CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 141

The Stock Market,

7 the Theory of
Rational Expectations,
and the Efficient
Market Hypothesis

Preview
R arely does a day go by that the stock market isn’t a major news item. We have
witnessed huge swings in the stock market in recent years. The 1990s were an
extraordinary decade for stocks: The Dow Jones and S&P 500 indexes increased
more than 400%, while the tech-laden NASDAQ index rose more than 1,000%. By
early 2000, all three indexes had reached record highs. Unfortunately, the good times
did not last. Starting in early 2000, the stock market began to decline and many inves-
tors lost their shirts. The NASDAQ crashed, falling by more than 50%, while the Dow
Jones and S&P 500 indexes fell by 30% through January 2003. After subsequently ris-
ing over 30%, the stock market crashed again during the global financial crisis, falling
by over 50% from its peak in the fall of 2007. Starting in 2009, the stock market recov-
ered quickly, rising by more than 50% by 2011.
Because so many people invest in the stock market and the prices of stocks affect
the ability of people to retire comfortably, the market for stocks is undoubtedly the
financial market that receives the most attention and scrutiny. In this chapter, we look
first at how this important market works.
We begin by discussing the fundamental theories that underlie the valuation of
stocks. These theories are critical to understanding the forces that cause the value of
stocks to rise and fall minute by minute and day by day. Once we have learned the
methods for stock valuation, we need to explore how expectations about the market
affect its behavior. We do so by examining the theory of rational expectations. When this
theory is applied to financial markets, the outcome is the efficient market hypothesis,
which has some general implications for how markets in other securities besides stocks
operate. The theory of rational expectations is also central to debates about the conduct
of monetary policy, to be discussed in Chapter 24.

COMPUTING THE PRICE OF COMMON STOCK

Common stock is the principal way that corporations raise equity capital. Stockholders—
those who hold stock in a corporation—own an interest in the corporation proportional to
the percentage of outstanding shares they own. This ownership interest gives them a bundle
of rights. The most important are the right to vote and to be the residual claimant of all
funds flowing into the firm (known as cash flows), meaning that the stockholder receives
whatever remains after all other claims against the firm’s assets have been satisfied. Stock-
holders may receive dividends from the net earnings of the corporation. Dividends are
141
142 PART 2 Financial Markets

payments made periodically, usually every quarter, to stockholders. The board of directors
of the firm sets the level of the dividend, usually based on the recommendation of manage-
ment. In addition, the stockholder has the right to sell the stock.
One basic principle of finance is that the value of any investment is found by
computing the present value of all cash flows the investment will generate over its life.
For example, a commercial building will sell for a price that reflects the net cash flows
(rents – expenses) it is projected to have over its useful life. Similarly, we value common
stock as the value in today’s dollars of all future cash flows. The cash flows a stockholder
might earn from stock are dividends, the sales price, or both.
To develop the theory of stock valuation, we begin with the simplest possible sce-
nario: You buy the stock, hold it for one period to get a dividend, then sell the stock.
We call this the one-period valuation model.

The One-Period Valuation Model

Suppose that you have some extra money to invest for one year. After a year, you will
need to sell your investment to pay tuition. After watching CNBC or Nightly Business
Report on TV, you decide that you want to buy Intel Corp. stock. You call your broker
and find that Intel is currently selling for $50 per share and pays $0.16 per year in
dividends. The analyst on CNBC predicts that the stock will be selling for $60 in one
year. Should you buy this stock?
To answer this question, you need to determine whether the current price accu-
rately reflects the analyst’s forecast. To value the stock today, you need to find the pres-
ent discounted value of the expected cash flows (future payments) using the formula in
Equation 1 of Chapter 4. In this equation, the discount factor used to discount the cash
flows is the required return on investments in equity rather than the interest rate. The
cash flows consist of one dividend payment plus a final sales price. When these cash
flows are discounted back to the present, the following equation computes the current
price of the stock:
Div1 P1
P0 = + (1)
11 + ke 2 11 + ke 2

where P0 = the current price of the stock. The zero subscript refers to
time period zero, or the present.
Div1 = the dividend paid at the end of year 1.
ke = the required return on investments in equity.
P1 = the price at the end of the first period; the predicted sales
price of the stock.
To see how Equation 1 works, let’s compute the price of the Intel stock if, after
careful consideration, you decide that you would be satisfied to earn a 12% return on
the investment. If you have decided that ke = 0.12, are told that Intel pays $0.16 per
year in dividends 1Div1 = 0.162, and forecast the share price of $60 for next year
1P1 = $602, you get the following from Equation 1:
0.16 $60
P0 = + = $0.14 + $53.57 = $53.71
1 + 0.12 1 + 0.12
On the basis of your analysis, you find that the present value of all cash flows from
the stock is $53.71. Because the stock is currently priced at $50 per share, you would
CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 143

choose to buy it. However, you should be aware that the stock may be selling for less
than $53.71, because other investors place a different risk on the cash flows or estimate
the cash flows to be less than you do.

The Generalized Dividend Valuation Model

Using the present value concept, we can extend the one-period dividend valuation
model to any number of periods: The value of a stock today is the present value of all
future cash flows. The only cash flows that an investor will receive are dividends and a
final sales price when the stock is ultimately sold in period n. The generalized multipe-
riod formula for stock valuation can be written as
D1 D2 Dn Pn
P0 = 1 + 2 + c + n + (2)
11 + ke 2 11 + ke 2 11 + ke 2 11 + ke 2 n
If you tried to use Equation 2 to find the value of a share of stock, you would soon
realize that you must first estimate the value the stock will have at some point in the
future before you can estimate its value today. In other words, you must find Pn before
you can find P0. However, if Pn is far in the future, it will not affect P0. For example, the
present value of a share of stock that sells for $50 seventy-five years from now, using a
12% discount rate, is just one cent 3 $50>11.1275 2 = $0.01 4 . This reasoning implies
that the current value of a share of stock can be calculated as simply the present value of
the future dividend stream. The generalized dividend model is rewritten in Equation 3
without the final sales price:

P0 = a
!
Dt
(3)
t=1 11 + ke 2 t
Consider the implications of Equation 3 for a moment. The generalized dividend
model says that the price of stock is determined only by the present value of the divi-
dends and that nothing else matters. Many stocks do not pay dividends, so how is it
that these stocks have value? Buyers of the stock expect that the firm will pay dividends
someday. Most of the time a firm institutes dividends as soon as it has completed the
rapid growth phase of its life cycle.
The generalized dividend valuation model requires that we compute the present
value of an infinite stream of dividends, a process that could be difficult, to say the
least. Therefore, simplified models have been developed to make the calculations
easier. One such model is the Gordon growth model, which assumes constant divi-
dend growth.

