of future payments from the share. - Dividend: amount of profits paid out per share. - so value of a share is the present value of expected dividends. - Let A1, A2, ...An be the expected value of dividends in periods 1…N. - Value of a share is then: 2

1+i¿ ¿ 3 1+i¿ ¿ N 1+i ¿ ¿ ¿ ¿ A A1 + 2 S= (1+i) ¿

- note: like profits future 'A' are uncertain now. (equation based on expected A)

- The two expressions for the stock price give the same share price if: - Profits are just paid as dividends. - Then:

A1= Profit1/(No. of Shares), A2= Profit2/(No. of Shares) etc.

- More generally? if the present value of profits paid equals present value of all future dividends paid. e.g., profits reinvested in the firm (not paid as dividends) generates additional dividends in the future. - so time pattern of profits and dividends can differ but their present values may be the same. 4

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- Note: - if a shareholder sells the share at some point in the future (say period m) then the asset equation becomes: 2

1+i¿ ¿ 3 1+i¿ ¿ m 1+i¿ ¿ ¿ ¿ A A1 + ¿2 S= (1+i)

- where Sm is the share price in period m. - Sm will reflect discounted future profits from period m to n (so get the same result as above). (Appendix: Gordon Growth Model – case where dividends grow at a constant rate)

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What determines stock prices according to the asset valuation model? - Value of a Stock reflects: - expectations of future profits (or dividends) - discount rate (i): includes a risk premium since future payments uncertain. - number of stocks issued : how big a share of profits does it entitle the owner of the stock to? Key factors:

Effect on Share Price

Level of the firm’s expected future profits

(+)

Number of stocks outstanding

(-)

Discount rate or required return (includes risk premium)

(-)

- Expected future profits: what lies behind this? - General business conditions: e.g. recession expected: future profits likely lower. - Specific business conditions (specific to industry or firm). - determinants of revenues and costs of the firm. - Discount rate (i): - depends on yields on alternative investments; - characteristics of the stock vs. other assets: risk, liquidity premia incorporated (see text equation (11)).

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Monetary policy and stock prices? - Bank of Canada cuts interest rates: - lowers the return on alternatives to stocks; - equivalently: lowers the discount rate on stocks - stock prices should rise. - Monetary policy can also affect future growth and profits: i.e. lower interest rates, more borrowing and spending, higher profits. - this will also raise stock prices.

- Central banks often respond to sharp falls in the stock market with interest rate cuts. e.g. recent crisis, Black Monday (Oct. 19, 1987).

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Stock Price Indices - Measures of the level of the stock market. - typically based on some average of stock prices. - Examples: Dow Jones Industrial Average: - Based on 30 largest US companies. - Mean of their share prices. i.e. reflects value of a portfolio that includes 1 stock from each of the 30 largest companies. - Oldest index (since 1880s!). Standard and Poor’s 500: - Largest 500 firms in US. - Value-weighted average of stock prices. - weight: $ value of outstanding shares. - Reflects value of a portfolio whose composition reflects relative sizes of largest firms. S&P/TSX Composite Index - Cdn. Version. About 250 firms on the Toronto Stock Exchange (size and trading volume)

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Application: “Dot.com Bubble” - Sharp rise in stock prices and PE ratios 1990s to 2000. - Some regarded it as reasonable at the time. - Some stories told (in terms of asset price model): Glassman and Hassett Dow 36,000: - investor behavior had changed: more sophisticated - view stocks as less risky (more diversification, mutual funds, etc.): smaller risk premium required. - result? They argued that - Discount rate on stocks had fallen (lower i). - Stock prices should rise permanently. High tech / info technology stories: - a “new economy” - higher future profits due to innovation and technology e.g. lots of Amazon.com’s out there! Baby-boomers saving for retirement. - bids up stock prices (lowers i on assets generally).

- Other views: a speculative bubble - A. Greenspan Federal Reserve: “irrational exuberance” - no real change in riskiness of stocks. - high tech boom: competition suggests main benefit will be to customers not higher profits. (More recent applications: The Economist “Are Stock Markets in a Bubble?” March 9, 2017 http://www.economist.com/news/leaders/21718524-it-will-be-hard-satisfy-bothpopulists-and-businesses-are-stockmarkets-bubble ), NY Times Sept. 15, 2017 “Mass Psychology Supports Pricey Stock Market” http://www.shillerfeeds.com/2017/09/masspsychology-supports-pricey-stock.html )

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Speculating on Stocks: Some Views - Much attention on strategies to make money trading stocks. i.e. by anticipating price changes - Expect price rise: buy low, sell high ! - Expect price fall: sell now if own it, “short” it if don’t own it. (short: borrow stock now, sell it at current high price, once price falls buy it and pay back the borrowed stock) - See: G. Mankiw handout: "What stock to buy? Hey Mom don't ask me?"

