CASE
On October 19, 1987, dubbed “Black Monday,” the Dow Jones Industrial Average declined more than 20%, the largest one-day decline in U.S. history. The collapse of the high-tech companies’ share prices from their peaks in March 2000 caused the heavily tech-laden NASDAQ index to fall from about 5,000 in March 2000 to about 1,500 in 2001 and 2002, for a decline of well over 60%. These stock market crashes have caused many economists to question the validity of the efficient market hypothesis. They do not believe that an efficient market could have produced such massive swings in share prices. To what degree should these stock market crashes make us doubt the validity of the efficient market hypothesis?
Nothing in the efficient market hypothesis rules out large changes in stock prices. A large change in stock prices can result from new information that produces a dramatic decline in optimal forecasts of the future valuation of firms. However, economists are hard pressed to come up with fundamental changes in the economy that can explain the Black Monday and tech crashes. One lesson from these crashes is that factors other than market fundamentals probably have an effect on asset prices. Indeed, as we will explore in Chapters 7 and 8, there exist good reasons to believe that there are impediments to financial markets working well. Hence these crashes have convinced many economists that the stronger version of the efficient market hypothesis, which states that asset prices reflect the true fundamental (intrinsic) value of securities, is incorrect. They attribute a large role in determination of asset prices to market psychology and to the institutional structure of the marketplace. However, nothing in this view contradicts the basic reasoning behind the weaker version of the efficient market hypothesis—that market participants eliminate unexploited profit opportunities. Even though stock mar- ket prices may not always solely reflect market fundamentals, as long as stock market crashes are unpredictable, the basic lessons of the efficient market hypothesis hold.
However, other economists believe that market crashes and bubbles suggest that unexploited profit opportunities may exist and that the efficient market hypothesis might be fundamentally flawed. The controversy over the efficient market hypoth- esis continues.
15Surveys of this field can be found in Hersh Shefrin, Beyond Greed and Fear: Understanding of Behavioral Finance and the Psychology of Investing (Boston: Harvard Business School Press, 2000); Andrei Shleifer, Inefficient Markets (Oxford: Oxford University Press, 2000); and Robert J. Shiller, “From Efficient Market Theory to Behavioral Finance,” Cowles Foundation Discussion Paper No. 1385 (October 2002).
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As we have seen, the efficient market hypothesis assumes that unexploited profit opportunities are eliminated by “smart money.” But can smart money domi- nate ordinary investors so that financial markets are efficient? Specifically, the effi- cient market hypothesis suggests that smart money sells when a stock price goes up irrationally, with the result that the stock falls back down to what is justified by fundamentals. However, for this to occur, smart money must be able to engage in short sales, in which they borrow stock from brokers and then sell it in the market, with the hope that they earn a profit by buying the stock back again (“covering the short”) after it has fallen in price. However, work by psychologists suggests that people are subject to loss aversion: That is, they are more unhappy when they suffer losses than they are happy from making gains. Short sales can result in losses way in excess of an investor’s initial investment if the stock price climbs sharply above the price at which the short sale is made (and these losses have the possibility of being unlimited if the stock price climbs to astronomical heights). Loss aversion can thus explain an important phenomenon: Very little short selling actually takes place.
Short selling may also be constrained by rules restricting it because it seems unsa- vory that someone would make money from another person’s misfortune. The fact that there is so little short selling can explain why stock prices sometimes get over- valued. Not enough short selling can take place by smart money to drive stock prices back down to their fundamental value.
Psychologists have also found that people tend to be overconfident in their own judgments (just as in “Lake Wobegon,” everyone believes he or she is above aver- age). As a result, it is no surprise that investors tend to believe they are smarter than other investors. These “smart” investors not only assume the market often doesn’t get it right but also are willing to trade on the basis of these beliefs. This can explain why securities markets have so much trading volume, something that the efficient market hypothesis does not predict.
