THE STOCK MARKET AND THE ECONOMY

1. 1
Objective
To understand the relationship between
the stock market and
economic activites

2. •Introduction
•Explaining Changes in Stock Prices
•How Stock Markets Affect the Economy
•The Fed and the Stock Market
•Rational Expectation and the Stock Market

3. INTRODUCTION
Firms raise funds in two ways: THROUGH
Debt finance - bonds and loans
Equity finance - through issues of stocks or shares.
Instead of paying predetermined amounts as bonds do,
stocks pay dividends in an amount decided by the firm
Choice depends on a host of various factors

4. STOCK INVESTMENT
• Share of stock is a private financial asset, like a corporate bond
• Both are issued by corporations to raise funds, both offer future
payments to their owners
• However, cash-flows from stock investment is not fixed – risky
asset vs fixed income asset
• When a firm issues new shares of stock through initial public
offerings
• sale of which generates funds for the firm
• newly issued shares can be re-sold in the secondary market

5. STOCK MARKET
Investment in equity/stocks
represents ownership of a corporation
NO promised returns
grants right to share in firm’s assets and earnings, if any
Investors are entitled to a particular percent of the firm’s after
tax profit
Retained earnings - firms do not pay all their after-tax profit to
share holders, some is kept for later use of the firm
Dividends - The part of profit distributed to share holders
Aside from dividends, usually more important reason to holding
stocks is to enjoy capital gains – return someone gets when they
sell a stock at a higher price than they paid for it

6. Stock Market
Stock market activity involves mainly the trading of issued
securities rather than the exchange of financial claims for new
capital
Virtually all the shares traded in the stock market are
previously issued- trading does not involve the firm that issued
the stock
But the firm still concerned about the price of its previously
issued shares
1. The firm’s owners-current stockholders-want high share prices because
that is the price they can sell in the market
2. Previously issued shares are perfect substitute of new public offerings -
firm cannot expect to receive higher price for its new shares than the going
price on its old shares

7. Tracking the stock market
Financial market is so important that stocks and bonds are
monitored on a continuous basis
You can find out the value of a stock instantly just by checking
with a broker or logging onto a website
Daily news paper or specialized financial publication such as
Wall Street Journal or Financial Times report daily information
Tracking the stock market indices:
Benchmark index: showing the overall performance of a
particular stock market
Sectoral index: showing the performance of certain sector in the
economy, for eg. technology, construction, consumer product,
finance, etc

8. Tracking..
Tracking the stock market index
 Dow Jones Industrial Average (DJIA)-tracks prices of 30 of the
largest companies; Oldest and most popular average
 Broader Standard & Poor’s 500 (S&P 500)- Another popular
average
 NASDAQ index tracks share prices of about 5,000 mostly newer
companies whose shares are traded on NASDAQ stock exchange
Often, stock market averages will rise and fall at the same
time, sometimes by the same percentage

9. STOCK MARKET INVESTORS
Direct holdings by HOUSEHOLDS represent the largest portion
of U.S. stock holdings
 From US$1 trillion in 1980 to US$5.5 trillion in 2006
 Proportion-wise, however, declined from 70.5% to 26.6%
There is a phenomenal growth in other holdings
 Investments by pension funds
 Mutual funds (from 2.9% to 24%)
 Foreign investors (from 5.2% to 18.6%)

10. STOCK MARKET INVESTORSSTOCK MARKET INVESTORS
•20-10

11. 2. Explaining Changes in Stock Prices—
Step #1: Characterize The Market
• Price of a share of stock—like any other— is determined
in a competitive market
• The market for a company’s shares as perfectly
competitive
 View stock market as a collection of individual, perfectly competitive
markets for particular corporations’ shares
 Many buyers and sellers
 Virtually free entry
Like all prices in competitive markets, stock prices are
determined by supply and demand
 However, in stock markets, supply and demand curves
require careful interpretations

