7informational Efficiency of Stock Markets7

The Empirics of Financial Markets 2011 Stan Maes
Lecture 7: Informational e ciency of stock markets

CET - European Commission
April 2011 - KULeuven
Stan Maes (CET - European Commission)
Empirics of Financial Markets
1 / 29
Predictability of stock returns (time series evidence)

Predictable patterns based on public information
Dividend discount model: start from the identity: Pk ,t +1 + Dk ,t +1 Pk ,t Rk ,t +1 = Pk ,t Rearranging gives: Dk ,t +1 + Pk ,t +1 Pk ,t = 1 + Rt +1 Substituting forward, and taking expectations: Pk ,t =
j =1
Et [Dk ,t +j ]
i = 1 Et
[1 + Rk ,t +i ]
Et [Pk ,t +S ] . S E [1 + R i =1 t k ,t +i ]
In the absence of speculative bubbles: limit of the last term on the right hand side for S ! is zero; limit for S ! becomes: Pk ,t =
j =1
Et [Dk ,t +j ]
i = 1 Et
[1 + Rk ,t +i ]
April 2011 - KULeuven 2 / 29
Semi-strong form e ciency implies that the dividend discount model holds.
Variance bound tests of stock market e ciency (Shiller 1981) DDM: Pk ,t is a forecast of the variable Pk ,t , dened as Pk ,t =
j =1
Dk ,t +j j (1 + Rk )
where Pk ,t is the ex post rational price and where we assumed a constant discount rate Rk . The observed price Pk ,t is the optimal forecast of Pk ,t Pk ,t = Et Pk ,t (notice that it does not say that Pk ,t = Pk ,t ). This implies that Pk ,t = Pk ,t + t V Pk ,t = V [Pk ,t ] + V [t ] Given that V [t ] 0, the dividend discount model implies that V Pk ,t
V [Pk ,t ]
The variance of the observed price series should be less than or equal to the variance of the ex post realization Pk ,t if the market is e cient! Compare sample estimates of the two variances. Note that Pk ,t is not directly observable. Implementation: Choose some value for Rk Use terminal condition, e.g. Pk ,T = Pk ,T Construct approximate series for Pk ,t using Pk ,t =
S&P 1871-1979 145.5 6.989 0.0480 50.1 9.0 DJI 1928-1979 982.6 44.76 0.0456 355.9 26.8
P k ,t +1 +D k ,t +1 (1 +R k )
Sample statistics for price and dividend series (Shiller (1981)) Average price Pk Average dividend Dk Average return Rk (Pkt ) (Pkt )
Note: Prices and dividends are detrended (detrended series assumed to be stationary).
4 / 29
Overall conclusion: LeRoy and Porter (1981) and Shiller (1981): aggregate stock prices seem to be far more volatile than plausible measures of expected future dividends. Stock prices (rational forecasts of ex post rational prices) are much too volatile! Evidence against semistrong form market e ciency.
Stan Maes (CET - European Commission) Empirics of Financial Markets April 2011 - KULeuven 5 / 29

Variance bound tests of stock market e ciency (Shiller 1981)
Central assumptions in the early volatility tests have been criticized: Constant expected returns
If you reverse engineer the time-varying returns that would align the formula: crazy expected return volatility required
Stationarity of stock prices and dividends (otherwise variances do not exist)

Mankiw and Shapiro (1985), Campbell and Shiller (1987) assume unit roots for prices and dividends: results qualitatively unchanged
6 / 29

Harvey (1991) includes a number of plausible variables, known at time t, in a cross-country regression: - a constant - the lagged return on a world index RtW - a dummy variable for January JANt +1 - the excess return on a 3-month T-Bill RtUS 3 - the junk bond spread RtJUNK - the dividend yield on the S&P500 index, RtDIV . The full model specication is as follows: Rk ,t +1 = 1 + 2 RtW + 3 JANt +1 + 4 RtUS 3 + 5 RtJUNK + 6 RtDIV + t +1 where Rk ,t +1 is the excess return in country k, while all other return variables are dened as excess returns over the one-month T-Bill rate as well. Main nding: The amount of predictability is too large to be explained by data-mining alone (Wald tests).
Rk ,t +1 = 1 + 2 RtW + 3 JANt +1 + 4 RtUS 3 + 5 RtJUNK + 6 RtDIV + t +1 R2 1 2 3 4 5 6