The Gordon Growth Model

Many firms strive to increase their dividends at a constant rate each year. Equation 4
rewrites Equation 3 to reflect this constant growth in dividends:
D0 * 11 + g2 1 D0 * 11 + g2 2 D0 * 11 + g2 !
P0 = + + c+ (4)
11 + ke 2 1 11 + ke 2 2 11 + ke 2 !

where D0 = the most recent dividend paid

g = the expected constant growth rate in dividends
ke = the required return on an investment in equity
144 PART 2 Financial Markets

Equation 4 can be simplified to obtain Equation 5:1

D0 * 11 + g2 D1
P0 = = (5)
1ke - g2 1ke - g2
This model is useful for finding the value of stock, given a few assumptions:
1. Dividends are assumed to continue growing at a constant rate forever. Actually, as long
as they are expected to grow at a constant rate for an extended period of time, the
model should yield reasonable results. This is because errors about distant cash
flows become small when discounted to the present.
2. The growth rate is assumed to be less than the required return on equity, ke. Myron
Gordon, in his development of the model, demonstrated that this is a reasonable
assumption. In theory, if the growth rate were faster than the rate demanded
by holders of the firm’s equity, in the long run the firm would grow impossibly
large.

HOW THE MARKET SETS STOCK PRICES

Suppose you go to an auto auction. The cars are available for inspection before the
auction begins, and you find a little Mazda Miata that you like. You test-drive it in the
parking lot and notice that it makes a few strange noises, but you decide that you would
still like the car. You decide $5,000 would be a fair price that would allow you to pay
some repair bills should the noises turn out to be serious. You see that the auction is
ready to begin, so you go in and wait for the Miata to enter.
Suppose another buyer also spots the Miata. He test-drives the car and recognizes
that the noises are simply the result of worn brake pads that he can fix himself at a
nominal cost. He decides that the car is worth $7,000. He also goes in and waits for the
Miata to come up for auction.
Who will buy the car and for how much? Suppose only the two of you are inter-
ested in the Miata. You begin the bidding at $4,000. Your competitor ups your bid to
$4,500. You bid your top price of $5,000. He counters with $5,100. The price is now
higher than you are willing to pay, so you stop bidding. The car is sold to the more
informed buyer for $5,100.

1
To generate Equation 5 from Equation 4, first multiply both sides of Equation 4 by 11 + ke 2>11 + g2 and sub-
tract Equation 4 from the result. This yields
P0 * 11 + ke 2 D0 * 11 + g2 !
- P0 = D 0 -
11 + g2 11 + ke 2 !
Assuming that ke is greater than g, the term on the far right will approach zero and can be dropped. Thus, after
factoring P0 out of the left-hand side,
1 + ke
P0 * c - 1 d = D0
1 + g
Next, simplify by combining terms: 11 + ke 2 - 11 + g2
P0 * = D0
1 + g

D0 * 11 + g2 D1
P0 = =
ke - g ke - g
CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 145

This simple example raises a number of points. First, the price is set by the buyer
willing to pay the highest price. The price is not necessarily the highest price the asset
could fetch, but it is incrementally greater than what any other buyer is willing to pay.
Second, the market price will be set by the buyer who can take best advantage of
the asset. The buyer who purchased the car knew that he could fix the noise easily and
cheaply. As a consequence, he was willing to pay more for the car than you were. The
same concept holds for other assets. For example, a piece of property or a building will
sell to the buyer who can put the asset to the most productive use.
Finally, the example shows the role played by information in asset pricing. Superior
information about an asset can increase its value by reducing its risk. When you con-
sider buying a stock, the future cash flows have many unknowns. The buyer who has
the best information about these cash flows will discount them at a lower interest rate
than will a buyer who is very uncertain.
Now let’s apply these ideas to stock valuation. Suppose that you are considering
the purchase of stock expected to pay a $2 dividend next year. Market analysts expect
the firm to grow at 3% indefinitely. You are uncertain about both the constancy of the
dividend stream and the accuracy of the estimated growth rate. To compensate yourself
for this uncertainty (risk), you require a return of 15%.
Now suppose Jennifer, another investor, has spoken with industry insiders and
feels more confident about the projected cash flows. Jennifer requires only a 12% return
because her perceived risk is lower than yours. Bud, on the other hand, is dating the
CEO of the company. He knows with more certainty what the future of the firm actually
is, and thus requires only a 10% return.
What are the values each investor will give to the stock? Applying the Gordon
growth model yields the following stock prices:

Investor Discount Rate Stock Price

You 15% $16.67

Jennifer 12% $22.22
Bud 10% $28.57

You are willing to pay $16.67 for the stock. Jennifer would pay up to $22.22, and
Bud would pay $28.57. The investor with the lowest perceived risk is willing to pay the
most for the stock. If there were no other traders but these three, the market price would
be between $22.22 and $28.57. If you already held the stock, you would sell it to Bud.
We thus see that the players in the market, bidding against one another, establish
the market price. When new information is released about a firm, expectations change
and with them, prices change. New information can cause changes in expectations
about the level of future dividends or the risk of those dividends. Because market par-
ticipants are constantly receiving new information and revising their expectations, it is
reasonable that stock prices are constantly changing as well.

APPLICATION ◆ Monetary Policy and Stock Prices

Stock market analysts tend to hang on every word that the chairman of the Federal
Reserve utters because they know that an important determinant of stock prices is
monetary policy. But how does monetary policy affect stock prices?
146 PART 2 Financial Markets

The Gordon growth model in Equation 5 explains this relationship. Monetary policy
can affect stock prices in two ways. First, when the Fed lowers interest rates, the return
on bonds (an alternative asset to stocks) declines, and investors are likely to accept a
lower required rate of return on an investment in equity (ke). The resulting decline in
ke would lower the denominator in the Gordon growth model (Equation 5), lead to a
higher value of P0, and raise stock prices. Furthermore, a lowering of interest rates is
likely to stimulate the economy, so the growth rate in dividends, g, is likely to be some-
what higher. This rise in g also causes the denominator in Equation 5 to decrease, which
also leads to a higher P0 and a rise in stock prices.
As we will see in Chapter 25, the impact of monetary policy on stock prices is one
of the key ways in which monetary policy affects the economy.