12. Step #2: Find The Equilibrium
Figure 1 presents a supply and demand diagram for shares of
Corporation X
On any given day, number of Corporation X shares in existence is
just the number that the firm has issued previously
 Just because 302 million shares of Corp X stock exist, that does not mean
that this is the number of shares that people will want to hold
-People have different expectations about firm’s future profits
 At any price other than $90 per share, number of shares people are
holding (on the supply curve) will differ from number they want to hold
(on the demand curve)
 Only at equilibrium price of $90— people satisfied holding number of
shares they are actually holding
Stocks achieve their equilibrium prices almost instantly

13. Figure 1: The Market For Shares of
Corporation X
Number of Shares
Price per Share
E
•S
$120
90
60
D
302 million

14. Step #3: What Happens When Things Change?
The changes observed in a stock’s price are mainly caused by
shifts in demand curve
What causes the sudden changes in demand for a share of stock?
In almost all cases, it is one or more of the following three factors
1. Changes in expected future profits of firm
-Any new information that increases expectations of firms’ future profits will shift
demand curves of affected stocks rightward
-Including announcements of new scientific discoveries, business developments,
or changes in government policy
1. Macroeconomic Fluctuations
-Any news that suggests economy will enter an expansion, or that an expansion
will continue, will shift demand curves for most stocks rightward
1. Changes in the interest rate
-A rise (drop) in the interest rate in the economy will shift the demand curves for
most stocks to the left (right)

15. Step #3: What Happens When Things Change?
• Example: expectations of a future interest rate change
results in change/shift demand curves for stocks
• Such an event occurred on February 27, 2002, when Fed
Chair Greenspan announced that it appeared economy
was recovering from its recession
– News that causes people to anticipate a rise in interest rate
will shift demand curves for stocks leftward
• Similarly, news that suggests a future drop in the interest rate
will shift demand curves for stocks rightward

16. Figure 2a: Shifts in the Demand for Shares
Curve
Number of Shares
Price
per Share •S
$75
60
D2
D1
(a)
298 million
The demand curve shifts rightward when new
information causes expectations of:
• higher future profits
• economic expansion
• lower interest rates

17. Figure 2b: Shifts in the Demand for Shares
Curve
45
D3
Number of Shares
Price
per Share
•S
60
D1
298 million
(b)
The demand curve shifts leftward when
new information causes expectations of:
• lower future profits
• recession
• higher interest rates

18. Step #3: What Happens When Things Change?
Prices can also change due to shifts in supply curve
Supply curve for a corporation’s shares shifts rightward
whenever
1.New round of public offering
2.Stock split:
-When a company divides its existing shares into multiple shares. Although the
number of shares outstanding increases by a specific multiple, the total dollar
value of the shares remains the same compared to pre-split amounts.
-The most common split ratios are 2-for-1 or 3-for-1, which means that the
stockholder will have two or three shares for every share held earlier
3. Large sell-off by institutional investors

19. Factors that Affect Stock PricesFactors that Affect Stock Prices
1. ECONOMIC FACTORS
Interest rates
 Most of the significant stock market declines occurred when
interest rates increased substantially
 Bonds are better investment option: high interest rate, price of
bonds decline
Exchange rates
 Foreign investors purchase U.S. stocks when dollar is weak or
expected to appreciate
 Stock prices of U.S. companies also affected by exchange rates
Income or GDP
Expectation of lower income reduces stock prices
Flight to quality to safer fixed income assets

20. Factors that Affect Stock PricesFactors that Affect Stock Prices
2. FIRM-SPECIFIC FACTORS/FIRM FUNDAMENTALS
Expected +NPV investments
Dividend policy changes
Significant debt level changes
Stock offerings and repurchases
Earnings surprises
Acquisitions and divestitures/divestment (a strategy to
remove some of a group's assets under its current business
portfolio)

21. Factors that Affect Stock Prices
3. MARKET-RELATED FACTORS
January effect – general increase in stock price in January
Noise trading
 Trading by uninformed investors pushes stock price away from
fundamental value
Trends
 Technical analysis
 Repetitive patterns of price movements