Australia Austria Belgium Denmark France Germany Hong Kong Italy Japan Netherlands Norway Spain Switzerland U.K. U.S.A. World 0.008 0.037* 0.017 0.002 0.014 0.005 0.026 0.006 0.016 0.001 0.033* 0.019 0.009 -0.007 -0.014 -0.005 0.189 0.139 -0.017 -0.148 0.071 0.098 0.305 0.210 0.287* -0.011 0.083 0.172 -0.049 -0.039 -0.092 0.032 0.022 -0.034* 0.018 0.016 0.018 -0.006 0.065* 0.027 0.005 0.026 0.044* 0.017 0.009 0.044 0.020 0.018 13.312* 2.353 6.423* 0.923 2.289 2.490 4.368 1.379 -0.416 6.205* 5.398 3.757 5.970* 9.103* 8.289* 6.602* -1.131 -22.002* 4.233 19.047 3.403 11.088 -2.551 -4.783 9.191 15.940 -27.865 -18.714 8.468 25.052 22.980* 16.848* 6.306* 3.074 8.068* 6.831* 6.283* 5.579* 6.756 1.057 5.822* 7.154* 0.932 0.329 7.850* 9.432* 6.175* 6.015* 0.073 0.058 0.058 0.032 0.013 0.021 0.029 0.005 0.067 0.076 0.020 0.009 0.052 0.079 0.125 0.133
8 / 29

Enormous literature: - earnings-price ratios (Campbell and Shiller (1988)) - dividend-price ratios (Campbell and Shiller (1988), Fama and French (1988), Hodrick (1992), Cochrane (1996, 2001)): less accounting dependent and hence more comparable across countries. - book-market ratios (Lewellen (1999)) - yield and credit spreads (Campbell (1987), Fama and French (1989), Keim and Stambaugh (1986)) - recent changes in short interest rates (Campbell (1987), Hodrick (1992)) - etc. Importantly, Fama and French (1989) nd that most of these variables are correlated with each other and with the business cycle. High expected returns follow when P/D and interest rates are low (recessions), and vice versa. Quid?

Price-dividend ratio: Link prices to dividends and returns (without taking expectations): Pt = Price-dividend ratio: Pt Dt
j =1
Dt + j
j i =1
(1 + Rt +i )
= =
1 Dt + 1 1 Dt + 2 Dt + 1 + + ... (1 + Rt +1 ) Dt (1 + Rt +1 ) (1 + Rt +2 ) Dt +1 Dt
j =1
i =1 Dt +i /Dt +i
j i =1
(1 + Rt +i )
j =1
i =1 Et [Dt +i /Dt +i
j i =1
1]
Et [1 + Rt +i ]
=> Low price-dividend ratio implies => low future (expected) dividend growth (i.e. a protracted recession) !! => high future (expected) returns (risk aversion)!!
Intuition Traders will bid up prices if news is revealed to them

that future dividend growth is expected to be higher. that expected returns will be lower.
Hence, if price (dividend) variation

comes from news about dividend growth (naive EMH, constant excess returns), then price-dividend ratios should forecast dividend growth. comes from news about changing discount rates (expected returns), then price-dividend ratios should forecast returns.
Either returns or dividend growth needs to be predictable by P/D (or a combination of both): which one is it? Empirical question => on average, market prices(-dividend ratios) are moving almost entirely on expected return news, not on dividend/cash ow growth news.
11 / 29
K
1 2 3 5
Rt :t +K = a + b (Dt /Pt ) + t +K R2 b b
5.3 10 15 33 2.0 3.1 4.0 5.8 0.15 0.23 0.37 0.60
Dt +K /Dt = a + b (Dt /Pt ) + t +K R2 b b

