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FNCE 3020 Financial Markets and Institutions

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  1. FNCE 3020Financial Markets and Institutions Lecture 7 Topics: Expectations and Financial Markets Forecasting Financial Asset Prices The Efficient Market Hypothesis

  2. Objectives for This Lecture Series • To discuss the role of expectations in financial markets. • Affecting asset prices and decisions of people in the financial markets. • To introduce you to the concept of market efficiency (the Efficient Market Hypothesis). • To introduce you to two basic approaches to forecasting financial asset prices. • Fundamental analysis • Technical analysis

  3. The Role of Expectations • Expectations play a critical role in financial markets. Here are some examples: • Expectations about inflation affect • Interest rates in the bond market. • Central Bank actions, such as the FOMC's vote on a federal funds rate target • Expectations about interest rates affect • The term structure of interest rates, i.e. the slope of the yield curve • The movement stock and bond prices and foreign exchange rates. • Expectations about future economic activity affect • Bond and stock prices. • Expectations about future profitability affect • Stock prices

  4. Adaptive Expectations Model • Prior to the 1960s, most economists assumed that economic participants formed adaptive expectations. • That is, their expectations about a variable were based on past values of that variable, and they changed slowly over time. • However, there were a couple of problems with this model of expectations: • A variable may be affected by many other variables, so people will likely use all relevant data in forming an expectation about a variable. • Expectations can change very quickly if the environment also experiences sudden, large changes.

  5. Rational Expectations Model • A more realistic model of expectations, called rational expectations, replaced adaptive expectations. • Rational expectations are formed using all available information to make the best forecast possible (known as the optimal forecast). • However, since it is still a forecast, it could be wrong, and will be if expectations are turn out to be incorrect. • Applying the theory of rational expectations to financial markets produces the efficient markets theory. • The efficient markets theory assumes that asset prices reflect all available information. • Based upon available information, the market forms its expectations and sets prices accordingly.

  6. Efficient Market • The efficient markets theory states that security prices are a reflection of the market fundamentals. • The fundamentals are variables that directly impact the future cash flow of a security and include information about the company, its product, and economic conditions. • One key implication of the efficient markets theory is that over time it will be almost impossible to "beat the market." • This means that we should not see any one group or person earning returns in a financial market that are consistently above average stock returns (the market return). Since prices already reflect all available information, using this information to predict asset prices will be worthless. • Thus it is impossible to predict asset prices, since it is impossible to predict “unanticipated” information.

  7. Impact of Unanticipated Information • Unanticipated Good Information = $25.00 • EMH Asset Price = $20.00 • Unanticipated Bad Information = $15.00 • Issue: How does one “predict” unanticipated information. • Answer: You can’t; thus you can’t beat the EMH market.

  8. Krispy Kreme and the Efficient Market Hypothesis? • Founded in 1937, the company went public (IPO) on April 5, 2000 and traded on NASDAQ. • The company listed on the NYSE on May 17, 2001. • The company sells over 7.5 million doughnuts a day. • Monday, November 22, 2004: • Krispy Kreme announced its quarterly earnings for the three months ending October 31. • Analysts had expected Krispy Kreme to earn 13 cents per share, • Instead, the company announced its first quarterly loss since going public in 2000. • Losses for the three months ending Oct. 31 were $3 million, or 5 cents per share, down from a profit of $14.5 million, or 23 cents per share, a year earlier.

  9. Krispy Kreme: Monday, November 22, 2004; Reaction to Bad Information

  10. Evidence Against Efficient Markets • Starting in the 1970s, researchers discovered some return patterns in the stock market that are inconsistent with efficiency. • Essentially researchers tested for abnormal returns (i.e., higher/lower than what one would expect) • These “return” inconsistencies are referred to as anomalies, and provide some evidence that the stock market is not perfectly efficient. • These anomalies include: • Small firm effect • January effect • Over-reaction effect • Market volatility

  11. Small Firm Effect • 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. • These included the possibility of an inappropriate risk measurement for small firms. • 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.

  12. January Effect • The January effect is the tendency for stocks to post large returns in January (over December) and to have done this over long periods of time. • Since the effect has been predictable, it is inconsistent with the efficient market hypothesis. • While the January 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.