APPLICATION: ◆ The Global Financial Crisis and the

Stock Market
The subprime financial crisis that started in August 2007 led to one of the worst bear
markets in the past 50 years. Our analysis of stock price valuation, again using the
Gordon growth model, can help us understand how this event affected stock prices.
The subprime financial crisis had a major negative impact on the economy, leading
to a downward revision of the growth prospects for U.S. companies, thus lowering the
dividend growth rate (g) in the Gordon model. The resulting increase in the denomi-
nator in Equation 5 would lead to a decline in P0 and hence a decline in stock prices.
Increased uncertainty for the U.S. economy and the widening credit spreads result-
ing from the subprime crisis would also raise the required return on investment in
equity. A higher ke also leads to an increase in the denominator in Equation 5, a decline
in P0, and a general fall in stock prices.
In the early stages of the global financial crisis, the decline in growth prospects and
credit spreads were moderate, and so, as the Gordon model predicts, the stock market
decline was also moderate. However, when the crisis entered a particularly virulent
stage in October 2008, credit spreads shot through the roof, the economy tanked, and
as the Gordon model predicts, the stock market crashed. From its peak in October 2007
(high of 14,066 for the DJIA) to the bottom in March 2009 (DJIA low of 6,547) the
market lost 53% of its value. ◆

THE THEORY OF RATIONAL EXPECTATIONS

The analysis of stock price evaluation we outlined in the previous section depends on
people’s expectations—especially of cash flows. Indeed, it is difficult to think of any
sector in the economy in which expectations are not crucial; this is why it is important
to examine how expectations are formed. We do so by outlining the theory of rational
expectations, currently the most widely used theory to describe the formation of busi-
ness and consumer expectations.
In the 1950s and 1960s, economists regularly viewed expectations as formed from
past experience only. Expectations of inflation, for example, were typically viewed as
CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 147

being an average of past inflation rates. This view of expectation formation, called
adaptive expectations, suggests that changes in expectations will occur slowly over
time as past data change.2 So if inflation had formerly been steady at a 5% rate, expec-
tations of future inflation would be 5%, too. If inflation rose to a steady rate of 10%,
expectations of future inflation would rise toward 10%, but slowly: In the first year,
expected inflation might rise only to 6%; in the second year, to 7%; and so on.
Adaptive expectations have been faulted on the grounds that people use more
information than just past data on a single variable to form their expectations of that
variable. Their expectations of inflation will almost surely be affected by their predic-
tions of future monetary policy as well as by current and past monetary policy. In addi-
tion, people often change their expectations quickly in the light of new information.
To meet these objections to adaptive expectations, John Muth developed an alternative
theory of expectations, called rational expectations, which can be stated as follows:
Expectations will be identical to optimal forecasts (the best guess of the future) using
all available information.3
What exactly does this mean? To explain it more clearly, let’s use the theory of
rational expectations to examine how expectations are formed in a situation that most
of us encounter at some point in our lifetime: our drive to work. Suppose that if Joe
Commuter travels when it is not rush hour, it takes an average of 30 minutes for his
trip. Sometimes it takes him 35 minutes, other times 25 minutes, but the average non–
rush-hour driving time is 30 minutes. If, however, Joe leaves for work during the rush
hour, it takes him, on average, an additional 10 minutes to get to work. Given that he
leaves for work during the rush hour, the best guess of the driving time—the optimal
forecast—is 40 minutes.
If the only information available to Joe before he leaves for work that would have
a potential effect on his driving time is that he is leaving during the rush hour, what
does rational expectations theory allow you to predict about Joe’s expectations of his
driving time? Since the best guess of his driving time using all available information
is 40 minutes, Joe’s expectation should also be the same. Clearly, an expectation of
35 minutes would not be rational, because it is not equal to the optimal forecast, the
best guess of the driving time.
Suppose that the next day, given the same conditions and expectations, it takes
Joe 45 minutes to drive because he hits an abnormally large number of red lights, and
the day after that he hits all the lights right and it takes him only 35 minutes. Do these
variations mean that Joe’s 40-minute expectation is irrational? No, an expectation of 40
minutes’ driving time is still a rational expectation. In both cases, the forecast is off by
five minutes, so the expectation has not been perfectly accurate. However, the forecast
does not have to be perfectly accurate to be rational—it need only be the best possible
given the available information; that is, it has to be correct on average, and the 40-minute
expectation meets this requirement. As there is bound to be some randomness in Joe’s

2
More specifically, adaptive expectations—say, of inflation—are written as a weighted average of past inflation rates:

p et = 11 - l2 a ljpt - j
!

j=0

where p et = adaptive expectation of inflation at time t

pt - j = inflation at time t - j
l = a constant between the values of 0 and 1
3
John Muth, “Rational Expectations and the Theory of Price Movements,” Econometrica 29 (1961): 315–335.
148 PART 2 Financial Markets

driving time regardless of driving conditions, an optimal forecast will never be com-
pletely accurate.
The example makes the following important point about rational expectations:
Even though a rational expectation equals the optimal forecast using all available
information, a prediction based on it may not always be perfectly accurate.
What if an item of information relevant to predicting driving time is unavailable or
ignored? Suppose that on Joe’s usual route to work an accident occurs and causes a two-
hour traffic jam. If Joe has no way of ascertaining this information, his rush-hour expec-
tation of 40 minutes’ driving time is still rational, because the accident information is
not available to him for incorporation into his optimal forecast. However, if there was a
radio or TV traffic report about the accident that Joe did not bother to listen to or heard
but ignored, his 40-minute expectation is no longer rational. In light of the availability
of this information, Joe’s optimal forecast should have been two hours and 40 minutes.
Accordingly, an expectation may fail to be rational for two reasons:
1. People might be aware of all available information but find it takes too much effort
to make their expectation the best guess possible.
2. People might be unaware of some available relevant information, so their best guess
of the future will not be accurate.
Nonetheless, it is important to recognize that if an additional factor is important but
information about it is not available, an expectation that does not take account of it can
still be rational.