2.0 2.5 2.4 4.7 1.1 2.1 2.1 2.4 0.06 0.06 0.06 0.12
Sample 1947-1996. Standard errors in parentheses use GMM to correct for heteroskedasticity and serial correlation.
Return regression
EMH would predict zero slope, zero R 2 , constant expected returns, but we nd positive, signicant coe cients and large R 2 s Caveat: Time-varying expected return is equally possible...
Dividend growth regression: relatively small, statistically insignicant, and even counterintuitive coe cients.
12 / 29
Derive the Campbell-Shiller formula by log-linearizing. Rewrite as Rt +1 = or in logs rt +1 = pt +1 pt + ln (1 + exp (dt +1 pt +1 )) Apply a rst order Taylor approximation of the last term around a steady state value of dt +1 pt +1 , denoted d p: ln (1 + exp (dt +1 ln 1 + exp d constant + (1 where = p pt +1 )) 1 + exp d ) (dt +1 pt +1 ) 1 1 + exp d Pt +1 Dt +1 + Pt +1 = Pt Pt 1+ Dt + 1 Pt +1
exp d
p p
dt +1
pt +1
1 1 + D/P
and D/P the average dividend price ratio.

Stan Maes (CET - European Commission) Empirics of Financial Markets
Average dividend price ratio is 4% => = 1/1.04 (forget about the constant term): rt +1 = pt +1 pt + (1 dt +1 ) ) (dt +1 pt + dt +1
0.96. Substitute pt +1 )
= (pt +1
where 0 < < 1. Add and subtract dt from the right hand side and rearrange: rt +1 = (pt +1 pt dt
= (pt +1
(pt dt ) + (dt +1 dt ) dt +1 ) + (dt +1 dt ) rt +1

dt +1 )
This is a forward-looking dierence equation, which we solve recursively. Provided that lims ! s (pt +s dt +s ) = 0, we get the famous Campbell-Shiller formula pt dt
s =0
s [(dt +1 +s
dt +s )
rt +1 +s ]
s =0
s [dt +1+s
rt +1 +s ]
As before, a high price-dividend ratio must imply high future dividend growth and/or low future returns.
Cochrane (2006): The dog that did not bark Reasoning: It cannot be that returns and dividend growth are both unforecastable, because if this were the case, the price dividend ratio would have to be a constant (which it is not): ! Var (pt dt ) = Cov pt dt ,
s =0
s (dt +1+s )
s =0
Cov
pt
dt ,
rt +1+s
s
s =0
s Cov (pt
s =0
dt , dt +1 +s ) dt , rt +1 +s )
s Cov (pt
The fact that the P/D ratio is not constant implies that the stock market does not behave like a coin ip! (predictability is required) it cannot be that both returns and dividend growth are unpredictable !
Dividend price ratio 8
1930
1940
1950
1960
1970
1980
1990
2000
Returns 50
Stock T Bill -50 1930 1940 1950 1960 1970 1980 1990 2000
16 / 29
Variance decomposition Historically we nd that virtually all variation in price-dividend ratios has reected varying expected returns !! Variance decomposition of value-weighted NYSE price-dividend ratio Dividends Returns Real -34 138 Std. error 10 32 Nominal 30 85 Std. error 41 19 Note: table entries are the percent of the variance of the price-dividend ratio attributable to dividend and return forecasts, 100 Cov pt dt , 15 0 s (dt +1 +s dt +s ) /Var (pt dt ) and similarly s= for returns. Do high prices reect expectations of high future cash ows or low expected risk premia? High prices seem to reect low risk premia, lower expected excess returns! Time-variation in the reward for risk, not time-variation in interest rates (or other non-risk explanations such as demand and supply eects). Stocks act a lot like long term bonds !!
18 / 29
Stylised facts on predictability Rt +1 = a + bRt + t +1 or Rte+1 = a + bRte + t +1 (ANNUAL data 1926-2008) b t(b) R2 E (R ) (Et (Rt +1 )) Stock return 0.03 0.27 0.00 11.4 0.77 T-Bill return 0.92 19.68 0.84 4.1 3.12 Excess return 0.04 0.30 0.00 7.25 0.91 E cient capital markets: b = 0, R 2 = 0, constant expected return. Stock market returns are characterised by a trivial amount of momentum (which is not statistical signicant) and little variation in expected returns. But not all returns are unpredictable! T-Bill return predictability is a much weaker corrective force (as borrowing to invest is not a money machine, hence you need to save). Excess stock returns aim to exclude the predictable component in stock returns: measure the willingness to bear risk (rather than willingness to save and invest).
Stylised facts on predictability Current stock prices and other variables may be informative. Results for regressing excess returns on lagged D/P 1926-today excess Rtexcess = a + b (D/P )t + t +1 and Rt,t +5 = a + b (D/P )t + t +1 +1 b t(b) R2 E (R ) (Et (Rt +1 )) 1 year 4.17 2.59 0.08 7.3 6.2 5 year, overlap 20.41 4.30 0.21 10.0 6.6 5 year, no overlap 24.89 2.28 0.29 1 year excess return preditability using D/P: Dramatically dierent results!
statistical signicance R 2 non-negligible Huge coe cient (unsophisticated investor one-for-one impact of dividend yield; EMH guy zero; data 4x!!) Huge volatility/swings in expected (market) excess returns !
5 year excess return predictability

