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Great Teachers Lecture Series
Hashem Dezhbakhsh November 16, 2000
"The Bulls, the Bears, and the Basics: What You Need to Know About the Stock Market"
Outline of the Talk
I. Introductory Remarks
1. Acknowledgments:
2. The purpose of the talk is
(i) to pose some interesting questions about the stock market. Questions
that are perhaps on the minds of many investors.
(ii) to discuss what we know about the stock market and stock prices using
the basic financial theories.
(iii) to discuss how these theories may or may not explain the recent market
trends and provide answers to the above questions.
(iv) to offer some long term investment advises drawing on the accepted
wisdom of the discipline.
II. Some Interesting Questions
1 Why did the U.S. stock market reach such high levels and what has caused its
poor performance during the past few months?
2 Given the recent roller coaster ride, what is next for DOW and NASDAQ?
3 Why does wall street mourn whenever there is good news for workers (report
of low unemployment and increased wage earnings)?
4 Why is Greenspan so concerned about a bullish stock market and investors'
exuberance?
5 What is happening to the cool internet stocks? I invested $22, 000 buying
1000 shares of Mortgage.com at $22 last year; my investment is now worth
$60!! Is the dot-com craze over?
6 Two weeks ago Dell Computers reported earnings in line with wall street
expectations and indicated that sales will grow by 20% next year. This seems
like good news. Why did Dell stock dropped by 30% following the news?
7 In a broader scheme, does it matter how the stocks are valued?
III. Stock Market Theories
1 Old Paradigms
(i) Firm Foundation Paradigm (John B. Williams, 1930s)
- Stocks have an intrinsic value, price may deviate from this value but
will return to it.
- Intrinsic value is determined by expected future dividends (earnings or
profit); example of gold mine; discounting.
- Importance of earning growth (in 25 years, $1 will be $3.40 with 5%
growth and $260 with 25% growth. The Indian who sold Manhattan to a
white man for $24 in 1626 [not cheated but smart at 6% return that
would be $50 Bil, can buy back much of the now improved land]).
- The larger the earning and dividend or their growth rate, the more you
should be paying for the stock.
- P/E ratio, growth vs. value stocks
- Warren Buffett has an outstanding investment record, allegedly
following this approach
(ii) Castle-in-the-Air Paradigm (John Maynard Keynes, 1920s)
- Stock prices are based on what crowds of investors are expected to pay
for them. You buy at three times the intrinsic value if you think you can
sell at four times value.
- Keynes made a fortune speculating in stock market in England (half an
hour a day).
- Can lead to bubbles (inflated price that may last for sometime but will
eventually burst); examples Dutch Tulip Craze of 1634-1637, Options
developed for tulip bulbs, lasted three years (mosaic virus caused
contrasting colored stripes in petals, attraction; a 20 fold price increase
in January of 1637 lead to crash. In US Florida Real Estate craze of the
1920s with a land values doubling in Palm Beach; Speculators from
everywhere bought land there till the crash in 1926. Stock market bubble
of the late 1920s and the crash of October of 1929. GE $120 March 1929,
$400 September, $170 November (after the crash) and $8 in 1932
(Great Depression), S&P lost 80% of its value. Japanese real estate and
stock market bubbles in the 1980s. America 25 times bigger but
estimated value of all Japan's properties were 5 times that of U.S. Stock
prices in 1989 were 100 times larger than 1955. P/E of 60. Nikkei
dropped from 40,000 in December of 1989 to 15,000 two years later
(and still 15,000). It was prompted by Bank of Japan increasing the
interest rate to avoid inflation.
2 Modern Theories: Stock valuation here is based on rational investor behavior
(i) Diversification and portfolio management: Risky stocks can be put
together in a way that the combined portfolio has a smaller risk (airline
and oil [drilling] companies); usefulness of Mutual Funds
(ii) CAPM and Beta: Risk factor and individual stock return vs. market
returns
(iii) Efficient Market Hypothesis: Developed by Fama, U of Chicago around
1970
- The Joke about $100 and U. of Chicago Professor conveys the essence
- Assumptions: Perfect pricing (rational investors arbitrage away any
deviation from intrinsic value), News spreads instantaneously, News is
interpreted correctly and incorporated into price immediately.