Formal Statement of the Theory

We can state the theory of rational expectations somewhat more formally. If X stands
for the variable that is being forecast (in our example, Joe Commuter’s driving time),
Xe for the expectation of this variable (Joe’s expectation of his driving time), and Xof for
the optimal forecast of X using all available information (the best guess possible of his
driving time), the theory of rational expectations then simply says
X e = X of (6)
That is, the expectation of X equals the optimal forecast using all available information.

Rationale Behind the Theory

Why do people try to make their expectations match their best possible guess of the
future, using all available information? The simplest explanation is that it is costly for
people not to do so. Joe Commuter has a strong incentive to make his expectation of the
time it takes him to drive to work as accurate as possible. If he underpredicts his driving
time, he will often be late to work and risk being fired. If he overpredicts, he will, on
average, get to work too early and will have given up sleep or leisure time unnecessarily.
Accurate expectations are desirable, and the incentives are strong for people to try to
make them equal to optimal forecasts by using all available information.
The same principle applies to businesses. Suppose that an appliance manufacturer—
say, General Electric—knows that interest-rate movements are important to the sales of
appliances. If GE makes poor forecasts of interest rates, it will earn less profit, because it
might produce either too many appliances or too few. The incentives are strong for GE
to acquire all available information to help it forecast interest rates and use the informa-
tion to make the best possible guess of future interest-rate movements.
CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 149

The incentives for equating expectations with optimal forecasts are especially
strong in financial markets. In these markets, people with better forecasts of the future
get rich. The application of the theory of rational expectations to financial markets
(where it is called the efficient market hypothesis or the theory of efficient capital
markets) is thus particularly useful.

Implications of the Theory

Rational expectations theory leads to two commonsense implications for forming
expectations that are important in the analysis of both the stock market and the aggre-
gate economy:
1. If there is a change in the way a variable moves, the way in which expectations
of this variable are formed will change as well. This tenet of rational expectations theory
can be most easily understood through a concrete example. Suppose that interest rates
move in such a way that they tend to return to a “normal” level in the future. If today’s
interest rate is high relative to the normal level, an optimal forecast of the interest rate in
the future is that it will decline to the normal level. Rational expectations theory would
imply that when today’s interest rate is high, the expectation is that it will fall in the future.
Suppose now that the way in which the interest rate moves changes so that when the
interest rate is high, it stays high. In this case, when today’s interest rate is high, the opti-
mal forecast of the future interest rate, and hence the rational expectation, is that it will
stay high. Expectations of the future interest rate will no longer indicate that the interest
rate will fall. The change in the way the interest-rate variable moves has therefore led to
a change in the way that expectations of future interest rates are formed. The rational
expectations analysis here is generalizable to expectations of any variable. Hence, when
a change occurs in the way any variable moves, the way in which expectations of this
variable are formed will change, too.
2. The forecast errors of expectations will, on average, be zero and cannot be
predicted ahead of time. The forecast error of an expectation is X – Xe, the difference
between the realization of a variable X and the expectation of the variable. That is, if
Joe Commuter’s driving time on a particular day is 45 minutes and his expectation of
the driving time is 40 minutes, the forecast error is five minutes.
Suppose that in violation of the rational expectations tenet, Joe’s forecast error is not, on
average, equal to zero; instead, it equals five minutes. The forecast error is now predictable
ahead of time because Joe will soon notice that he is, on average, five minutes late for work
and can improve his forecast by increasing it by five minutes. Rational expectations theory
implies that this is exactly what Joe will do because he will want his forecast to be the best
guess possible. When Joe has revised his forecast upward by five minutes, on average, the
forecast error will equal zero so that it cannot be predicted ahead of time. Rational expecta-
tions theory implies that forecast errors of expectations cannot be predicted.

THE EFFICIENT MARKET HYPOTHESIS: RATIONAL EXPECTATIONS

IN FINANCIAL MARKETS
While monetary economists were developing the theory of rational expectations, finan-
cial economists were developing a parallel theory of expectations formation in financial
markets. It led them to the same conclusion as that of the rational expectations theorists:
150 PART 2 Financial Markets

Expectations in financial markets are equal to optimal forecasts using all available infor-
mation.4 Although financial economists gave their theory another name, calling it the
efficient market hypothesis, in fact their theory is just an application of rational expecta-
tions to the pricing of stocks and also other securities.
The efficient market hypothesis is based on the assumption that prices of securities
in financial markets fully reflect all available information. You may recall from Chapter 4
that the rate of return from holding a security equals the sum of the capital gain on
the security (the change in the price), plus any cash payments, divided by the initial
purchase price of the security:
Pt + 1 - Pt + C
R = (7)
Pt

where R = rate of return on the security held from time t to t + 1 (say, the
end of 2012 to the end of 2013)
Pt + 1 = price of the security at time t + 1, the end of the holding period
Pt = price of the security at time t, the beginning of the holding period
C = cash payment (coupon or dividend payments) made in the period
t to t + 1
Let’s look at the expectation of this return at time t, the beginning of the holding
period. Because the current price Pt and the cash payment C are known at the begin-
ning, the only variable in the definition of the return that is uncertain is the price next
period, Pt + 1.5 Denoting expectation of the security’s price at the end of the holding
period as Pet+ 1, the expected return Re is
Pet+ 1 - Pt + C
Re =
Pt
The efficient market hypothesis views expectations of future prices as equal to
optimal forecasts using all currently available information. In other words, the market’s
expectations of future securities prices are rational, so that
Pet+ 1 = Poft+ 1
which in turn implies that the expected return on the security will equal the optimal
forecast of the return:
Re = Rof (8)
Unfortunately, we cannot observe either R or e
Pet+ 1,
so the rational expectations equations
by themselves do not tell us much about how the financial market behaves. However, if
we can devise some way to measure the value of Re, these equations will have important
implications for how prices of securities change in financial markets.
The supply and demand analysis of the bond market developed in Chapter 5 shows us
that the expected return on a security (the interest rate, in the case of the one-year discount
bond examined) will have a tendency to head toward the equilibrium return that equates
the quantity demanded to the quantity supplied. Supply and demand analysis enables us
to determine the expected return on a security with the following equilibrium condition:
4
The development of the efficient market hypothesis was not wholly independent of the development of rational
expectations theory, in that financial economists were aware of Muth’s work.
5
There are cases in which C might not be known at the beginning of the period, but that does not make a substan-
tial difference to the analysis. We would in that case assume that not only price expectations but also the expecta-
tions of C are optimal forecasts using all available information.
CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 151

The expected return on a security Re equals the equilibrium return R*, which equates
the quantity of the security demanded to the quantity supplied; that is,
Re = R* (9)
The academic field of finance explores the factors (risk and liquidity, for example) that
influence the equilibrium returns on securities. For our purposes, it is sufficient to
know that we can determine the equilibrium return and thus determine the expected
return with the equilibrium condition.
We can derive an equation to describe pricing behavior in an efficient market by
using the equilibrium condition to replace Re with R* in the rational expectations equa-
tion (Equation 8). In this way, we obtain
Rof = R* (10)
This equation tells us that current prices 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. Financial economists state it more simply: In an efficient
market, a security’s price fully reflects all available information.