  13. Excess Market Volatility • Another anomaly is the occurs when stock prices fluctuate much more than the fundamentals behind them fluctuate. • On October 19, 1987, the stock market plunged with what was the largest one-day point loss in history for the Dow Jones Industrial Average (507.99 points, or 22.6% of the index value). • Could such a large one-day loss be reconciled with efficient markets? • The were several factors justifying lower stock prices at the time: widening federal budget, trade deficits, legislation against corporate takeovers, rising inflation, and a falling dollar. However, none of these fundamentals experienced such a dramatic one-day change as to precipitate the decline. • Most economists conclude that this episode is evidence that investor psychology plays a role in stock prices along with the fundamentals.

  14. Over Reaction Effect • A final anomalyis theover-reaction of stock prices to news (good or bad) and that the resulting pricing errors are correctly only slowly. • Studies show the stock prices plunge in response to bad earnings reports, only to creep back upward the following weeks. • This violates the efficient market as investors could earn abnormally high returns from investing in companies immediately after a bad earnings report.

  15. Nike and the Overreaction Effect • Thursday, November 18, 2004  • Near the close of the market (just before 4:00) the company announced that Philip H. Knight, co-founder of Nike (NYSE: NKE) Inc., was stepping down as president and chief executive officer of the company.

  16. Close Day Before $85.99 (11/17) Close Day Of $85.00 (11/18) % change* -1.2% Close the Day After: $82.50 (11/19) % change* -4.1% Close 7 Days After $86.55 (12/1) % change** = 4.9% Note: * = % change from close day before announcement. ** = % change from second day. Movement of Nike Stock

  17. Forecasting Asset Prices • There are essentially two types of methods which forecasters used to “estimate” the future price of a financial asset. • Fundamental Analysis. • Technical Analysis (Charting). • Both of these approaches are at odds with the Efficient Market Hypothesis assuming that one cannot beat the market.

  18. Approaches to Forecasting • Fundamental Analysis: • Uses economic and financial data upon which to base the calculation of the appropriate price of a financial asset. • For example, for common stock, the analysis would: • Estimate future earnings per share, future dividends per share and future stock prices on the basis of: • Examining financial statements • New product developments, • Competition, • Relevant macro economic data which may have an impact on the company’s performance • Warning flags (litigation, change in management, product recalls).

  19. Fundamental Analysis • Fundamental Analysis: • Historically this is the approach most used by financial analyst. • Popularized by Graham and Dodd (1934, Security Analysis). • They argued that investors should buy stocks in corporations that have undervalued assets relative to their true market value, or • current assets exceeding current liabilities, • low price/earnings ratio. • Popular fundamental approach today is use of price earnings (i.e., p/e) ratios in forecasting a stock’s future price. • Analysis will estimate future earnings (per share) and then attach a P/E ratio to that estimate.

  20. Price Earnings Formula • This fundamental approach assumes that the future value (price) of a firm’s stock can be estimated by multiplying the firms expected earnings per share by some multiplier, which is either the: • (1) average industry P/E or • (2) company’s historical P/E • Future Price = EPS x P/E • Assume: • Expected future earnings for firm = $1.25 • Historical P/E = 25 • The calculated appropriate price = $1.25 x 25 = $31.50

  21. Technical Analysis • Technical Analysis of Common Stock • This approach is NOT interested in a company’s financial statement data or in economic data that may affect the company. • Looks at charts of past stock price movements to estimate where stock price may move in the future. • Assumes stock prices are not random • That patterns of prices develop and can be used to forecast the future. • Approach is applied to individual stocks or to the market as a whole. • The approach is also applied to other financial assets, such as foreign exchange.

  22. Two Types pf Technical Patterns • Moving Average Analysis • Where is the individual stock (or market) in relation to some moving average of past prices? • If breaking above, this is a sign of strength. • If breaking below, this is a sign of weakness. • Overbought and Oversold Analysis • Is the individual stock (or market) trading above or below its historical range? • Above its range suggests overbought condition. • Stock (or market) should move down. • Below its range suggests oversold condition. • Stock (or market) should move up.

