EMH & Bubbles/Financial Crises Cards only related to essay questions

Question 1

Do fear and greed influence stock prices?

Answer 1

Associated with each episode of rising prices or recovery of prices around the time of the dot-com bubble was a decline in perceived risk (potentially tunnel vision created by greed), as indicated by falling volatility (both actual volatility and implied volatility from option prices). Associated with each episode of falling prices was the opposite: rising volatility (both actual and implied). The periods of high volatility are also associated with loss of market liquidity as measured for example by bid-ask spreads. This indicates how ‘fear’ perceived risk can influence stock prices.

Question 2

What are some common arguments used to explain today’s high level of stock prices?

Answer 2

• Irrationality (so called irrational exuberance)
• Rational responses to new information about the changing prospects for future earnings and growth
• New market arrangements (e.g., the ability to buy financial assets ‘on margin’ (using borrowed money))
• Increased incentvives for focusing on short-term gains created by fund management mandates and performance bonuses
• Lower general perceptions of risk amongst market participants around the world

Question 3

What is an argument for today’s high level of stock prices NOT being a bubble?

Answer 3

A decrease in required returns (due to decrease in real interest rates and equity risk premium) and a rise in share of corporate profits is US GDP over the last few decades can explain much of the rise in share prices relative to incomes. So we can explain the substantial rise in equity prices using fundamentals (the Gordon growth model). This suggests that the rise in equity prices of the past 40 years is not necessarily irrational (like it is with many bubbles). It is not obviously a bubble that will burst.

Question 4

If current stock prices roughly reflect their intrinsic value, what could still cause stock prices to fall from current levels in the future?

Answer 4

• The real growth rate of dividends might fall (recession/slow growth).
• Required returns may increase relative to nominal dividend growth rates either because the real interest rate rises or because the equity risk premium rises (both have fallen substantially but there is no guarantee that they will stay low).
• Labour shortage could reduce the share of profits in GDP (corporate profitability could shrink relative to the economy as a whole).