Rationale Behind the Hypothesis

To see why the efficient market hypothesis makes sense, we make use of the concept
of arbitrage, in which market participants (arbitrageurs) eliminate unexploited profit
opportunities, that is, returns on a security that are larger than what is justified by the
characteristics of that security. Arbitrage is of two types: pure arbitrage, in which the
elimination of unexploited profit opportunities involves no risk; and the type of arbitrage
we discuss here, in which the arbitrageur takes on some risk when eliminating the unex-
ploited profit opportunities. To see how arbitrage leads to the efficient market hypothesis,
suppose that, given its risk characteristics, the normal return on a security, say, Exxon-
Mobil common stock, is 10% at an annual rate, and its current price Pt is lower than the
optimal forecast of tomorrow’s price Poft+ 1 so that the optimal forecast of the return at an
annual rate is 50%, which is greater than the equilibrium return of 10%. We are now
able to predict that, on average, ExxonMobil’s return would be abnormally high, so there
is an unexploited profit opportunity. Knowing that, on average, you can earn such an
abnormally high rate of return on ExxonMobil because Rof 7 R*, you would buy more,
which would in turn drive up its current price Pt relative to the expected future price
Poft+ 1, thereby lowering Rof. When the current price had risen sufficiently so that Rof
equaled R* and the efficient market condition (Equation 10) was satisfied, the buying
of ExxonMobil would stop, and the unexploited profit opportunity would disappear.
Similarly, a security for which the optimal forecast of the return is -5% and the
equilibrium return is 10% 1Rof 6 R*2 would be a poor investment, because, on aver-
age, it earns less than the equilibrium return. In such a case, you would sell the security
and drive down its current price relative to the expected future price until Rof rose to the
level of R* and the efficient market condition was again satisfied. What we have shown
can be summarized as follows:
Rof 7 R* S Pt c S Rof T
Rof 6 R* S Pt T S Rof c
until
Rof = R*
152 PART 2 Financial Markets

Another way to state the efficient market condition is this: In an efficient market, all
unexploited profit opportunities will be eliminated.
An extremely important factor in this reasoning is that not everyone in a finan-
cial market must be well informed about a security or have rational expectations
for its price to be driven to the point at which the efficient market condition
holds. Financial markets are structured so that many participants can play. As long
as a few people (often referred to as the “smart money”) keep their eyes open for
unexploited profit opportunities, they will eliminate the profit opportunities that
appear, because in so doing, they make a profit. The efficient market hypothesis
makes sense, because it does not require everyone in a market to be cognizant of
what is happening to every security.

APPLICATION ◆ Practical Guide to Investing in the

Stock Market
The efficient market hypothesis has numerous applications to the real world.6 It is
especially valuable because it can be applied directly to an issue that concerns many of
us: how to get rich (or at least not get poor) in the stock market. A practical guide to
investing in the stock market, which we develop here, provides a better understanding
of the use and implications of the efficient market hypothesis.

How Valuable Are Published Reports

by Investment Advisers?
Suppose you have just read in the “Heard on the Street” column of the Wall Street Jour-
nal that investment advisers are predicting a boom in oil stocks because an oil shortage
is developing. Should you proceed to withdraw all your hard-earned savings from the
bank and invest it in oil stocks?
The efficient market hypothesis tells us that when purchasing a security, we can-
not expect to earn an abnormally high return, a return greater than the equilibrium
return.
Information in newspapers and in the published reports of investment advisers is
readily available to many market participants and is already reflected in market prices.
So acting on this information will not yield abnormally high returns, on average. The
empirical evidence for the most part confirms that recommendations from investment
advisers cannot help us outperform the general market. Indeed, as the FYI box suggests,
human investment advisers in San Francisco do not, on average, even outperform an
orangutan!
Probably no other conclusion is met with more skepticism by students than this
one when they first hear it. We all know or have heard of someone who has been
successful in the stock market for a period of many years. We wonder, “How could

6
The empirical evidence on the efficient market hypothesis is discussed in an appendix to this chapter, which can
be found on the Companion Website at [Link]/mishkin.
CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 153

someone be so consistently successful if he or she did not really know how to predict
when returns would be abnormally high?” The following story, reported in the press,
illustrates why such anecdotal evidence is not reliable.
A get-rich-quick artist invented a clever scam. Every week, he wrote two let-
ters. In letter A, he would pick team A to win a particular football game; in letter B,
he would pick the opponent, team B. He would then separate a mailing list into
two groups, and he would send letter A to the people in one group and letter B to
the people in the other. The following week he would do the same thing but would
send these letters only to the group who had received the first letter with the correct
prediction. After doing this for ten games, he had a small cluster of people who had
received letters predicting the correct winning team for every game. He then mailed
a final letter to them, declaring that since he was obviously an expert predictor of
the outcome of football games (he had picked winners ten weeks in a row) and since
his predictions were profitable for the recipients who bet on the games, he would
continue to send his predictions only if he were paid a substantial amount of money.
When one of his clients figured out what he was up to, the con man was prosecuted
and thrown in jail!
What is the lesson of the story? Even if no forecaster is an accurate predictor of the
market, there will always be a group of consistent winners. A person who has done well
regularly in the past cannot guarantee that he or she will do well in the future. Note that
there will also be a group of persistent losers, but you rarely hear about them because
no one brags about a poor forecasting record.

Should You Be Skeptical of Hot Tips?