Overconfidence and social contagion provide an explanation for stock market bubbles. When stock prices go up, investors attribute their profits to their intelli- gence and talk up the stock market. This word-of-mouth enthusiasm and the media then can produce an environment in which even more investors think stock prices will rise in the future. The result is then a so-called positive feedback loop in which prices continue to rise, producing a speculative bubble, which finally crashes when prices get too far out of line with fundamentals.16
The field of behavioral finance is a young one, but it holds out hope that we might be able to explain some features of securities markets’ behavior that are not well explained by the efficient market hypothesis.
16See Robert J. Shiller, Irrational Exuberance (New York: Broadway Books, 2001).
S U M M A R Y
1. The efficient market hypothesis states that current security prices will fully reflect all available informa- tion because in an efficient market, all unexploited profit opportunities are eliminated. The elimination of unexploited profit opportunities necessary for a financial market to be efficient does not require that all market participants be well informed.
2. The evidence on the efficient market hypothesis is quite mixed. Early evidence on the performance of investment analysts and mutual funds, whether stock prices reflect publicly available information, the random-walk behavior of stock prices, or the suc- cess of so-called technical analysis, was quite favor- able to the efficient market hypothesis. However, in
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recent years, evidence on the small-firm effect, the January effect, market overreaction, excessive vola- tility, mean reversion, and that new information is not always incorporated into stock prices suggests that the hypothesis may not always be entirely cor- rect. The evidence seems to suggest that the efficient market hypothesis may be a reasonable starting point for evaluating behavior in financial markets, but it may not be generalizable to all behavior in financial markets.
3. The efficient market hypothesis indicates that hot tips, investment advisers’ published recommenda- tions, and technical analysis cannot help an inves- tor outperform the market. The prescription for investors is to pursue a buy-and-hold strategy—pur- chase stocks and hold them for long periods of time.
Empirical evidence generally supports these implica- tions of the efficient market hypothesis in the stock market.
4. The existence of market crashes and bubbles has convinced many financial economists that the stron- ger version of the efficient market hypothesis, which states that asset prices reflect the true fundamen- tal (intrinsic) value of securities, is not correct. It is far less clear that stock market crashes show that the efficient market hypothesis is wrong. Even if the stock market were driven by factors other than fun- damentals, the crashes do not clearly demonstrate that many of the basic lessons of the efficient market hypothesis are no longer valid as long as the crashes could not have been predicted.
5. The new field of behavioral finance applies concepts from other social sciences, such as anthropology, sociology, and particularly psychology, to under- stand the behavior of securities prices. Loss aversion, overconfidence, and social contagion can explain why trading volume is so high, stock prices get overval- ued, and speculative bubbles occur.
arbitrage, p. 160
behavioral finance, p. 171 bubbles, p. 170
efficient market hypothesis, p. 158
January effect, p. 165 market fundamentals, p. 170 mean reversion, p. 166 random walk, p. 162
short sales, p. 172
theory of efficient capital markets, p. 158
unexploited profit opportunities, p. 160
K E Y T E R M S
Q U E S T I O N S
1. “Forecasters’ predictions of inflation are notoriously inaccurate, so their expectations of inflation cannot be optimal.” Is this statement true, false, or uncer- tain? Explain your answer.
2. The efficient market hypothesis is often referred to in financial markets. To test this hypothesis, which states that prices of securities fully reflect all avail- able information, market participants eliminate unex- ploited profit opportunities. Explain what the market participants are referring to. How are they benefitting from it? Does the efficient market hypothesis, and optimal forecast, apply to this situation?
3. If a forecaster spends hours every day studying data to forecast interest rates, but his expectations are not as accurate as predicting that tomorrow’s interest rates will be identical to today’s interest rates, are his expectations optimal?
4. “If stock prices did not follow a random walk, there would be unexploited profit opportunities in the market.” Is this statement true, false, or uncertain?
Explain your answer.
