(no subject)
Section 1 Internet Thingy Questions
1. Suppose you are watching the news one evening and the reporter states that Microsoft had reported earnings better than expected earlier that day. If the stock market is indeed efficient, would it be possible to buy Microsoft stock the next day and profit from this new information?
If the market was truly efficient, it would not be possible to buy stock and profit the next day with this information. As the activity showed, you can’t accurately predict a stock’s rise or fall over time, and profits of one day can just as easily become losses the next.
ANSWER: [No. Although the price of Microsoft stock most likely did rise after the positive announcement, it is too late for you to profit from this information. As soon as new information is reported, investors react immediately. Unless you were one of the first investors to hear the information, you will be too late. Think of it this way: if someone tells you there is a $20 bill lying in an aisle at Wal-Mart, this does not mean that you can go grab it an hour later. Someone else is likely to have already picked it up.]
4. What factors can you think of that might explain why U.S. stock markets are more efficient (i.e., that prices reflect all available information) than stock markets in less developed countries?
America has a very efficient communication system compared to other countries. Information is transferred quickly through the internet, phones, television, and radio. This instantaneous information enables people to buy and sell more quickly, keeping the market efficient.
ANSWER: [The U.S. stock market is likely to be more efficient than most financial markets for the following reasons:
a) More professional analysts following stocks.
b) Better information about the companies that are analyzed.
c) Better technology to analyze companies' information, better software, computational power, etc.
d) Faster dissemination of information via the Internet, television, etc.
e) Better regulatory authorities to make sure the information being disseminated by corporations is accurate, Enron notwithstanding.
f) Better markets in terms of being able to process orders, quote prices, etc.]
5. If markets are indeed efficient, why do all these investment managers, financial analysts, mutual fund managers, etc., get paid for trying to find undervalued stocks?
People are stupid and greedy. They will pay anyone who can convince them that their service is needed, especially when it comes to making money. If they think that these people can properly pick out ways to make them rich, and the people don’t have to deal with it themselves, then they will pay ridiculous amounts in the hope that they will make ridiculous profit.
ANSWER: [Keep in mind that somebody has to do the research to keep stock prices accurate--i.e., somebody is always looking for $20 bills lying around. Even if these managers do manage to find "$20 bills lying around," after accounting for the time and effort it took to find them, they only earn enough to compensate them for their time and effort. Because all these analysts are constantly researching companies, we can be fairly confident, when buying or selling a stock, that we are getting the best price for it.]
Notes and Stuff on Section 2
Price/Earnings Ratio: how much a person pays for every dollar a company earns
Dividend Yield: payments to shareholders from the company’s earnings
Interest Rate: expected earnings on bonds over a period of time
Section 3 Questions
1. If a company reported $2 in earnings last year and its’ PE ratio is 15, what is its stock price?
30$
2. Assume the average PE ratio for the stock market is 28 and dividend yields are less than 2%. In the recent past, the PE ratio has averaged around 18 and the dividend yield was 4%. The Federal Reserve begins to raise interest rates. Based on these facts, do you think stock prices will rise, stay the same or fall? Why?
ANSWER: [This was actually the situation in 2000. Stock prices were valued at very high levels relative to historical averages and when interest rates began to rise, stocks began to tumble. The bursting of the technology bubble led fuel to the fire but fundamental analysis based on PE ratios, dividend yields, and interest rates should did portend some decline in the future. Unfortunately, most people ignored these factors and thought earnings and PE ratios would continue to rise. When reported earnings begin to not meet expectations, stock prices began to fall.]