Economics 134a

1
Economics 134a

• Lecture notes

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Magellan

• Can Lange Pull Magellan Fund Out of Its
  Straits?
• Magellan underperformed SP by about 2 over
  1,3,5,10 years.
• Go to wsj.com, log in (username SantaBarbara,
  password gradstudent), search on Hechinger

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Readers Guide to Malkiel

• A Random Walk Down Wall Street
• A great example of how a smart and sensible
  investors thinks about investing
• Despite the title, Malkiel is NOT an extreme
  efficient-markets guy. Pretty eclectic
• But he views himself as an ECM guy.
• And hes certainly closer to ECM than the
  opposite.

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Most important chapters

• 1,2,6,7,8
• Malkiels basic argument if either technical or
  fundamental analysis worked, everyone would be
  doing it, and it would no longer work.
• His recommendation buy-and-hold.
• Look for stocks that other investors will use to
  build castles in the air
• Index funds (diversification, low management fees)

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Ch. 1. Firm Foundations and Castles in the Air

• First paragraph Many people say that the
  individual investor has scarcely a chance today
  
• In an efficient markets, investment pros have no
  advantage
• Firm Foundation Theory values have a firm
  anchor in intrinsic value
• NPV
• But note hes not saying P NPV always.
• PNPV eventually
• Not particularly a fundamentalist cant
  necessarily identify deviation.

6
Castle-in-the-Air Theory

• Psychological considerations are often important
• Keynes beauty contest

7
Speculative Bubbles

• tulip bulb
• South Sea Bubble
• Mississippi Bubble
• US Stocks in 1920s
• Japanese land, stocks in 1980s
• US Internet/tech stocks in 1990s
• Malkiel does not assert that these were rational.
  His point is that they all ended.

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Problem for Identifying Bubbles

• They occur when its rational to be very
  optimistic
• How do you distinguish?

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Ch. 5. The Firm-Foundation Theory

• An informal exposition of NPV, especially the
  growing-perpetuity formula
• Importance of expected growth rate of earnings
• P-E determined mostly by growth rate of earnings.
• strong positive correlation between growth rate,
  P/E
• see diagram p. 117 (GM, Verizon, IBM, Pfizer,
  Home Depot, Microsoft, eBay
• Look for stocks that will have high earnings
  growth rate, but this hasnt been recognized
• This is Malkiel in his non-ECM mode

10

• Determinant 2 dividend payout rate
• Determinant 3 risk
• Determinant 4 interest rates
• Problem none of these is easy to forecast
• In particular, earnings growth rate forecasts are
  inaccurate
• Earnings growth isnt highly autocorrelated.

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Random Walk Hypothesis

• Rules out technical analysis
• Doesnt rule out fundamental analysis
• Imagine that most investors can see ahead 1
  period, but you can see ahead 2.
• Market is inefficient with respect to the
  information you have!

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Ch. 8 How Good is Fundamental Analysis?

• As with mutual funds, analysts that do well for a
  while dont typically continue to do so.
• forecasts inaccurate
• Conflict of interest!
• Recommendations are overwhelmingly positive
• Manipulation of earnings statements
• pro forma earnings

13
Mutual Funds

• Those that went up the most in 1998-9 went down
  the most in 2000-1.
• What about those claims of success in the past?
• Survivor bias.

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Ch. 11 Potshots at ECM Theory and Why They Miss

• A lot of people dont believe it. Would it occur
  if people dont believe it?
• LTCM picking up loose change or gambling?
• Dogs of the Dow
• January effect
• P/E
• Price-Book

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Roll quote p. 273

• Shiller prices are irrational, but they dont
  produce trading opportunities
• Roll then why are we calling prices irrational?