22. Factors that Affect Stock PricesFactors that Affect Stock Prices
Integration of factors affecting stock prices
Evidence on factors affecting stock prices
Fundamental factors influence stock prices, but they do
not fully account for price movements
 Smart-money investors
 Noise traders
 Excess volatility
Indicators of future stock prices
Things that affects cash flows and required returns
Variance in opinions about indicators

23. International
Economic
Conditions
Fiscal
Policy
Industry
Conditions
Firm’s
Systematic
Risk
(Beta)
Expected
Cash Flows
to Be
Generated
by the
Firm
Required Return
by Investors
Who Invest in
the Firm
Firm-
specific
condition
Monetary
Policy
Economic
Conditions
Stock Market
Conditions
Market
Risk
Premium
Firm’s
Risk
Premium
Risk-Free
Interest
Rate
Price of the
Firm’s
Stock
Factors Affecting Stock PricesFactors Affecting Stock Prices

24. The Two-Way Relationship Between The Stock Market and the
Economy
Stock Market Macroeconomy
3. How the Stock Market Affects the Economy?

25. How the Stock Market Affects the Economy
On October 19, 1987, there was a dramatic drop in the stock market
Dow Jones Industrial Average fell by 508 points—a drop of 23%— about
$500 billion in household wealth disappeared
“The Black Monday”
The Fed intervene by offering discount loans
Avoiding non-bank panic which could result in systemic panic

26. •26 of 41
How Stock Market Affects the EconomyHow Stock Market Affects the Economy
1. Consumer: An increase in stock prices causes an
increase in wealth, and consequently an increase in
consumer spending – WEALTH EFFECT
2. Businesses: Investment is also affected by higher stock
prices. With a higher stock price, a firm can raise more
money per share to finance investment projects –
TOBIN-Q EFFECT

27. The Wealth Effect
Positive relationship between stock price and households’
wealth
When stock prices rise, so does household wealth
What do households do when their wealth increases?
Typically, they increase their spending-consumption; multiplier effect
Link between stock prices and consumer spending
Autonomous consumption spending tends to move in same direction as
stock prices
When stock prices rise (fall), autonomous consumption spending rises
(falls)

28. The Wealth Effect and Equilibrium GDP
Autonomous consumption is a component of total spending
The wealth effect: Changes in stock prices—through the wealth
effect—cause both equilibrium GDP and price level to move in
same direction
An increase in stock prices will raise equilibrium GDP and price level
While a decrease in stock prices will decrease both equilibrium GDP and
price level

29. The Wealth Effect and Equilibrium GDP
How important is wealth effect?
Economic research shows that marginal propensity to consume out of
wealth is between 0.03 and 0.05
 Change in consumption spending for each one-dollar rise in wealth
As a rule of thumb, a 100-point rise in DJIA—which generally
means a rise in stock prices in general—causes household
wealth to rise by about $100 billion
This rise in household wealth will increase autonomous consumption
spending by between $3 billion and $5 billion—we’ll say $4 billion
Rapid increases in stock prices can cause significant positive
demand shocks to economy, shocks that policy makers cannot
ignore
Similarly, rapid decreases in stock prices can cause significant negative
demand shocks to economy, which would be a major concern for
policy makers

30. Effect of Higher Stock Prices on the EconomyEffect of Higher Stock Prices on the Economy
(a) (b)
Y1 Y2
Real GDP
AggregateExpenditure
AEhigher stock prices
Real GDP
Price
Level
Y1Y3Y2
AS
45°
AElower stock prices
ADhigher stock
ADlower stock
P1
P2

31. How the Economy Affects the Stock
Market
• The other side of the two-way relationship
– How economy affects stock prices
• Many different types of changes in the overall economy can
affect the stock market
• In typical expansion (recession), higher (lower) profits and
stockholder optimism (pessimism) cause stock prices to rise
(fall)