R 2 signicantly higher coe cients about 5 times larger
If rt +1 = bxt + t +1 xt +1 = xt + t +1 then rt +1 + rt +2 = (bxt + t +1 ) + (bxt +1 + t +2 )
= b (1 + ) xt + (bt +1 + t +1 + t +2 )
rt +1 + rt +2 + rt +3 = b 1 + + 2 xt + (error ) Bottom line (compare with temperature predictions): Forecasts from persistent variables build up over time and are more important at long horizons. forecasts from fast-moving variables die out more quickly. There is nothing special about long-run forecasts. they are the mechanical result of short-run forecasts and a persistent forecasting variable.
Dividends are fairly stable, hence the top line reects stock price swings. A 7-year return of 1 means 100%.total return, not annualised.
Results for regressing dividend growth on lagged D/P 1926-today D t +1 D D t = a + b P t + t +1 DDt,t +5 = a + b (D/P )t + t +1 b t(b) R2 1 year 0.17 0.14 0.00 5 year, overlap 2.28 0.79 0.01 5 year, no overlap 0.37 0.05 0.00 1 year/ 5 year dividend growth preditability: Dramatic dierence with previous table results
statistically insignicant results low R 2 low coe cient values, counterintuitive sign
23 / 29
Actual and forecast 5 year excess returns forecast actual
1.5 1 0.5 0 -0.5 1940 1950 1960 1970 1980 1990
2000
Actual and forecast 10 year excess returns 4 3 2 1 0 1940 1950 1960 1970 1980 1990 2000 forecast actual
24 / 29
Actual and forecast 5 year dividend growth 2 forecast actual
1.5
0.5 1940 1950 1960 1970 1980 1990 2000
Actual and forecast 10 year dividend growth 2.5 forecast actual
1.5
1940
1950
1960
1970
1980
1990
2000
25 / 29

Conclusions
Predictability does not mean "being able to predict with certainty", but the question is whether there is a way to know that "the odds are in favour" on some days/weeks/months and against you in others (above or below average returns).
Momentum or mean reversion? Current returns imply something about future returns. Other signals?
If there is (some) predictability Rt +1 = a + bxt + t +1

we might be able to make money, or alternatively expected returns vary over time in a rational way: E [Rt +1 ] = a + bxt
Key question: Are stock returns like coin ips or are there "seasons" in stock returns?
Expected return of a fair coin ip is constant over time. Expected temperature changes slowly and gradually between Winter and Summer seasons.