5. Suppose that increases in the money supply lead to a rise in stock prices. Does this mean that when you see that the money supply has had a sharp rise in the past week, you should go out and buy stocks? Why or why not?
6. Sarah is an avid reader of Smart Investing magazine that provides the latest news and trends in the stock market. Based on the most updated information, it is advisable to sell the technology stocks. Discuss.
7. Stuart’s stockbroker has called him up to advise him to buy the real estate stocks as there has been a prop- erty boom in Manhattan recently. The broker has an excellent track record. Advise Stuart.
8. What do you understand by optimal expectation?
If Sally had optimal expectation on the decreased prices of the airline stocks due to recent plane crashes worldwide, how accurate is her assumption?
9. Suppose that you have been observing the financial markets for a while and have decided to buy shares of a bank. You have information regarding Alfa Bank, which has not been performing well during
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the last two years. Today you read that Alfa’s CEO has resigned and a new CEO, Jeremy Anderson, is in charge. You are aware that he was a successful leader of an international bank, has quite a lot of experience, and a good reputation in the industry. Based on this piece of news, what decisions will you make? What theories may influence your decisions?
10. A colleague at Ethan’s workplace does not believe in the efficient market hypothesis. How can Ethan convince them otherwise?
11. If higher money growth is associated with higher future inflation and if announced money growth turns out to be extremely high but is still less than the mar- ket expected, what do you think would happen to long-term bond prices?
12. Tessa is an avid follower of the technical analysis method. How can she convince her friends to use this method of stock investing?
13. Financial crises outlined some issues, which were not really covered in financial text-books. For instance, we observed so called “herd” behavior from investors, which is not normal according to academic knowl- edge in finance. The situation could be explained by using so called behavioral finance subject. What is an idea behind behavioral finance? Why is an additional theory required to explain market bubbles?
14. Suppose that you work as a forecaster of future monthly inflation rates and that your last 6 forecasts have been off by minus 1%. Can you say that your expectations are optimal?
Q U A N T I T A T I V E P R O B L E M S
1. Verizon Wireless has just announced a 2-for-1 stock split, effective immediately. Prior to the split, Verizon Wireless had a market value of $10 billion with 200 million shares outstanding. Assuming that the split conveys no new information about the company, what is the value of the company, the number of shares outstanding, and price per share after the split? If the actual market price immediately follow-
ing the split is $34.00 per share, what does this tell us about market efficiency?
2. If the public expects the Microsoft Corporation to increase $10 a share this quarter and it actually increases $6, which is still one of the largest gains in the history of the company, what does the efficient market hypothesis say will happen to the price of the stock when the $6 increase is announced?
W E B E X E R C I S E S
The Efficient Market Hypothesis
1. Visit http://research.stlouisfed.org/fred2/. Click on “Category,” then “Financial Indicators,” then
“Stock Market Indexes.” Review the indices for the DJIA, the S&P 500, and the Wilshire 5000 Market Index. Which index appears most volatile? In which index would you rather have invested in 1985 if the investment had been allowed to compound until now?
2. The Internet is a great source of information on stock prices and stock price movements. Go to http://
finance.yahoo.com and in Search Finance enter Dow Jones Industrial Average and click to view cur- rent data on the Dow Jones Industrial Average. Click on “Historical Prices” and change the time range, and observe the stock trend over various intervals.
Have stock prices been going down over the past day, week, three months, and year?
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175
PREVIEW
A healthy and vibrant economy requires a financial system that moves funds from peo- ple who save to people who have productive investment opportunities. But how does the financial system make sure that your hard-earned savings get channeled to those with productive investment opportunities?
This chapter answers that question by providing a theory for understanding why financial institutions exist to promote economic efficiency. The theoretical analysis focuses on a few simple but powerful economic concepts that enable us to explain fea- tures of our financial markets, such as why financial contracts are written as they are, and why financial intermediaries are more important than securities markets for getting funds to borrowers.