Suppose your broker phones you with a hot tip to buy stock in the Happy Feet Cor-
poration (HFC) because it has just developed a product that is completely effective in
curing athlete’s foot. The stock price is sure to go up. Should you follow this advice and
buy HFC stock?
The efficient market hypothesis indicates that you should be skeptical of such
news. If the stock market is efficient, it has already priced HFC stock so that its
expected return will equal the equilibrium return. The hot tip is not particularly valu-
able and will not enable you to earn an abnormally high return.
You might wonder, though, if the hot tip is based on new information and would
give you an edge on the rest of the market. If other market participants have gotten this
information before you, the answer is no. As soon as the information hits the street,
the unexploited profit opportunity it creates will be quickly eliminated. The stock’s
price will already reflect the information, and you should expect to realize only the
equilibrium return. But if you are one of the first to gain the new information, it can
do you some good. Only then can you be one of the lucky ones who, on average, will
earn an abnormally high return by helping eliminate the profit opportunity by buying
HFC stock.

Do Stock Prices Always Rise When There Is Good News?

If you follow the stock market, you might have noticed a puzzling phenomenon: When
good news about a stock, such as a particularly favorable earnings report, is announced,
the price of the stock frequently does not rise. The efficient market hypothesis explains
this phenomenon.
154 PART 2 Financial Markets

FYI Should You Hire an Ape as Your Investment Adviser?

The San Francisco Chronicle came up with an amusing results found in the “Investment Dartboard” feature
way of evaluating how successful investment advisers of the Wall Street Journal, Jolyn beat the investment
are at picking stocks. They asked eight analysts to pick advisers as often as they beat her. Given this result,
five stocks at the beginning of the year and then com- you might be just as well off hiring an orangutan
pared the performance of their stock picks to those as your investment adviser as you would hiring a
chosen by Jolyn, an orangutan living at Marine World/ human being!
Africa USA in Vallejo, California. Consistent with the

Because changes in stock prices are unpredictable, when information is announced

that has already been expected by the market, the stock price will remain unchanged.
The announcement does not contain any new information that should lead to a change
in stock prices. If this were not the case and the announcement led to a change in stock
prices, it would mean that the change was predictable. Because that is ruled out in an
efficient market, stock prices will respond to announcements only when the informa-
tion being announced is new and unexpected. If the news is expected, no stock price
response will occur. This is exactly what the evidence shows: Stock prices do reflect
publicly available information.
Sometimes an individual stock price declines when good news is announced.
Although this seems somewhat peculiar, it is completely consistent with the workings
of an efficient market. Suppose that although the announced news is good, it is not
as good as expected. HFC’s earnings may have risen 15%, but if the market expected
earnings to rise by 20%, the new information is actually unfavorable, and the stock
price declines.

Efficient Market Prescription for the Investor

What does the efficient market hypothesis recommend for investing in the stock
market? It tells us that hot tips and investment advisers’ published recommenda-
tions—all of which make use of publicly available information—cannot help an
investor outperform the market. Indeed, it indicates that anyone without better
information than other market participants cannot expect to beat the market. So
what is an investor to do?
The efficient market hypothesis leads to the conclusion that such an investor (and
almost all of us fit into this category) should not try to outguess the market by con-
stantly buying and selling securities. This process does nothing but boost the income of
brokers, who earn commissions on each trade.7 Instead, the investor should pursue a
“buy and hold” strategy—purchase stocks and hold them for long periods of time. This

7
The investor may also have to pay Uncle Sam capital gains taxes on any profits that are realized when a security
is sold—an additional reason why continual buying and selling does not make sense.
CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 155

will lead to the same returns, on average, but the investor’s net profits will be higher,
because fewer brokerage commissions will have to be paid.
It is frequently a sensible strategy for a small investor, whose costs of managing
a portfolio may be high relative to its size, to buy into a mutual fund rather than
to buy individual stocks. Because the efficient market hypothesis indicates that no
mutual fund can consistently outperform the market, an investor should not buy
into one that has high management fees or that pays sales commissions to brokers,
but rather should purchase a no-load (commission-free) mutual fund that has low
management fees.
The evidence indicates that it will not be easy to beat the prescription suggested
here, although some anomalies (discussed in an appendix found on this book’s website)
to the efficient market hypothesis suggest that an extremely clever investor (which rules
out most of us) may be able to outperform a buy-and-hold strategy. ◆

WHY THE EFFICIENT MARKET HYPOTHESIS DOES NOT IMPLY

THAT FINANCIAL MARKETS ARE EFFICIENT
Many financial economists take the efficient market hypothesis one step further in their
analysis of financial markets. Not only do they believe that expectations in financial
markets are rational—that is, equal to optimal forecasts using all available information—
but they also add the condition that prices in financial markets reflect the true funda-
mental (intrinsic) value of the securities. In other words, all prices are always correct
and reflect market fundamentals (items that have a direct impact on future income
streams of the securities) and so financial markets are efficient.
This stronger view of market efficiency has several important implications in
the academic field of finance. First, it implies that in an efficient capital market, one
investment is as good as any other because the securities’ prices are correct. Second,
it implies that a security’s price reflects all available information about the intrinsic
value of the security. Third, it implies that security prices can be used by managers
of both financial and nonfinancial firms to assess their cost of capital (cost of financ-
ing their investments) accurately and hence that security prices can be used to help
them make correct decisions about whether a specific investment is worth making.
This stronger version of market efficiency is a basic tenet of much analysis in the
finance field.
The efficient market hypothesis may be misnamed, however. It does not imply the
stronger view of market efficiency, but rather just that prices in markets like the stock
market are unpredictable. Indeed, as the following application suggests, the existence
of market crashes and bubbles, in which the prices of assets rise well above their
fundamental values, casts serious doubt on the stronger view that financial markets
are efficient, but provides less of an argument against the basic lessons of the efficient
market hypothesis.
156 PART 2 Financial Markets