32. What Happens When Things Change?
Figure 5 illustrates three different types of changes we
might explore
A change might have most of its initial impact on the
overall economy, rather than the stock market
There might be a shock that initially affects stock
market
Shock could have powerful, initial impacts on both
stock market and overall economy

33. Three Types of Shocks
Shock to both
stock market and
macroeconomy
Shock to
macroeconomy
Shock to
stock market
Stock Market Macroeconomy

34. A Shock To the Economy and the Stock Market:
The High-Tech Boom of the 1990s
1990s—especially second half—saw dramatic rise in
stock prices
Growth in real GDP averaged 4.2% annually from 1995-2000
In part, economic expansion and rise in stock prices were
reinforcing
Each contributed to the other
Internet had a direct impact on stock market through its
effect on expected future profits of U.S. firms
At the same time, technological revolution was having a
huge impact on overall economy

35. A Shock To the Economy and the Stock Market:
The High-Tech Boom of the 1990s
Faced with these demand shocks, Federal Reserve would
ordinarily have raised its interest rate target to prevent
real GDP from exceeding potential output
Technological changes of 1990s were an example of a
shock to both stock market and economy
Result was a market and an economy that were feeding on each
other, sending both to new performance heights
Was this a good thing?
 Yes, and no
In spite of all this good news, there were dark clouds on
horizon

36. A Shock to the Economy and the Stock Market:
The High-Tech Bust of 2000 and 2001
The market—especially high-tech NASDAQ stocks—began to decline in
early 2000
Both economy and market were being affected by several events
During 1990s, there had been an investment boom
 Businesses rushed to incorporate the internet into factories, offices, and
their business practices in general
Fed may have played a role as well
Decline in investment—and the recession it caused—can be regarded
as a shock to economy
In addition, there was a direct shock to market
A change in expectations about the future
Unfortunately, in late 2000 and early 2001, reality set in

37. Stock Market Indexes, DJIA (a)

38. Stock Market Indexes, DJIA (b)

40. 4. The Fed and the Stock Market
Experience of late 1990s and early 2000s raised some
important questions about relationship between Federal
Reserve and stock market
In 1995 and 1996, Greenspan and other Fed officials
began to worry that share prices were rising out of
proportion to the future profits they would be able to
deliver to their owners
In this view, market in late 1990s resembled stock
market in 1920s, which is also often considered a bubble

41. The Fed and the Stock Market
In 1996, when Alan Greenspan first made his “IRRATIONAL
EXUBERANCE” speech: believed that the stock market was in midst of a
speculative bubble
Fed would be forced to intervene to prevent wealth effect—this time
in a negative direction—from creating a recession
In mid-1990s, Greenspan tried to “talk the market down” by letting
stockholders know that he thought share prices were too high
Implied threat: If stocks rose any higher, Fed would raise interest rates and
bring them down
It didn’t work: As 1990s came to a close, and the stock market
continued to soar, Fed faced a new problem - Wealth effect

42. The Fed and the Stock Market
• Fed continued to raise interest rates to rein in the economy,
– By slowing economic growth and growth in profits
– Through direct effect of higher interest rates on stocks; Fed also
brought down stock prices
• By 2001, high-tech bust, recession of 2001, and attacks of
September 11 brought criticism to an end
• As the economy began a slow expansion, in 2002 and early
2003, Fed kept the interest rate low
– Unresolved question: Who should be setting the general level of share
prices—millions of stockholders who buy and sell shares, or Federal
Reserve?

43. The Fed’s Problem In 2000: An AS-AD View
Real GDP
Price
Level
Y1 Y2
(a)
P1
AD2
A
BP2
AD1
AS AS1
AS2
A AD2
AD1
(b)
Real GDP
P1
P2
Y1 Y2
B
CP3
Price
Level
If output exceeds potential, the
self-correcting mechanism will
raise the price level further
Wealth effect of rising
stock prices shifts AD
rightward, raising real
GDP and the price level

44. Figure 7: The Fed’s Problem in 2000: A
Phillips Curve View
A
C
B
D
4%5%
2.5%
5.0%
1.5%
PC1PC2
. . . or recession
Unemployment
Rate
Inflation
Rate
A
4%
2.5%
PC1
UN?
(a) (b)Inflation
Rate
If the natural rate of
unemployment is 4%, the
Fed can keep the economy
at point A in the long run
Unemployment
Rate
UN?
But if the natural
rate is above 4%
the Phillips curve
will shift upward
and the Fed must
choose between
higher inflation . . .

