Economics Asked by user31121 on February 5, 2021
I’m narrowing this question on Reddit’s r/investing to North America. But don’t hesitate to discuss other Five Eyes (FVEY) – Australia, Canada, New Zealand, UK, US. I’m posting here because I prefer self-contained answers. I hate scrolling reddit’s long-winded dialogue!
It’s common to postulate that
stock market indices are semi-strong efficient, so that "all available information about a company has already been priced in".
in the long term, indices such as the S&P500 and NASDAQ100 are expected to grow, so that investing in them will usually profit you in the long term.
How are these two postulates compatible? Doesn’t semi-strong Efficient Market Hypothesis mean that the market semi-strong-efficiently values X’s share price, so that on average, X’s share price remains steady?
News may arrive in the future and affect this semi-strong-efficient stock price, but shouldn’t such news average out to 0? Because there’s no reason to expect more negative news that positive news, or vice versa? If there was, such news should have already been priced into X’s current share price.
As an example, let’s postulate that the market behaves semi-strong-efficiently and values X’s stock at 100 tomorrow. This means X’s stock today should also be Net Present Value of 100, correct? If not, then X’s stock is undervalued today, and thus not semi-strong-efficiently valued by the market.
Similarly, if X’s share price is expected to value 1000 next month, this 1000 should also be reflected into today’s share price, so that today’s share price is the Net Present Value of 1000.
This comment mentions "discount rate (risk free rate plus the equity risk premium", but Discount Rate is already incorporated into Net Present Value. Correct?
The efficient market hypothesis allows for markets to grow. Markets usually grow thanks to economic growth, because more productive firms are more valuable. There is no economic law that says the market should grow. They are expected to grow because they historically grew for a long period and because there is no expectation that economic growth will stop soon.
Answered by csilvia on February 5, 2021
The composition of a stock market index is not fixed but changes over time. Moreover, it usually changes so as to increase/decrease the weight of good/poor performers.
For example, the S&P500 assigns weights to 500 large companies that meet various criteria, including at least a $8.2B cap.* These weights change over time. In fact, companies can even be dropped (e.g. recently Macy's) or added (e.g. Netflix, Google, and Facebook were not on the index in 2000 but are today).
So, suppose we're transported back 20 years to 2000-11-06. Consider the 500 stock prices that were included in the S&P500 on that day. It is true that the EMH would have predicted that those 500 stock prices would, on average, not have grown in the following 20 years (ignoring inflation). However, the EMH would not have said anything about the S&P500 Index, whose composition may and indeed did change.
(We can repeat this same thought experiment for the 500 stock prices included in the S&P500 today: The EMH predicts that, ignoring inflation, these 500 stock prices will not change over the next 20 years. However, the EMH says nothing about what the S&P500 will be in 2040.)
So, if we expect economic growth and creative destruction, then we also expect the S&P500 (and any other index whose composition is allowed to change) to keep growing over time, even if we do not expect any individual stock price to grow.
*See e.g. "S&P U.S. Indices Methodology, Aug 2020" PDF.
Answered by Kenny LJ on February 5, 2021
Efficient market hypothesis does not hold as a working assumption because stock market trades are made with respect to subjective and uncertain forward-looking evaluations of buyers and sellers. Since projections of forward earnings per share and price to earnings ratios are subjective and uncertain it is absurd to assume that all such information is priced into the market. If one applies the EMH it is only a tautology, that is, a statement of belief or that it is true because one holds it to be true.
Answered by SystemTheory on February 5, 2021
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