Conclusions
- Mixed evidence about weakform market e ciency (depending on data frequency) - Strong evidence against semi-strong form market e ciency: stock returns are predictable by dividend-price ratios and other public information. - Basic lesson of the fact of return predictability: recession-related, slow time varying risk premium. - December 2008: You "Dividend yields are high, so returns going forward look better than they have in years." Investor: "thanks, I know that, but I am about to loose my job, my company may not be able to roll over its debt, and my house is about to foreclose. I cannot take more risk right now."
27 / 29

Conclusions
Two generations of return predictability studies which come to 100% opposite conclusions! First generation of return predictability studies - Returns are unpredictable (driven by free entry and competition). - Expected returns are constant (or vary only marginally). - Prices are close to random walks - Technical analysis is nearly useless. - There is no good or bad time to invest. - Markets are informationally e cient. - Low P/D implies that the market expects declines in dividend growth. Variations in P/D are driven by cash ow news. - The only way to earn larger returns is by taking on additional risk.
28 / 29

Conclusions
New generation of return predictability studies: views exactly the opposite !! - Returns are predictable. - Over business cycle and longer horizons, variables including the dividend-price ratio can in fact predict substantial amounts of stock return variation. - Technical analysis is still close to useless after transaction costs. - The new view does not overturn the view that markets are reasonably competitive and therefore reasonably e cient. It does enlarge our view of what activities provide rewards for holding risks, and it challenges our economic understanding of those risk premia. - Our focus should be on huge swings in expected market return, rather than cash ows and beta: CAPM-based corporate nance calculus: value cash ow = Expected cash ow = Expected(R m R f ) Expected return R f + E

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The Empirics of Financial Markets 2011 Stan Maes

Lecture 7: Informational e ciency of stock markets

April 2011 - KULeuven

Stan Maes (CET - European Commission)

Empirics of Financial Markets

April 2011 - KULeuven

Predictability of stock returns (time series evidence)

Empirics of Financial Markets

Stan Maes (CET - European Commission)

Empirics of Financial Markets

April 2011 - KULeuven

Predictability of stock returns (time series evidence)

Stationarity of stock prices and dividends (otherwise variances do not exist)

Stan Maes (CET - European Commission)

Empirics of Financial Markets

April 2011 - KULeuven

Predictability of stock returns (time series evidence)

Rk ,t +1 = 1 + 2 RtW + 3 JANt +1 + 4 RtUS 3 + 5 RtJUNK + 6 RtDIV + t +1 R2 1 2 3 4 5 6

Stan Maes (CET - European Commission)

Empirics of Financial Markets

April 2011 - KULeuven

Predictability of stock returns (time series evidence)

Predictability of stock returns (time series evidence)

Intuition Traders will bid up prices if news is revealed to them

Hence, if price (dividend) variation

Stan Maes (CET - European Commission)

Empirics of Financial Markets

April 2011 - KULeuven

Dt +K /Dt = a + b (Dt /Pt ) + t +K R2 b b

Stan Maes (CET - European Commission)

Empirics of Financial Markets

April 2011 - KULeuven

and D/P the average dividend price ratio.

(pt dt ) + (dt +1 dt ) dt +1 ) + (dt +1 dt ) rt +1

Dividend price ratio 8

Stan Maes (CET - European Commission)

Empirics of Financial Markets

April 2011 - KULeuven

Stan Maes (CET - European Commission)

Empirics of Financial Markets

April 2011 - KULeuven

5 year excess return predictability

If rt +1 = bxt + t +1 xt +1 = xt + t +1 then rt +1 + rt +2 = (bxt + t +1 ) + (bxt +1 + t +2 )

Stan Maes (CET - European Commission)

Empirics of Financial Markets

April 2011 - KULeuven

Actual and forecast 5 year excess returns forecast actual

1.5 1 0.5 0 -0.5 1940 1950 1960 1970 1980 1990

Stan Maes (CET - European Commission)

Empirics of Financial Markets

April 2011 - KULeuven

Actual and forecast 5 year dividend growth 2 forecast actual

0.5 1940 1950 1960 1970 1980 1990 2000

Actual and forecast 10 year dividend growth 2.5 forecast actual

Stan Maes (CET - European Commission)

Empirics of Financial Markets

April 2011 - KULeuven

Predictability of stock returns (time series evidence)

If there is (some) predictability Rt +1 = a + bxt + t +1

Predictability of stock returns (time series evidence)

Stan Maes (CET - European Commission)

Empirics of Financial Markets