  23. Moving Average: DJIA Over the Last 6 Months

  24. Moving Average: Google Over the Last 6 Months

  25. Overbought or Oversold Market: The DJIA with Trading Bands

  26. Overbought or Oversold Market: Google with Trading Bands

  27. Source of Technical Charts • Data for individual stocks: • http://finance.yahoo.com/q?s=goog • For charts of individual stocks and the market: • http://finance.yahoo.com/q/bc?s=goog&t=1d • For interactive charts of individual stocks and the market: • http://finance.yahoo.com/charts#chart1:symbol=goog;range=1d;indicator=volume;charttype=line;crosshair=on;logscale=off;source= • Data for U.S. market and overseas markets • http://finance.yahoo.com/intlindices?u

  28. Three Forms of The Efficient Market Hypothesis • There are actually three stages of the EMH model: • Weak Form: Current prices reflect all past price and past volume information. • The fundamental information contained in the past sequence of prices of a security is fully reflected in the current market price of that security. • Semi-strong Form: Current prices reflect all past price and past volume information AND all publicly available information. • Information such as interest rates, earnings, inflation, etc. • Strong Form: Current prices reflect all past price and past volume information, all publicly available information publicly available information AND all private (e.g., insider) information.

  29. Forecasting asset prices within the 3 Types of Efficient Markets: • Weak form: In this type of a market, all past data and prices are reflected in the current prices. • Thus, Technical Analysis is not of any use. • Semi strong form: In this type of a market, all public information is reflected in the current stock prices. • Thus, here, even Fundamental Analysis is of no use (as well as technical analysis) • Strong form: In this type of market, all information is reflected in the current stock prices. • Thus, not only is any kind of analysis useless, even insider information is useless for predicting future stock market prices.

  30. FNCE 3020Financial Markets and Institutons Lecture 7 (Appendix) The Efficient Market Hypothesis

  31. Efficient Market Hypothesis • Accoridn to the Efficient Market Hypothesis, the prices of securities in financial markets fully reflect all available information. • The model assumes that the market makes an optimal forecast (“best guess”) of the future price using all available information. • This is called Rational Expectations. • This optimal forecast, in turn, represents the expected return on the security. • This is what investors expect to receive given all the information available to them.

  32. How can we Represent the Expected Rate of Return on a Security? • The expected rate of return (expressed as a %) on a security equals • The capital gain on the security (i.e., change in price, or Pet-1 – Pt) plus • Any cash dividends (C), • Divided by the initial purchase price of the security, or: • Where Re is the expected return

  33. Can we Measure the Expected Return? • However, a security’s expected return cannot be observed (i.e., it cannot be calculated). • Why is this the so? • Because the market does not know what future changes in prices or dividends will be. • This is dependent upon information which the market does not yet have. • Thus, we need to devise some way to “conceptualize” the expected return and how it moves, or responds to new information.

  34. Conceptualizing the Expected Return • The EMH assumes that each security has an equilibrium return. • This is the return which equates the quantity of the security demanded with the quantity of the security supplied. • The security’s equilibrium return is determined by the security’s risk characteristics. • Higher risk securities carry a higher equilibrium return. • The EMH assumes that the expected return on a security (Re) will move towards the security’s equilibrium return (R*).

  35. Efficient Market Hypothesis, Deviation from Equilibrium : Re>R* • Assume the expected return (Re) on a security is suddenly greater than the equilibrium return (R*) on that security. • How could this happen? • Any unexpected information which increased the cash flow of the security for the given market price. • We can view this situation in the context of the EMH expected rate of return model, or:

  36. Restoring Equilibrium • If the expected return (Re) is suddenly greater than the equilibrium return (R*), the current price (Pt) must adjust to satisfy equilibrium, or in this case the current price will rise: • And will do so, until Re = R* • As the price rises, the expected return will fall.

  37. Efficient Market Hypothesis, Deviation from Equilibrium : Re<R* • Assume the expected return (Re) on a security is suddenly less than the equilibrium return (R*) on that security. • How could this happen? • Any unexpected information which decreased the cash flow of the security for the given market price. • We can view this situation in the context of the expected rate of return model, or:

  38. Restoring Equilibrium • If the expected return (Re) is suddenly less than the equilibrium return (R*), the current price (Pt) must adjust must adjust to satisfy equilibrium, or in this case the current price will fall: • And will do so, until Re = R* • As the price falls, the expected return will rise.

  39. Unexploited Profits • According to the EMH, all unexploited profit opportunities (defined as expected returns greater than equilibrium returns) will be eliminated through price changes. • Prices will rise or fall so that expected returns will adjust to equilibrium return. • Conclusion: • You can’t beat the market. • When new information affecting the expected return becomes public, prices will adjust. • Unless you have “expected return” information that the rest of the market doesn’t have, you can’t take advantage of this market move.