Money and Banking (6): The Stock Market
From Frederic S. Mishkin, The Economics of Money, Banking, and Financial Markets — Chapter 7
The stock market is always major news, and it brings either joy or disaster. Understanding how stock prices are set and how efficient stock markets are is very important.
Common stock is the principal way that corporations raise equity capital. Stockholders have the right to vote and to be the residual claimant of all funds flowing into the firm.
The Gordon Growth Model
The Gordon growth model is the simplest way to value a stock: the price equals the present value of dividends that grow at a constant rate forever.
where
It means the max price I am willing to pay today given the required return, dividends and growth rate of it.
Rational Expectations
The price in the Gordon growth model depends on what people expect dividends and their growth to be. So the next question is how people form expectations.
The theory of rational expectations says that people’s expectations equal the best forecast that can be made with all available information. Best does not mean always right. A rational forecast can still miss, but the misses cannot be predicted in advance.
People forecast this way because being wrong costs money, so they have a strong reason to use every piece of information they can get.
The Efficient Market Hypothesis
The efficient market hypothesis is rational expectations applied to financial markets: a stock’s price reflects all available information.
Here is why. If a stock were priced too low, the investors who noticed would buy it and push the price up until the extra profit was gone. In an efficient market, all unexploited profit opportunities will be eliminated. Not every investor needs to notice. A few are enough.
This means prices move only on news, which is information that was not expected. As soon as the information hits the street, the unexploited profit opportunity it created will be quickly eliminated. A company can report higher profits and still see its stock fall, if the market expected even more.
For an ordinary investor, the lesson is that hot tips and published stock picks should not beat the market, because the price already reflects them. This is the textbook argument for buying and holding instead of trading often.