45. The Fed and the Stock Market
According to Bernanke and Kuttner (2004), on “What Explains
the Stock Market’s Reaction to Federal Reserve Policy?”
Understanding the effect of monetary policy on stock prices is
fundamental to understand the transmission mechanism of monetary
policy through the wealth effect
Analyze the effect of unexpected Fed funds rate changes, as proxied by the
Fed funds future contracts, on various measures of stock market
performance:

46. The Fed and the Stock Market
FINDINGS:FINDINGS:
1. The market responds much more strongly to surprises than expected
actions.
1. Stock prices may respond to unexpected funds rate increases because of:
expected future dividends, real interest rates, and expected future excess
returns
2. The response of equity prices to monetary policy is not through effects on the
real interest rate, but appears to come through its effects on expected future
excess returns
2. A surprise 25 basis point rate decrease leads to a 1.3 percent gain in the
index.
3. Differential impact of monetary policy: construction sector presents the
largest coefficient. Mining and utility sectors the smallest.

47. •47 of 35
Making (Some) Sense of the News:
Why the Stock Market Moved
Yesterday and Other Stories
Here are some quotes from the Wall Street Journal from April 1997 to
August 2001. Try to make sense of them, using what you’ve just
learned:
 April 1997.Good news on the economy, leading to an increase in
stock prices: “Bullish investors celebrated the release of market-
friendly economic data by stampeding back into stock and bond
markets, pushing the Dow Jones Industrial Average to its second-
largest point gain ever and putting the blue-chip index within
shooting distance of a record just weeks after it was reeling.”
 December 1999.Good news on the economy, leading to a decrease
in stock prices: “Good economic news was bad news for stocks and
worse news for bonds. . . . The announcement of stronger-than-
expected November retail-sales numbers wasn’t welcome.
Economic strength creates inflation fears and sharpens the risk that
the Federal Reserve will raise interest rates again.”

48. •48 of 35
Making (Some) Sense of the News: Why the
Stock Market Moved Yesterday and Other
Stories
 September 1998. Bad news on the economy, leading to an
decrease in stock prices: “Nasdaq stocks plummeted as
worries about the strength of the U.S. economy and the
profitability of U.S. corporations prompted widespread
selling.”
 August 2001. Bad news on the economy, leading to an
increase in stock prices: “Investors shrugged off more gloomy
economic news,
and focused instead on their hope that the worst is now over
for both the economy and the stock market. The optimism
translated into another 2% gain for the Nasdaq Composite
Index.”

49. Computing the Price
of Common Stock
Valuing common stock is, in theory, no different from
valuing debt securities: determine the future cash
flows and discount them to the present at an
appropriate discount rate.
We will review FOUR different methods for valuing
stock, each with its advantages
and drawbacks.

50. Computing the Price of Common Stock:
(1) The One-Period Valuation Model
Simplest model, just taking using the expected
dividend and price over the next year.


51. Computing the Price of Common Stock: (1) The
One-Period Valuation Model (cont..)
What is the price for a stock with an expected dividend
and price next year of $0.16 and $60, respectively? Use a
12% discount rate
Answer:

52. Computing the Price of Common Stock:
(2) The Generalized Dividend Valuation
Model
Extended to any number of periods (similar concept
with the one-period dividend model
Having the assumption that the stock pays (or will
pay) some dividends. Hence the price is the PV of the
dividends…

53. Computing the Price of Common Stock:
(3) The Gordon Growth Model
Same as the previous model, but it assumes that
dividend grow at a constant rate, g. That is,

54. Example: Gordon Growth Model

55. The model is useful, with the following assumptions:
Dividends do, indeed, grow at a constant rate forever
The growth rate of dividends, g, is less than the
required return on the equity, ke.

56. Computing the Price of Common Stock:
(4) Price Earnings Valuation Method
The price earnings ratio (PE) is a widely watched
measure how much the market is willing to pay
for $1.00 of earnings from
the firms.
 High PE have 2 interpretations:
- Higher than ave may mean the market is expected earnings to rise in the
future. Eventually PE will return to normal level
- -High PE may indicate market’s perception that the firms earnings are low
risk and willing to pay premium for it

57. Computing the Price of Common Stock: The
Price Earnings Valuation Method
If the industry PE ratio for a firm is 16,
what is the current stock price for a firm
with earnings for $1.13 / share?
Answer:
Price = 16 × $1.13 = $18.08

58. The price earning valuation
method
FORMULA
P/E = Market value per share (price) / Earnings
per share
where,
Earnings per share = Company earnings (net profit) over the last 12
months divided by the number of shares in circulation

59. The price earning valuation
method
FORMULA
Market value per share (price) =
P/E * Earnings per share

60. The price earning valuation
method
Important to note:-
i) P/E multiple shows HOW MUCH investors are
willing to pay per dollar of earnings – higher P/E,
investors anticipate higher growth in the future
ii) It is more useful to compare P/E of one company
to another within SAME industry
iii) Loss making company do not have any P/E –
why?

63. 5. RATIONAL EXPECTATION
THEORY AND THE STOCK MARKET
Stock valuations largely dependent on EXPECTATIONS regarding
(i) cashflows (ii) risk
Important role of expectations: the RET is currently the most
widely used theory to describe the formation of business and
consumer expectations
Earlier theory: Adaptive expectations: changes in expectations
occur slowly overtime due to past experience
Now: RET:
1. Expectations will be identical to optimal forecasts (the best guess
of the future) using all available information (Muth, 1961)
2. Even though RE equals optimal forecast using all available
information, a prediction based on the RET may not always be
perfectly accurate

64. 5. RATIONAL EXPECTATION
THEORY AND THE STOCK MARKET
Relating this to the Efficient Market Hypothesis:
Current price in a financial market will be set so that the
optimal forecast of a security’s return using all available
information equals the security’s equilibrium return
In an efficient market, a security’s price fully reflects all
available information

65. 5. RATIONAL EXPECTATION
THEORY AND THE STOCK MARKET
Evidence in favor of market efficiency
1. Performance of Investment Analysts and Mutual Funds
 It is impossible to beat the market: when purchasing a security, investors
cannot expect to earn an abnormal high return, a return greater than
equilibrium return
 Having performed well in the past does not indicate that an investment
adviser will perform well in the future
2. Random-walk behaviour of stock prices
 Stock price mostly follow a random walk-future changes in stock price is
unpredictable
 Test: Long memory properties

66. Bubbles, Fads, and Stock Prices
Stock prices are NOT always equal to their
fundamental value, or the present value of
expected dividends.
Rational speculative bubbles occur when stock
prices increase just because investors expected
them to.
Deviations of stock prices from their
fundamental value are called fads.
•66 of 35

67. Anomalies in the Stock Market
Anomalies are empirical results that seem to be inconsistent
/unexplained by the theories of asset-pricing behavior.
Puzzling behavior of stock market as it does not conform with the
predictions of accepted models of asset pricing
They indicate either market inefficiency (profit opportunities) or
inadequacies in the underlying asset-pricing model: contradict the
EMH
Some examples are
1. The Size effect
2. The “Incredible” January Effect
3. P/E Effect
4. Day of the Week (Monday Effect)

68. 1. The Size Effect
Small firm effect
In the early 1980’s, a number of studies found that the
stocks of small firms typically OUTPERFORM (on a risk-
adjusted basis) the stocks of large firms
This is even true among the large-capitalization stocks
within the S&P 500: smaller (but still large) stocks tend to
outperform the really large ones

69. 1. The Size Effect

70. 1. The Size Effect

71. •71
 Examine the historical performance of portfolios formed by
dividing the NYSE stocks into 10 portfolios each year
according to firm size (i.e., the total value of outstanding
equity).
 Average annual returns between 1926 and 2006 are
consistently higher on the small-firm portfolios. The
difference in average annual return between portfolio 10
(with the largest firms) and portfolio 1 (with the smallest
firms) is 8.86%.
The small-firm effect

72. •72
Average annual return for 10 size-based
portfolios (1926-2006):

73. •73
Some explanations:
 The smaller-firm portfolios tend to be riskier. But even when
returns are adjusted for risk using the CAPM, there is still a
consistent premium for the smaller-sized portfolios
 Thus, while size per se is not a risk factor, it perhaps might
act as a proxy for the more fundamental determinant of risk.
 Theories: tax issues, low liquidity of small firm stocks, large
information costs in evaluating small firms, inappropriate
measurement of risk for small firm stocks
 This pattern of returns may thus be consistent with an
efficient market in which expected returns are consistent
with risk
1. The Size Effect

74. 2. The “Incredible” January Effect
Stock prices tend to experience abnormal price rise from
Dec to January that is predictable, thus inconsistent with
the random walk behavior
Stock returns appear to be higher in January than in
other months of the year
It may also be related to end of year tax selling
Investor has incentive to sell stocks before year-end
(reducing price) because they can take capital losses on
their tax return and reduce their tax liability
Then repurchase in January (increasing price)

75. •75
The January effect is tied to tax-loss selling at the end of the
year:
 Many people sell stocks that have declined in price during the
previous months to realize their capital losses before the end of
the tax year
 Such investors do not put the proceeds from these sales back
into the stock market until after the turn of the year. At that point
the rush of demand for stock places an upward pressure on
prices that results in the January effect
 The evidence shows that the ratio of stock purchases to sales of
individual investors reaches an annual low at the end of
December and an annual high at the beginning of January
2. The “Incredible” January Effect

76. 3. The P/E Effect
• P/E ratio: the ratio of a stock’s price to its earnings per share.
It has been found that portfolios of “low P/E” stocks generally
outperform portfolios of “high P/E” stocks: Portfolios of low
P/E ratio stocks have higher returns than do high P/E
portfolios
• This may be related to the size effect since there is a high
correlation between the stock price and the P/E: It may be
that buying low P/E stocks is essentially the same as buying
small company stocks.

77. •77
Possible explanation:
• The returns are not properly adjusted for risk
•If two firms have the same expected earnings, then the riskier
stock will sell at a lower price and lower P/E ratio
•Because of its higher risk, the low P/E stock also will have
higher expected returns
• Thus, unless the CAPM beta fully adjusts for risk, P/E
will act as a useful additional descriptor of risk, and will
be associated with abnormal returns if the CAPM is
used to establish benchmark performance
3. The P/E Effect

78. 4. The Day of the Week Effect
• Based on daily stock prices from 1963 to 1985, Keim
(1984) found that returns are higher on Fridays and
lower on Mondays than should be expected.
• This is partly due to the fact that Monday returns actually
reflect the entire Friday close to Monday close time
period (weekend plus Monday), rather than just one day.
• However, after the stock market crash in 1987, this effect
disappeared completely and Monday became the best
performing day of the week between 1989 and 1998.

79. 5. Market Over-Reaction
• Stock prices may over-react to news announcements and
pricing errors are corrected only slowly
• Also related to excessive volatility: fluctuations in stock
prices may be much greater that is warranted by
fluctuations in their fundamental value
• Shiller (1981) along with other studies seemed to produce
a consensus that stock market prices appear to be drivenstock market prices appear to be driven
by factors other than fundamentalsby factors other than fundamentals