(1) Fundamental analysis: - Determine the true value of a stock: - true value reflects “fundamentals” - stock prices are rooted in firm profits. - focus on predicting and anticipating future profits, risks. e.g. analyze info on the firm, its markets, its competitors (fundamentals). - Buy if true value > share price. - Sell if true value < share price. i.e. buy before expected rise in profits is priced in. sell before expected fall in profits is priced in. - An early statement of this view in 1934: B. Graham and D. Dodd, Security Analysis. Warren Buffet “Oracle of Omaha” was a student of Graham’s. 11

(2) Technical Analysis or “Chartists”: - A data driven approach. - Look for patterns in historical stock price movements. - idea that patterns reflect past regularities in investor behavior. - patterned behavior gives rise to predictable trends. - Monitor current stock prices for such patterns. - Use historical patterns and current trends to predict future prices. - See regular feature “What the Charts Say” in The Globe and Mail Report on Business. Canadian Society of Technical Analysts. - Example: “head and shoulders” – price reaches the neckline (straight, black line) then price will fall substantially.

- Some claim the approach is linked to “behavioral finance”: - patterns may be rooted in irrational but predictable behavior. - Newer methods: neural networks, chaotic dynamics - also look for patterns in past data for use in predicting future prices. (3) Efficient Markets Hypothesis: (see extended discussion below) 12

Efficient Markets Hypothesis (EMH): - Stock prices reflect present value of future expected profits. - How are these expectations formed? - Efficient Markets view assumes “rational expectations” i.e. expectations will be the “best guess” or “optimal forecast” and will make use of all relevant available information. - Why? Profitable to be accurate. - Investor behavior ensures that stock prices build in relevant current information on future profits. - Say “good news” becomes known: ↑ expected profits. - investors realize the stock price will rise. - Investors buy to profit from the expected price rise. - Extra demand raises the price. - “Good news” is now built into the stock price.

- If new information is not built in investors are not acting rationally. - profits that could be made aren’t; or - (with bad news) losses that could be avoided aren’t. - All or some investors? - actions of specialists or traders (“smart money”) alone may be able to make hypothesis hold. (some disagree) 13

- Some Consequences of the Efficient Markets Hypothesis: (1) Stock prices only change when new information on future profitability becomes known. - old and current information is already built into stock prices.

(2) Future changes in stock prices are unpredictable. - Future new information is unknown now. - So given point (1): can’t predict future price changes. Paul Samuelson (1965): “properly anticipated prices fluctuate randomly” - Stock prices will follow a “random walk”: - Tomorrow’s stock price (S): Stomorrow = Stoday+ e where:

e = random error (reflects effect of new info)

- best prediction of tomorrow’s price is today’s price. - price change is unpredictable (random).

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(3) Explaining successful speculation - Success for those who obtain new information first. - could be an insider, could be the first realize something. - can profit from this new information - Chance /luck: another possible explanation of success. - Apparent success may reflect risk taking (not so successful if adjusted for risk) or fraud (Bernie Madoff) - Generally: future price movements are unpredictable and speculation will not be successful.

(4) Patterns in past prices or yields will not be useful in predicting current prices or yields. - ‘Technical analysis” will be wrong: history is already built into current prices.

(5) EMH is critical of “Fundamental analysis”: - current knowledge of fundamentals is already built into prices. - study of existing info on a firm and its prospects will be of little value in determining future stock prices.

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- What strategies do advocates of “Efficient Markets” typically suggest: - can’t beat the market - speculative strategies will generally be unsuccessful. - can’t pick winners. - Favor “index funds” or equivalents: invest in the average stock value, invest long-term. i.e. don’t pay for “expertise” (avoid high mgt. fees) See for example: B. Malakiel A Random Walk Down Wall Street.

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Evidence on the Efficient Markets Hypothesis: (see text Web Appendix to Ch. 7) For Efficient Markets: - Experts vs. the market: - Wall St. Journal’s Dart board portfolio, San Francisco Chronicle’s Orangutan! i.e. random picks do as well on average as expert choices. - Mutual funds: good past performance does not help predict future strong performance. (see Malakiel (2003) paper on webiste: Exhibit 5-9) (also Malakiel (2011) Exhibits 2,3 – funds vs. benchmarks) - Many studies suggest technical analysis doesn’t outperform the market. - Announcements or publicity regarding already known information do not seem to affect stock prices. - Many studies suggest new information is built in quickly (Challenger disaster) - Random walk prediction: Stomorrow = Stoday+ e - Testing this? - are changes in S related to historical data: shouldn’t be. - are changes related to publicly available information: shouldn’t be. - most studies have supported these predictions.

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- Some claim support for EMH based on the recent crisis: - inability of most to predict the end of bubble: consistent with new information as cause.

- Does information technology enhance financial markets ability to process information? If so markets may be closer to EMH than before.