APPLICATION ◆ What Do Stock Market Crashes Tell Us

About the Efficient Market Hypothesis
and the Efficiency of Financial Markets?
On October 19, 1987, dubbed “Black Monday,” the Dow Jones Industrial Average
declined more than 20%, the largest one-day decline in U.S. history. The collapse
of the high-tech companies’ share prices from their peaks in March 2000 caused the
heavily tech-laden NASDAQ index to fall from about 5,000 in March 2000 to about
1,500 in 2001 and 2002, a decline of well over 60%. These stock market crashes have
caused many economists to question the validity of the efficient market hypothesis.
They do not believe that a rational marketplace could have produced such a massive
swing in share prices. To what degree should these stock market crashes make us
doubt the validity of the efficient market hypothesis?
Nothing in efficient markets theory rules out large changes in stock prices. A
large change in stock prices can result from new information that produces a dramatic
decline in optimal forecasts of the future valuation of firms. However, economists are
hard pressed to come up with fundamental changes in the economy that can explain the
Black Monday and tech crashes. One lesson from these crashes is that factors other than
market fundamentals probably have an effect on asset prices. Indeed, as we will explore
in Chapters 8 and 9, there are good reasons to believe that impediments to financial
markets working well do exist. Hence these crashes have convinced many economists
that the stronger version of market efficiency, which states that asset prices reflect the
true fundamental (intrinsic) value of securities, is incorrect. They attribute a large role
in determination of stock and other asset prices to market psychology and to the institu-
tional structure of the marketplace. However, nothing in this view contradicts the basic
reasoning behind rational expectations or the efficient market hypothesis—that market
participants eliminate unexploited profit opportunities. Even though stock market
prices may not always solely reflect market fundamentals, as long as market crashes are
unpredictable, the basic lessons of efficient markets theory hold.
However, other economists believe that market crashes and bubbles suggest that
unexploited profit opportunities may exist and that the efficient market hypothesis
might be fundamentally flawed. The controversy over the efficient market hypothesis
continues. ◆

BEHAVIORAL FINANCE
Doubts about the efficiency of financial markets, triggered by the stock market crash
of 1987, led to the emergence of a new field of study, behavioral finance. It applies
concepts from other social sciences such as anthropology, sociology, and, particularly,
psychology to understand the behavior of securities prices.8

8
Surveys of this field can be found in Hersh Shefrin, Beyond Greed and Fear: Understanding of Behavioral Finance
and the Psychology of Investing (Boston: Harvard Business School Press, 2000); Andrei Shleifer, Inefficient Markets
(Oxford, UK: Oxford University Press, 2000); and Robert J. Shiller, “From Efficient Market Theory to Behavioral
Finance,” Cowles Foundation Discussion Paper No. 1385 (October 2002).
CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 157

As we have seen, the efficient market hypothesis assumes that unexploited profit
opportunities are eliminated by “smart money” market participants. But can smart
money dominate ordinary investors so that financial markets are efficient? Specifically,
the efficient market hypothesis suggests that smart money participants will sell when a
stock price goes up irrationally, with the result that the stock price falls back down to
a level that is justified by fundamentals. For this to occur, smart money investors must
be able to engage in short sales; that is, they must borrow stock from brokers and then
sell it in the market, with the aim that they earn a profit by buying the stock back again
(“covering the short”) after it has fallen in price. Work by psychologists, however, sug-
gests that people are subject to loss aversion: They are more unhappy when they suffer
losses than they are happy when they achieve gains. Short sales can result in losses far in
excess of an investor’s initial investment if the stock price climbs sharply higher than the
price at which the short sale is made (and losses have the possibility of being unlimited
if the stock price climbs to astronomical heights).
Loss aversion can thus explain an important phenomenon: Very little short selling
actually takes place. Short selling may also be constrained by rules restricting it because
it seems unsavory for someone to make money from another person’s misfortune. The
existence of so little short selling can explain why stock prices are sometimes overval-
ued. That is, the lack of enough short selling means that smart money does not drive
stock prices back down to their fundamental value.
Psychologists have also found that people tend to be overconfident in their own
judgments. As a result, investors tend to believe that they are smarter than other inves-
tors. Because investors are willing to assume that the market typically doesn’t get it
right, they trade on their beliefs, rather than on pure facts. This theory may explain
why securities markets have such a large trading volume—something that the efficient
market hypothesis does not predict.
Overconfidence and social contagion (fads) provide an explanation for stock mar-
ket bubbles. When stock prices go up, investors attribute their profits to their intel-
ligence and talk up the stock market. This word-of-mouth enthusiasm and glowing
media reports then can produce an environment in which even more investors think
stock prices will rise in the future. The result is a positive feedback loop in which prices
continue to rise, producing a speculative bubble, which finally crashes when prices get
too far out of line with fundamentals.9
The field of behavioral finance is a young one, but it holds out hope that we
might be able to explain some features of securities markets’ behavior that are not well
explained by the efficient market hypothesis.

9
See Robert J. Shiller, Irrational Exuberance (New York: Broadway Books, 2001).

Summary
1. Stocks are valued as the present value of future divi- that the dividends are growing at a constant rate for-
dends. Unfortunately, we do not know very precisely ever. Given our uncertainty regarding future dividends,
what these dividends will be. This uncertainty intro- this assumption is often the best we can do.
duces a great deal of error into the valuation process. 2. The interaction among traders in the market is what
The Gordon growth model is a simplified method of actually sets prices on a day-to-day basis. The trader
computing stock value that depends on the assumption who values the security the most (either because of less
158 PART 2 Financial Markets

uncertainty about the cash flows or because of greater periods of time. Empirical evidence generally supports
estimated cash flows) will be willing to pay the most. these implications of the efficient market hypothesis in
As new information is released, investors will revise the stock market.
their estimates of the true value of the security and 5. The existence of market crashes and bubbles has con-
will either buy or sell it, depending on how the market vinced many economists that the stronger version of
price compares with their estimated valuation. Because market efficiency, which states that asset prices reflect
small changes in estimated growth rates or required the true fundamental (intrinsic) value of securities, is
return result in large changes in price, it is not surpris- not correct. It is far less clear that these crashes show
ing that the markets are often volatile. that the efficient market hypothesis is wrong. Even
3. The efficient market hypothesis states that current if the stock market was driven by factors other than
security prices will fully reflect all available informa- fundamentals, these crashes do not clearly demonstrate
tion, because in an efficient market, all unexploited that many basic lessons of the efficient market hypoth-
profit opportunities are eliminated. The elimination of esis are no longer valid, as long as these crashes could
unexploited profit opportunities necessary for a finan- not have been predicted.
cial market to be efficient does not require that all mar- 6. The new field of behavioral finance applies concepts
ket participants be well informed. from other social sciences such as anthropology, soci-
4. The efficient market hypothesis indicates that hot tips ology, and psychology to understand the behavior of
and investment advisers’ published recommendations securities prices. Loss aversion, overconfidence, and
cannot help an investor outperform the market. The social contagion can explain why trading volume is so
prescription for investors is to pursue a buy-and-hold high, stock prices become overvalued, and speculative
strategy—purchase stocks and hold them for long bubbles occur.

