Efficient Market Or

1
Lecture 1

• Efficient Market Or
• Irrational Exuberance?

2
Random Walk Hypothesis

• The return in each period is an independent
  random draw from a stable distribution.
• One cant predict future returns from past
  returns.
• The distribution of stock returns is stable over
  time.

3
Efficient Market Hypothesis

• Everything that is known about a stock is
  reflected in its current price.
• Prices respond quickly, and on average correctly,
  to new information.
• Changes in stock prices are unpredictable.

4
Irrational Exuberance

• On December 5, 1996 Alan Greenspan used the term
  irrational exuberance to describe the behavior
  of stock market investors.
• Has investor overconfidence bid stock prices up
  to unsustainably high levels?
• Is the recent stock market boom a classic
  speculative bubble?

5
Irrational Exuberance

• Robert Shiller, Irrational Exuberance, Princeton
  University Press, 2000.
• In his 1999 mail questionnaire of a random sample
  of wealthy individuals, Shiller asked the
  following three questions.

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Question 1

• The stock market is the best investment for
  long-term holders, who can just buy and hold
  through the ups and downs of the market.
• - Strongly agree
• - Agree somewhat
• - Neutral
• - Disagree somewhat
• - Strongly disagree

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Question 2

• If there is another crash like October 19, 1987,
  the market will surely be back up to its former
  levels in a couple years or so.
• - Strongly agree
• - Agree somewhat
• - Neutral
• - Disagree somewhat
• - Strongly disagree

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Question 3

• If the Dow dropped 3 tomorrow, I would guess
  that the day after tomorrow the Dow would
• - Increase
• - Decrease
• - Stay the same
• - No opinion

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Speculative Bubbles?

• 1929 US market crash.
• October 1987 US market crash.
• The nifty fifty stocks (1970-1972).
• Biotechnology stocks (1980s).
• Japanese stock market (1980s)
• Internet stocks (1990s)

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1929 Crash

• RCA went from a high of 101 in 1929 to a low of
  2.5 in 1932.
• GE went from a high of 396.25 in 1929 to a low of
  8.5 in 1932.
• ATT went from a high of 304 in 1929 to a low of
  70.25 in 1932.

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1929 Crash

• The stock market started to decline on September
  3, 1929, 55 days before the October 28 crash.
• On October 26 the DJIA closed 22.6 below its
  high on September 3.

12
1987 Crash

• The greatest one day percentage losses in the
  DJIA.
• 10/19/87 -22.61
• 10/28/29 -12.82
• 10/29/29 -11.73
• 9/6/29 -9.92

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The Nifty Fifty

• Examples of large decreases in P-E ratios from
  1972 to 1980.
• McDonalds 83 to 9
• Walt Disney 76 to 11
• Sony 92 to 17
• Polaroid 90 to 16

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Real Stock Prices, 1958-99

• Investors are interested in the real return on
  their investment.
• Historical price series in 1999 dollars.
• - Scale the CPI to be equal to 1.0 in August
  1999.
• - Divide the stock price by the scaled CPI.

15
Biotech Bear Market Ballad

• Those were the days my friend.We thought theyd
  never end.Wed clone a gene and form a
  company.Wed raise some venture cashAnd do our
  IPO in a flash.Cause selling dreamsRequires no
  p-e.

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Japanese Real Estate,1955-90

• Real estate values increased 75 times.
• In 1990 real estate was valued at nearly 20
  trillion.
• 20 of worlds wealth.
• 5 times the value of all US property.

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Japanese Stocks,1955-90

• Prices increased 100 times.
• Japanese stocks accounted for 45 of the value of
  worlds equity market.
• Japanese stocks were valued at 1.5 times the
  value of all US equities.
• Market price-to-earnings ratio was 60.

18
Internet Stocks

• Example of IPO craze.
• - IPOs issued Thursday, 10/12/98 Offering Fr
  idays Price Close theGlobe.com
  9.00 63.00 EarthWeb 14.00 67.00

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Relation Between P/E Ratio and Ten-Year Returns

• Shillers P/E ratio
• - Numerator is the current price.
• - Denominator is the average annual earnings
  over the past ten years.
• Shiller uses the P/E ratio as a predictor of the
  future ten-year return.