Stock Market Efficiency, part 2

Let me see if I can restate my question.

A) If it were known that historically, the market rises 10%, on average, in the first week of December, people would begin to buy stocks well in advance of December. This would push prices up. By the time the first week of December came around, there would be no 10% rise left in the market; that 10% rise has already happened.

B) Let's say that a PE ratio of 10 is a "good" value. Company A is priced at a PE ratio of 10 and is forecasted to grow earnings at 10% per year. Company B is priced at a PE ratio of 10 and is forecasted to grow earnings at 50% a year. Which company would you buy? Clearly company B. The "E" for company B is going to rise much faster than that of company A, and hence, the "P" should also rise faster. Well in advance of those higher earnings actually materializing, the "P" will rise to account for expected future earnings growth. This is why faster growing companies demand higher PEs.

So, to restate my question, if it is known that the stock market returns 10% a year, why don't prices rise in advance to account for this expected return, thus negating the expected 10% return?

Patri says I am just restating the equity premium puzzle. Am I? The equity premium puzzle asks, "Why do stocks return a higher rate than risk-free instruments?" whereas I believe I am asking a different question, "Why doesn't the stock market discount its future expected returns?"

Or if the stock market does discount its future expected returns, then, "Isn't it true that people shouldn't expect 10% returns?"

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Patri is right

You mentioned that you know there is a time value to money, so you know why the equity index returns aren't discounted to 0% instead of the risk free rate.

After taking that step, you are asking about the equity premium puzzle.

After the timeless

After the timeless masterpiece: Hotshots! Part Deux, the phrase "part 2" is as dead as Charlie Sheen's water pistol.

Finbarr, answer the mans question!

masterpiece

That was a good movie, especially if you're 17.

Yup, it really is the Equity Premium Puzzle after all....

The equity premium puzzle ponders why people demand so much higher risk from equities than from bonds; the data suggests that investors are VASTLY more risk averse than would seem rational. In contrast, Wilde asks why a person on the margin would sell an investment that is presumed to offer an average return of 10% when there are few substitute investments offering similar returns. Are these really the same issue?

I think so. Both issues address a trade of something with relatively volatile returns (equity) for something with relatively stable returns (cash or bonds). Both issues are designed to explore why people would regard these two sides of the trade as roughly equivalent.

But Wilde’s larger point remains: If you believe in efficient markets, then you should conclude that the value of every investment – including an investment in cash – is roughly comparable once you adjust for the marginal person’s assessment of risk, tax consequences, time preference, need for liquidity, etc. Thus, the sage advice to invest in stocks is just hooey. The only reason you should invest in the stock market rather than something else is because you believe that you are in a better position to bear risk/avoid tax/bear delay/benefit from liquidity than the marginal investor. (And suddenly all that blather about adjusting your portfolio balance to reflect your stage of life starts to sound a little better....)

One more time

You should start making your own posts here. Does a brotha need to beg?

But Wilde’s larger point remains: If you believe in efficient markets, then you should conclude that the value of every investment – including an investment in cash – is roughly comparable once you adjust for the marginal person’s assessment of risk, tax consequences, time preference, need for liquidity, etc.

This is exactly the conclusion that I seem to be coming around to, though on some level, it sounds ridiculous.

This is a correct

This is a correct implication of the EMH.

Wohwohwoh... no, this is NOT

Wohwohwoh... no, this is NOT the equity premium puzzle. This is the equity premium period. Equities are risky... they will rise on average 10% over the year, maybe less maybe more. The more people buy the stock, the lesser its room for appreciation but the risk is approximately unchanged, so an equilibrium forms.

The equity premium PUZZLE wonders why the equity premium is so high. In fact it's not clear that there is an equity premium at all. Most studies focus on the US over the 20th century, but really in 1901, why invest in the US... Russia and Argentina look like awesome investments. There's a big selection bias in the studies done.

Elaborate

I don't understand your distinction.

Nor do I understand your answer. Can someone reasonably expect 10% returns? If most investors expect 10% returns, won't the market discount these returns ahead of time?

Elaborated below but the key

Elaborated below but the key point is that they expect 10% on average. They don't fully discount the 10% because they're not sure they will get the 10%. In fact these 10% is precisely what remains undiscounted...

Say for example a company

Say for example a company will be worth $50 with probability 1/2 ans $150 with probability 1/2 one year from now. What price is it trading at today ? Since people are risk averse, it has to be less than $100, so let's say it's trading at $90.9... "AHAH" says Johnathan, on average we expect the security to be worth $100 in one year, an appreciation of 10%, so let's buy it now... Problem is, you may not want to enter such a risky contract. It's not a guaranteed $100, so there is no discount to be made. 10% is what you're paid for taking this risk. If risk aversion in the population becomes lower, then the price will be more attractive, people will buy the contract, rising its price and thus diminishing the equity premium.

Still the same thing

if it is known that the stock market returns 10% a year, why don't prices rise in advance to account for this expected return, thus negating the expected 10% return?

Suppose there was no equity premium. Let's also eliminate differential risk, to make things simpler. So the return on stocks and the return on bonds are now exactly the same - say, 4%. Now, why would prices rise in advance to account for this expected return? Prices will only rise in advance on an instrument if investing in that instrument beats the market rate of return.

The EMH says that prices should rise or fall so that every instrument earns the same rate of return. Not so that every instrument earns a zero rate of return! The exact same reason that an overly-high return gets lowered (people put money into it until the price goes up and eliminates the excess return) will lead to an overly-low return (like 0%/year) getting raised (people will sell it until the price goes down and the return rises to market average).

Now we add risk. Say stocks earn 5%/yr, bonds earn 4%/yr (there is no excess equity premium, stocks earn a little more b/c they are a little riskier). The same argument applies. People are indifferent between the two returns due to their different risk, so neither will get changed.

The puzzle is why stocks can make 10%/yr and bonds 4%/yr when stocks don't seem *that* much riskier. That's the equity premium paradox. But having them both earn more than 0%/year is not a paradox. Nor is having the riskier instrument earn more, as Arthur B is saying.

I most emphatically did not say that.

Nor is having the riskier instrument earn more, as Arthur B is saying.

I did not say that... at all.

Suppose there was no equity premium. Let's also eliminate differential risk, to make things simpler. So the return on stocks and the return on bonds are now exactly the same - say, 4%. Now, why would prices rise in advance to account for this expected return? Prices will only rise in advance on an instrument if investing in that instrument beats the market rate of return.

Absent risk aversion and time preference the average return would be 0%.