Against efficient markets (see text, Malakiel, 2011): - Pricing anomalies: - Small firm and January effects: - finding of “abnormally high” returns for small firms over long periods of time. - stock prices experience abnormal rises in January (may be small firms again); - why is this not anticipated? - rational investors should bid up the prices of small firm stocks eliminating the high returns (see Exhibit 2 from Malakiel (2003) ) - January effect: if anticipated, investors should buy more in December eliminating the effect. - Several studies suggest there is short-term “momentum” in stock price movements (successive price changes in same direction) - a predictable pattern inconsistent with EMH

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- “Return reversals” or “mean-reversion”: some studies find that low (high) returns today are associated with higher (lower) future returns. - if correct, this should be anticipated. - How to EMH proponents respond pricing anomalies? - could small firm effect be related to risk? - question how dependable these patterns are over time. - these effects may be too small to be profitably exploited. - evidence that such effects weaken once identified) Richard Roll (Portfolio Manager and economist), cited in Malakiel, 2011: “I have tried to invest my client’s money and my own in every single anomaly and predictive device that academics have dreamed up … and I have yet to make a nickel on any of these … inefficiencies.” - Excessive volatility: - evidence of overreaction, more fluctuations in prices than justified by later variations in profits and dividends. (see Shiller’s data – shouldn’t prices be less volatile than actual profits if prices are optimal forecasts?)

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- Stock market crashes: - Great Crash (Oct. 1929: -25%), Black Monday 1987 (20% fall in 1 day, 30% in 1 week); Tech stock collapse 2000-01. - Can such large changes really reflect new information?

- Successful investors: - Some investors have earned high returns for long periods e.g. Warren Buffett, David Swensen (Yale U. endowment), James Simons (Medallion Fund), Peter Lynch (Magellan Fund) “I’d be a bum on the street with a tin cup if the markets were efficient” Warren Buffett - How would EMH explain this? - luck? (coin flip example) - excessive risk - first to receive new information? - Maybe they are just better than others at analyzing fundamentals? - EMH: why don’t others learn or monitor and copy?

- Or are these investors exploiting predictable patterns? (vs. EMH)

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- Paul Krugman’s (Nobel Prize winner) conclusions on EMH are interesting: He defines EMH: “Rational investors will build all available information into asset prices, so movements in these prices will be driven only by unanticipated events – that is, they’ll follow a random walk, with no patterns you can exploit to make money”

He is critical of EMH: ‘is wrong in detail – there are lots of anomalies.’ ‘anyone who believed that rationality of investors precluded the possibility of massive, obvious mispricing – say, of subprime-backed securities – has not had a happy decade.’

He still thinks it is useful: ‘Yet the broader proposition that asset price movements are unpredictable, that patterns are subtle, unstable, and hard to make money off of, seems to be right. On the whole, it seems to me that considering the implications of rational behavior has done more good than harm to the field of finance.’ ‘ ‘So, rationality is a lie. But in some parts of economics it seems to be a bit of a noble lie, useful as a guide for thinking’ ‘I can think of some reasons why. In financial markets, smart investors can, within limits, arbitrage against the irrationality of others.’ (see New York Times Oct.11, 2017 “Rabbit Holes and Rationality” https://krugman.blogs.nytimes.com/2017/10/10/rationality-and-rabbit-holes/?module=BlogPostReadMore&version=Blog %20Main&action=Click&contentCollection=Opinion&pgtype=Blogs®ion=Body#more41680 )

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- Efficient markets hypothesis is usually discussed in connection stocks - it is widely applicable to financial other speculative markets. - Current prices and yields will reflect all known information affecting borrowing and lending in the market.

- Note on the term "Efficient" in EMH: - not in the "Pareto efficiency" sense (maximize overall surplus from trading). - efficient at processing and acting on information. - welfare implications: efficient prices provide good information - price signals will tend to do a good job directing finance to the high return projects. - financial system will work quite well. - not so if prices are not “efficient”.

-Additional information on the still unresolved EMH debate (see website): B. Malakiel (2011) “The Efficient Markets Hyothesis and the Financial Crisis” see course website (goes through pros and cons) N. Smith Feb. 8, 2013 (Noahopinion blog): interesting perspective – EMH lots of problems but valuable basic insight for individual investor.)

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Behavioural Finance - Questions whether usual economic assumption of rational decision-makers is appropriate in financial economics. - Links to psychology and experimental economics. Kahneman and Tversky -- psychologists. R. Shiller (see bubble model below), R. Thaler another prominent figure. Experiments important (see bubble example below) - Aims: - to identify departures from rationality - identify actual patterns of behavior - explain outcomes - some attempts to build models based on patterns discovered. - Evidence of investor overconfidence, reliance on rules of thumb, loss aversion, herd behavior. - Proponents: greater realism, ability to explain anomalies. - Critics:

collection of observations, no unify...