- Implications: Stock prices follow a random walk (future changes in price
are random and cannot be predicted); No one has any advantage over
someone else in picking stocks, so paying someone to manage funds and
pick stocks is a waste (Darts and Monkey picked stocks); volatility is
event driven.
- Initial support: Random Walk evidence, Fund performance vs. S&P 500
index performance (84-94 12% and 14%).
- Later Doubts: Anomalies (January Effect: tax reasons and window
dressing by fund managers; Blue Mondays, good Wednesdays and
Fridays; High return for small stocks) that have now disappeared since
they were discovered; mean reversion and correlation in returns;
Bubbles; and Shiller's finding long: term volatility of price in excess of
dividend volatility.
- Price deviation may last for a long time LTCM and its Ph.D. and Noble
Laureate managers hedged correctly but run out of money before the
market returns to its fundamental path.
- Example of incorporation of news: Earning estimates dictate price,
"missed earnings" argument (who missed? company or analyst)? Price
drops to adjust.
3 Behavioral (New) Finance Theory Shiller and Shleifer
(i) It takes into account the psychological and social details of human
behavior; implication is that investors do not always act rationally.
(Ii) It observes that: when price deviates from the intrinsic path, the smart
investor may choose to ride with the crowd (Sores claims he has done
so), rather than betting against the market.
(Iii) It is based on some documented facts:
- People see pattern in random behavior.
- Conservatism leads to not changing ones belief quickly and holding to
losing stocks.
- Desire to conform to peers (example of line segments and incorrect
answer acted by the confederate respondents [aloud] making the other
respondents to doubt themselves and chose the wrong segment) leads to
mob behavior and trend chasing (often following noise traders).
- Extrapolation of expectations; for example, in the case of earning
expectations this leads to overly optimistic investment strategies (case
for US since the earnings have been good and extrapolation makes them
to look as if they were exploding)
(v) Evidence
- Various Bubbles
- Excess volatility of stock prices over dividends
- Shiller's extensive survey of market participant in 1987 crash that
shows news did not affect their behavior, only sudden drop that day
affected it (WSJ comparison of 1987 and 1929 the day of the crash
contributed to fears) but many did not even know about a legislation in
the works to restrict corporate takeovers-market fuel of the 80s.
IV. Recent Stock Market Rise
1. Data:
Dow Jones
Ind. 3,300 (March
1992) 10,000 (March
1999) 11,000 (March 2000);
15%
NASDAQ 600 (March
1992) 2,500 (March
1999) 5,000 (March 2000);
30%
S&P 500 400 (March
1992) 1,300 (March
1999) 1,500(March 2000);
18%
Broader Indices (Russell, Wilshire) have not increased as much
2. Historical P/E Multiple: For S&P it is 15 (historically) but around 40 during the
early 2000
3. Reasons for the rise:
(i) Rapid growth of GDP (at times 5%) and increase in Corporate profit
(50% in mid 90s)
(ii) Productivity growth, technological progress, and information revolution
(iii) Baby Boom effect (born 45-60, 30-45 years old in 1990); less risk averse
(they prefer stocks in their retirement funds)
(iv) Low inflation and low inflation uncertainty (Fed's prudence and low
import and raw material prices), low interest rate
(v) Discount brokers, Internet trading and low transaction cost (also added
to volatility)
(vi) Capital Gain Tax Cut in 1997, from top 28% to 20%
(vii) Decline of foreign economic rivals (Japan in the 90s, Asian Tigers in
1998)
(viii) Growth of Mutual funds (340 in 82 now around 4000, 6 mil accounts,
now 150 mil accounts)
(ix) The New Media: CNBC CNNfn, availability of information, and investor
seduction
(x) Analysts optimistic forecasts and recommendations (bias in favor of
clients and PR considerations)
(xi) Appetite for risk due to earlier capital gains; extrapolative expectation
(continued earning growth)
V. Stock Market Fall of the Recent Months
1. Data:
Dow Jones Ind. 11,000 (March 2000) 10,700 (Now); 2.7%
NASDAQ 5,000 (March 2000) 3,100 (Now); 38%
S&P 500 1,500 (March 2000) 1,400 (Now); 6.6%
2. Reasons for the fall:
(i) Broad overvaluation.
(Ii) Inflation fears (oil price increases from $15 to $35)and Fed's raising the
interest rate (Bank of Japan experience of 1989 comes to mind that set
off bursting of their bubble)
- OMC (7 BOG members plus NY Fed Chair and four other regional Fed
chairs, meet once every six weeks to set policy)
- Wall Street dislikes rate increases (appeal of bonds [immediate effect],
increase in cost of capital, reduced consumer demand)
(iii) Economic slow down, growth at 2.7% rather than 5%, lower corporate
profitability (warnings)
(iv) Internet Bubble bursts PCLN, MDCM, ETYS
- Expectation of future earnings and rapid growth of earnings started the
dot-com mania; Low number of shares made them volatile; Greedy
Investors ignoring risk {THE COW STORY}
- Demand cannot grow as fast as it appeared (1.8 million use web to find
their cars, but 82,000 but it on the web)
- Perfect Competition (free entry) makes profit sustainability hard;
Microsoft ($2,000 in 1986 would be $700,000 now) sustains earnings due
to market monopoly power.
- Why ETYS, PCLN, and MDCM are poor stocks (Etoys $30 Mil sales $30
Mil loss, and $8 Bil capitalization (market value of all stocks), Toys-R-Us
$11 Bil sales, over $300 Mil, but only $6 Bil capitalization)
- Even venture capital is drying up (Jim Clark, cofounder of Netscape and
subject of the now famous book the New New Thing, pulled the plug on a
couple he was involved with to cut his losses.
- Not the first time for a fad or frenzy in US stocks market; tronics mania
of late 50s (P/E's of 100+), biotech craze of early 80s (3/4th of market
values lost in 85-87)
VI. Winning Strategy
1. 1- Invest for long run (try to GET RICH SLOWLY BUT SURELY rather than
QUICKLY), This has tax advantages (defers payment on tax on immediate
gain)
2. Do not try to time the market, in 1980s S&P rose by 18% a year (2500 trading
days) if you missed the top 10 days your gain was only 12%
3. 3- Diversify, use of Index stocks QQQ, DIA, etc. [www.ishares.com]
4. 4- Avoid stocks with very high (P/E) multiples
VII. Does It Matter How Stocks Are Valued?
1. Affects allocation of capital resources (zero sum game, less for education,
human capital, and infrastructure).
2. Can lead to complacency and reduced savings for retirement.
Relevant References
Williams, John Burr, 1938, The Theory of Investment Value, Harvard University Press.
(On Firm foundation, III-1-I)
Kindleberger, Charles P., 1978, Manias, Panics, and Crashes, Basic Books.
(On Castle in the Air, III-1-ii)
Malkiel, Burton G., 1996, A Random walk Down wall Street, The Best and Latest
Investment Advise Money Can Buy, W.W. Norton and Company.
(On Modern Finance and Efficient Markets, III-2)
Shleifer, Andrei, 2000, Inefficient Markets, An Introduction to Behavioral Finance,
Oxford University Press.
(On Behavioral Finance, III-3)
Shiller, Robert J., 2000, Irrational Exuberance, Princeton University Press.
(On Behavioral Finance, III-3)
Shiller, Robert J.,1993, Market Volatility, MIT Press.
(On Inefficient of the Stock Market, III-3 and IV)
Lewis, Michael, 1999, The New New Thing : A Silicon Valley Story,
(On Internet Craze, V-iv)