Key Terms
adaptive expectations, p. 147 efficient market hypothesis, p. 149 residual claimant, p. 141
arbitrage, p. 151 generalized dividend model, p. 143 short sales, p. 157
behavioral finance, p. 156 Gordon growth model, p. 143 stockholders, p. 141
bubbles, p. 155 market fundamentals, p. 155 theory of efficient capital markets,
cash flows, p. 141 optimal forecast, p. 147 p. 149
dividends, p. 141 rational expectations, p. 147 unexploited profit opportunity, p. 151

Questions
All questions are available in MyEconLab at out of hand and cause later damage when they burst.
[Link]. How can monetary policy be used to prick a bubble?
1. What basic principle of finance can be applied to the Explain how it can do this using the Gordon growth
valuation of any investment asset? model.
2. What are the two main sources of cash flows for a 4. If monetary policy becomes more transparent about the
stockholder? How reliably can these cash flows be esti- future course of interest rates, how would that affect
mated? Compare the problem of estimating stock cash stock prices, if at all?
flows to estimating bond cash flows. Which security 5. “Forecasters’ predictions of inflation are notoriously
would you predict to be more volatile? inaccurate, so their expectations of inflation cannot
3. Some economists think that central banks should try be rational.” Is this statement true, false, or uncertain?
to prick bubbles in the stock market before they get Explain your answer.
CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 159

6. “Anytime it is snowing when Joe Commuter gets up in 14 “If most participants in the stock market do not follow
the morning, he misjudges how long it will take him to what is happening to the monetary aggregates, prices
drive to work. When it is not snowing, his expectations of common stocks will not fully reflect information
of the driving time are perfectly accurate. Considering about them.” Is this statement true, false, or uncertain?
that it snows only once every ten years where Joe lives, Explain your answer.
Joe’s expectations are almost always perfectly accurate.” 15. “An efficient market is one in which no one ever prof-
Are Joe’s expectations rational? Why or why not? its from having better information than the rest.” Is
7. If a forecaster spends hours every day studying data to this statement true, false, or uncertain? Explain your
forecast interest rates, but his expectations are not as answer.
accurate as predicting that tomorrow’s interest rates will 16. If higher money growth is associated with higher future
be identical to today’s interest rate, are his expectations inflation, and if announced money growth turns out
rational? to be extremely high but is still less than the market
8. “If stock prices did not follow a random walk, there expected, what do you think would happen to long-
would be unexploited profit opportunities in the mar- term bond prices?
ket.” Is this statement true, false, or uncertain? Explain 17. “Foreign exchange rates, like stock prices, should fol-
your answer. low a random walk.” Is this statement true, false, or
9. Suppose that increases in the money supply lead to a uncertain? Explain your answer.
rise in stock prices. Does this mean that when you see 18. Can we expect the value of the dollar to rise by 2%
the money supply has sharply increased in the past next week if our expectations are rational?
week, you should go out and buy stocks? Why or why
19. “Human fear is the source of stock market crashes, so
not?
these crashes indicate that expectations in the stock
10. If the public expects a corporation to lose $5 per share market cannot be rational.” Is this statement true, false,
this quarter and it actually loses $4, which is still the or uncertain? Explain your answer.
largest loss in the history of the company, what does
20. In the late 1990s, as information technology rapidly
the efficient market hypothesis say will happen to the
advanced and the Internet widely developed, U.S. stock
price of the stock when the $4 loss is announced?
markets soared, peaking in early 2001. Later that year,
11. If you read in the Wall Street Journal that the “smart these markets began to unwind, and then crash, with
money” on Wall Street expects stock prices to fall, many commentators identifying the previous few years
should you follow that lead and sell all your stocks? as a “stock market bubble.” How might it possible for
12. If your broker has been right in her five previous buy this episode to be a bubble, but still adhere to the effi-
and sell recommendations, should you continue listen- cient market hypothesis?
ing to her advice? 21. Why might the efficient market hypothesis be less
13. Can a person with rational expectations expect the likely to hold when fundamentals suggest stocks
price of a share of Google to rise by 10% in the next should be at a lower level?
month?

Applied Problems
All applied problems are available in MyEconLab at foreseeable future. The firm’s last dividend was $3.
[Link]. Compute the current price of this stock, assuming the
22. Compute the price of a share of stock that pays a $1 required return is 18%.
per year dividend and that you expect to be able to 24. The current price of a stock is $65.88. If dividends are
sell in one year for $20, assuming you require a 15% expected to be $1 per share for the next five years, and
return. the required return is 10%, then what should the price
23. After careful analysis, you have determined that a of the stock be in 5 years when you plan to sell it? If
firm’s dividends should grow at 7%, on average, in the the dividend and required return remain the same, and
160 PART 2 Financial Markets

the stock price is expected to increase by $1 five years shares outstanding. Assuming that the split conveys no
from now, does the current stock price also increase by new information about the company, what is the value
$1? Why or why not? of the company, the number of shares outstanding, and
25. A company has just announced a 3-for-1 stock split, price per share after the split? If the actual market price
effective immediately. Prior to the split, the company immediately following the split is $17.00 per share,
had a market value of $5 billion with 100 million what does this tell us about market efficiency?

Web Exercises
1. Visit [Link]/data/[Link]. Click on is a great source for stock market data. Go to
Stock Index at the very top of the page. Now choose [Link] .[Link] and click on the DOW ticker
U.S. Stock Indices—monthly. Review the indexes for in the Market Summary section to view current data on
the DJIA, the S&P 500, and the NASDAQ composite. the Dow Jones Industrial Average. Click on the chart
Which index appears most volatile? In which index to manipulate the different variables. Change the time
would you have rather invested in 1985 if the invest- range and observe the stock trend over various intervals.
ment had been allowed to compound until now? Have stock prices been going up or down over the past
2. The Internet is a great source of information on stock day, week, three months, and year?
prices and stock price movements. Yahoo Finance

Web References
[Link] [Link]/[Link]
Access detailed stock quotes, charts, and historical stock Learn more about the efficient market hypothesis.
data.

Web Appendix
Please visit the Companion Website at [Link] Appendix : Evidence on the Efficient Market Hypothesis
.com/mishkin to read the Web appendix to Chapter 7: