Market Efficiency in The Long Run

Market Efficiency and Bubbles in the long run:
an empirical test on the S&P Composite

Niccol`o Ferragamo
April 30, 2012
Contents
1 Historical evidence from Stock Returns

1.1 Defining returns in the equity market . . . . . . . . . . . . . . . .
1.2 Returns and the S&P Composite . . . . . . . . . . . . . . . . . .
1.2.1 S&P Composite as proxy for the world equity market. . . .
1.2.2 Total Return Index . . . . . . . . . . . . . . . . . . . . . .
1.2.3 Dividends and Capital Gains components in the S&P Composite . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.2.4 Equity, risk and volatility . . . . . . . . . . . . . . . . . .
1.2.5 Future returns . . . . . . . . . . . . . . . . . . . . . . . . .
15
16
20
2 Pricing and Market Efficiency

2.0.6 Why should the equity market be efficient? . . . . . . .
2.0.7 Testing market efficiency and the joint stock hypothesis
2.1 The Net present Value . . . . . . . . . . . . . . . . . . . . . .
2.1.1 The long run matters . . . . . . . . . . . . . . . . . . .
2.1.2 Dividend policy . . . . . . . . . . . . . . . . . . . . . .
2.2 The market equity premium . . . . . . . . . . . . . . . . . . .
.
.
.
.
.
.
22
24
25
26
32
34
35
.
.
.
.
.
.
.
.
43
44
46
48
52
56
60
61
67
.
.
.
.
.
.
3 Abnormal returns from fundamental analysis

3.1 The P/E10 ratio . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.1.1 Price-Earnings as fundamental market-timing indicators
3.1.2 Test on Total Real Returns . . . . . . . . . . . . . . . .
3.1.3 Test on Extra Returns . . . . . . . . . . . . . . . . . . .
3.1.4 Test on Real Dividend Returns . . . . . . . . . . . . . .
3.2 Statistical Significance issues with the P/E10 test . . . . . . . .
3.3 An approach to solve the overlapping problem . . . . . . . . . .
3.4 Where could the PE ratio go? . . . . . . . . . . . . . . . . . . .
5
5
7
8
11
CONTENTS
4 EMH and Behavioural Finance

4.1 Cross-section abnormal Returns on single value stocks . . . .
4.2 Speculative Bubbles . . . . . . . . . . . . . . . . . . . . . . .
4.2.1 Overconfidence, Overreaction and trend extrapulation
4.3 Shillers Variance Test . . . . . . . . . . . . . . . . . . . . .
4.3.1 Reconciling excessive volatility with EMH . . . . . .
4.3.2 How can mispricing persist? . . . . . . . . . . . . . .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
72
73
74
79
80
84
85
Abstract
One of the fundamental assumptions of modern finance in that investors have

risk averse preferences and that, therefore, higher returns from an investment
should be the result of an higher systematic risk. The aim of this dissertation
is to analyse the equity market performance in aggregate from an historical
perspective and to evaluate if its movements can be totally explained by the
efficient market hypothesis. In particular we want to evaluate how reasonable it
is to explain some of the market movements as a consequence of noisy traders
who over-react and generate speculative bubbles.
In order to do so, we use as proxy for the global equity market the U.S. S&P
Composite, representing the world biggest equity financial market, and attempt
to find abnormal returns from long term investments. In particular, we use the
Price-Smoothed Earnings Ratio, as introduced by Shiller, as a fundamental value
indicator. If extreme Price Earnings ratios represent a valid indicator of market
over-valuation, we suggest that both policy-makers and investors can use this
indicator as an early warning system for bubble formation.
This dissertation is organized as follows: chapter 1 formally defines different
returns in the equity market and analyses the S&P Composite performances in
terms of total real returns, dividend returns, extra returns on U.S. t-bonds and
volatility. In order to do so, we compute different indexes and statistics from
Shillers data on the S&P Composite and show how this index has offered, in the
long run, returns that highly outperformed fixed income securities.
Chapter 2 defines the efficient market hypothesis and introduces different
Net Present Value methodologies, showing the impact of expectations on current prices and which variables influence the most risk premiums required by
operators.
In Chapter 3 we test the historical correlation between Shillers P E10 ratio
and returns from 20-years buy and hold strategies on the S&P Composite. We
perform linear regressions on the S&P Composite historical data and show that
this correlation has been persistent in time. In order to check if this relation has
3
CONTENTS
to be attributed only to variations of real interest rates, we repeat the test using
extra returns instead of total real returns and show that the negative correlation
is less strong than before, but still existing. We also show that the P E10 ratio has
mainly had an impact on the capital gain component of total returns, and this
supports the irrational exuberance and bubble formation theories. These tests,
however, violate the linear regression model assumption of independence and
identical distribution of the dependent variables. To overcome this problem and
evaluate the impact of the P E10 on subsequent returns, we decompose the extra
returns over a generic -years period into different i.i.d. yearly k-forward extra
returns. We then perform linear regressions on the latter and recombine their k
coefficient estimates to get the cumulative correlation coefficient between P E10
ratios and the average extra return over the whole -years period. This approach
strengthens the previous conclusions and shows that the negative correlation is
statistically significant.
Chapter 4 offers a review of theories in favour of the irrational exuberance
and bubble formation thesis and analyses the concepts of over-reaction and trend
extrapolation from a behavioural perspective. We conclude repeating Shillers
1981 variance-bound exercise with the newly available data in order to show what
price levels should have ex-post been had operators forecast exactly the future
level of dividends. The excessive volatility that emerges as result of this analysis
supports, despite its limitations, the hypothesis in which the equity market as a
whole over-reacts.
Chapter
Historical evidence from Stock Returns

1.1
Defining returns in the equity market
Stocks are financial instruments that represent an ownership position in a certain

company, do not expire over time and give the right to their holder to claim on
a proportional share in a corporations assets and profits. Ordinary stocks owners are provided with voting rights which can be used in shareholders meetings
to decide important issues of the company such as the election of the board of
directors. Even though only incorporated companies have stocks, these are particularly important in modern economies as their ownership rights can be more
easily traded on both regulated and over the counter financial markets. The
direct consequence of these peculiarity is the possibility for investors to easily
allocate part of their portfolios in these instruments in order to get a return on
their investment. The stock of a business is divided into multiple shares, the
return on which can be divided into two components:
dividends;
capital gains.
Dividends Dt represent the part of corporate profits which is distributed from
t
of earnings paid out as
a corporation to its shareholder at time t. The ratio D
Et
dividends in a fiscal year is called dividend payout ratio. This ratio can change
over time and from company to company at the discretion of management, depending on the amount of earning that is retained and re-invested in the business
every year. Differently from other instruments such as bonds, the cash flows that
a shareholder has the right to receive are not certain in their amount and, as we
will discuss later, present a certain level of risk. In particular, common stocks
should be riskier than debt issued by the same corporation as their holders receive only companys residual cash flows and cannot be paid dividends until all
5
1. Historical evidence from Stock Returns
the interests on the companys debt and the preferred stock dividends are paid
in full. In other words, earnings are subject to a leverage effect, which results
in a shares price volatility which is, at least in the short run, higher than fixed
income instruments.
Capital gains or losses are represented by the variation of the market price
P of the share over time. The market price of the share is the amount of money
at which operators exchange at a certain time a given share on a financial market
and, determined by the interaction of supply and demand, is different from the
share face value. We will see later that, in efficient markets, a share should be
priced according to its net present value.
In a stock investment, the total nominal return rn,t from time t 1 to time t
can be defined as the sum of nominal capital gains and nominal dividends returns
over (t-1,t). Formally:
rn,t =
Dn,t
Pn,t Pn,t1
(Dn,t + Pn,t Pn,t1 )
=
+
.
Pn,t1
Pn,t1
Pn,t1
Where Dn,t and Pn,t represent nominal dividend and share price at time t.
When a certain investments is evaluated, it is possible to consider either nominal
or real returns. Real variables take into account the variation usually negative
of purchasing power in time caused by inflation. If the utility of an operator is
function only of its level of consumption, we should expect a rational investor to
care only about the variation of its purchasing power and about real variables
while evaluating a given investment. It is interesting to notice that the Media and
the financial press almost never present data and stock charts only in nominal
terms, putting not much emphasis on real returns and, perhaps, stimulating a
certain money illusion effect1 .
To compute the real return on a stock investment we have to deflate cash flows
by an appropriate price index, such as the European Harmonised Consumer Price
Index or the United States Consumer Price Index published by the U.S. Bureau
of Labour Statistics. If CP It is the consumer price index at time t, we can
compute real prices Pt and real dividends Dt as:
1
The term money illusion was introduced by John Maynard Keynes to indicate the tendency
of people to mistake the nominal value of money for its purchasing power. If money illusion
exists, then investors may irrationally consider nominal variables when they evaluate returns
on investments.
Pn,t
CP It
Dn,t
Dt =
CP It
Pt =
and we can then define total real returns as:

rt =
D,t
Pt Pt1
+
.
Pt1
Pt1
Where the first part of the equation on the right represents the real dividends
return and the second part the real capital gain return.
t CP It1
Note that, given an inflation t = CP ICP
in (t, t+1), the relation between
It1
total real returns rt and total nominal returns rn,t is equal to:
rt =
1.2
(1 + rn,t )
1
1 + t
(1.1)
Returns and the S&P Composite
The aim of this dissertation is to consider returns and abnormal returns from
an aggregate market perspective. What we need to do, hence, is to consider an
highly diversified index which can approximate as well as possible the risk and
return profiles of the equity market.
The evolution of financial markets in developed countries and the consequent
fall in transaction costs has made it easy and realistic for both private and institutional operators to diversify their investments into portfolios with hundreds
of securities, held in proportions that reflect their market capitalization. Diversification enables investors to get rid of idiosyncratic risks2 of single assets by
exploiting lower than unitary covariances among returns from different assets. A
fast way for an investor to do so is to buy a share of a mutual fund or, in recent
times, of a large Exchange traded fund.
An ETF is an investment fund which passively replicates the returns of a
certain stock index, such as the American S&P500 or the Italian FTSE Mib.
ETFs differ from traditional mutual funds in the fact that their shares can be
bought and sold throughout the day like stocks on a securities exchange through
a broker-dealer. Thanks to their low costs, tax efficiency and stock-like features,
ETFs have proliferated significantly in the last ten years, reaching in the United
2
Idiosyncratic risk is often called specific risk as well.
States at the end of February 2012 a total amount of assets under management
of 1,18 trillion dollars3 . The concept of total real returns and its combination
of dividend and real returns can be applied to these instruments as well as to
corporation shares.
In order to evaluate the return opportunities from stocks, it is important for
an investor to analyse how equities have performed in aggregate in the past.
The ideal analysis would involve considering data on the equity market portfolio,
which consists of a weighted sum of every stock security in the market, with
weights in the proportions that they exist in the market and assuming that these
assets are infinitely divisible. This would theoretically include all existing stocks,
from both listed and unlisted corporations and from every country in the world,
and would represent the equity portfolio with the highest possible degree of
diversification. Note that this would still be only a subset of the even bigger true
market portfolio, as introduced by Markowitz, which includes virtually anything
with marketable value not only equities in every market.
Roll4 criticised Markovitzs model considering the fact that the true market
portfolio is unobservable as not only it is not possible to physically invest in all
these assets, but also it is impossible to observe the returns of many of these. A
similar critique can be addressed to the equity market portfolio, as it is practically
impossible to observe all existing corporations and to invest on all of them. What
is possible to do is, at most, to combine ETFs from different countries into a
portfolio with a degree of diversification which is comparable to the theoretical
equity market portfolio.
The problem that emerges at this time is where to find data on a global
equity index going sufficiently back in time to analyse its return and volatility
in an historical perspective. As we lack such a data set, in this dissertation we
will use the S&P Composite index, with information available on a monthly base
since 1871, as a proxy for the equity market portfolio. Before we go further, it
is important to discuss on how reasonable this assumption is.
1.2.1
S&P Composite as proxy for the world equity market.
The correlation presented in figure 1.1 partly supports the use of the S&P Composite as a proxy for the global equity market.
3
Data from ETF Industry Association, March 2012.

See A critique of the asset pricing theorys tests, Journal of Financial Economics, Vol.
4, March 1977
4
Figure 1.1: Historical correlation between real GDP growth rates in the U.S. and
in the World. Personal elaboration from World Bank Data
Nevertheless, it is important to take into account the limitations of this approach. First of all, the coefficient of determination R2 shows that only 68.8% of
the variance of World GDP real growth is related to the variance of U.S. GDP.
Secondly, there are several reasons why different equity markets could move differently in countries with the same GDP growth. Equity returns are related to
corporate earnings and, thus, to the share of national GDPs represented by corporate profits. This share changes from country to country and could be, at a
global level, different from the U.S. Secondly, even though the corporate profits
share was exactly the same in the U.S. and in the World, equity returns could be
functions of different risk premiums required by local investors to cover different
risks. An investor in a less developed and less liquid market could, for example,
request an higher risk premium for its equity investment.
Despite these factors, the increasing level of market openness and globalization are making local markets and probably, as investors diversify their portfolio
internationals and as multinationals listed on a certain stock exchange develop
their businesses abroad, the equity market will tend to become more and more
correlated.
To show how global equity markets and the U.S. S&P 500 have been correlated
in recent years, we take the Global S&P 1200 index as proxy for global returns
and show how the two price indexes have moved from January 2007 to April
2012.
9
The S&P Global 1200 Index is a free-float weighted stock market index of
global equities from Standard & Poors which covers 31 countries and approximately 70 percent of global stock market capitalization5 . The S&P 500 is a subset
of the S&P Global 1200, and it account, as on April 2012 , for approximately
52% of the capitalization of the latter.
Figure 1.2: S&P 500 (Gray line) and S&P Global 1200 (Black line) price indexes
from January 2007 to April 2012
Figure 1.2 shows how similar the paths of the two indexes, computed on a
yearly base, have been in the last 5 years. For simplicity, we have set the initial
price levels of both the indexes as on January 2007 at 100. This means that
the part of the S&P Global 1200 which is not made by the S&P 500 is highly
correlated with the movements of the latter. Unfortunately, data on the S&P
Global 1200 index is not available for past decades and, consequently, it is not
possible to see whether this correlation did hold in past years or not.
Even if this approach is susceptible to critiques, and even though this does
not take into account the potential survivorship bias 6 of the U.S. stock market, if
the mentioned limitations are clear, then we conclude that the S&P can be used
as a proxy for global equity returns.
Even in the case in which the S&P Composite did not represent a good proxy
for the market as a whole, an analysis of the returns of the world biggest stock
5
The S&P Global 1200 combines six different regional indexes: the S&P 500, S&P TSX 60
(Canada), S&P Latin America 40 Index (Mexico, Brazil, Peru, Chile), S&P TOPIX 150 Index
(Japan), S&P Asia 50 Index (Hong Kong, Korea, Singapore, Taiwan), S&P/ASX 50 Index
(Australia), S&P Europe 350 Index. Source: Standard and Poors.
6
We will discuss on this bias, as reported in Jorion and Goetzmann (1999), in chapter 4.
10
market is still crucial to make capital allocation decisions and understand how
equities have behaved historically.
An operator can easily invest on the S&P Composite index, now named S&P
500, by buying one of its replicating ETFs7 .
The S&P 500 is a free-float capitalization-weighted index published since 1957
of the prices of 500 large-cap common stocks actively traded in the United States.
The stocks included in the S&P 500 are those of large publicly held companies
traded on both the New York Stock Exchange NYSE and the NASDAQ. These
securities vary in time in order to keep the index reflective of American stocks8 ,
and are included with weights that are proportional to the capitalization of their
public float 9 . It is possible to extend the data set back in time by using data on
previous versions of the index, created since 1871. Even though the composition
of the index has slowly changed through time, the S&P Composite has always
been a good and objective representation of the U.S. equity market. With its
actual capitalization of 12,38 trillion dollars, the S&P 500 represents about 70%
of the total capitalization of listed companies in the U.S.10
In order to proceed with our analysis, in the following sections we will build a
few useful return indexes on the S&P Composite. The data set used in this dissertation consists of monthly observations for the Standard and Poor Composite
Stock Price Index, extended back to 1871 by using the data in Cowles as made
available by Shiller. Figure 1.3 shows the S&P Composite Total Return Index
from 1871 to 1945 and from 1946 to 2012 with an initial value of the index set
to 1$ in January 1871.
1.2.2
Total Return Index
The total return index can be computed from an underlying price index, such
as the S&P500 by assuming that all dividends and distributions are reinvested
immediately on the underlying index11 .
T RIt = T RIt1 (1 + rt )
where T RIt is the level of the total return index at time t and (1 + rt ) is the
7
The Standard & Poors 500 Index Depository Receipts ETF SPY.N with its 99.6
billion dollars net assets as in March 2012, is currently the biggest U.S. EFT by capitalization
8
Siegel (2009) shows that, out of the 500 firms in 1957, only 125 remained in the same
corporate form in 2003.
9
Public float refers to the number of outstanding shares in the hands of public investors
which are publicly traded. The capitalization of a company is usually higher than the capitalization of its public float because of the existence of shares holed by insiders which are not
traded.
10
Data on the U.S. market capitalization from Worldbank, 2011.
11
Index Mathematics Methodology - S&P index official data.
11
Figure 1.3: Real S&P Composite Stock. Total real return from 1871 to the end of
WWII and from 1946 to March 2012. Personal calculations from Shillers Data.
total real return on the index over (t-1,t), representing the amount of money one
receives in t after investing one monetary unit in t-1:
1 + rt =
Pt + D t
Pt1
(1.2)
Where Pt and Dt represent respectively the real price and the real dividend
paid in t of the underlying price-index. The initial value of T RI0 is set to 1
dollar.
As we would expect, the U.S. equity market has produced returns in the long
term not only in nominal terms, but also when real variables are considered. An
investor who had invested one dollar in 1871 would have multiplied that amount
over 141 years, in real terms, by over 7300 times thanks to the effect of compound
12
capitalization. It is essential to note that this total return index does not take
into account the important impact of individual taxes on both dividends and
capital gains, which would noticeably decrease the final value of the investment
in 2012.
Despite the volatility of returns, it is significant that stocks in the U.S., as
noted by Siegel, have never delivered to investors a negative real return over
periods of 17 years or more12 . Even if an operator had invested his savings in
the S&P Composite in September 1929, at the peak of the U.S. stock market
and just before the biggest drop ever in the total real return index13 , he would
have recovered all the losses by October 1936. After October 1947, moreover,
the total real return index has never reached a value lower than the 1929 peak.
Did the same recovery happen after the other two most impressive shocks in
recent history? Regarding the dot come bubble, real prices had reached a peak
in August 2000 while the Total Return Index TRI was at its highest level in
December 1999. After the collapse of the bubble, by September 2002 the TRI
had dropped 50% of its value: that means that, in real terms, any investor who
had put his money in the U.S. aggregate equity market at its peak would have
lost 50% of the value in less than 3 years. By March 2012, had the investor
held his investment, he would have recovered 60% of this loss, achieving a minus
20% in real term from the 1999 peak. Such a negative performance is pretty
impressive if we consider that almost 13 years have passed since 1999. This
empirical evidence shows us that, hence, in the short to medium run the stock
market can make investors lose a significant part of their capital.
If we consider that in 2007-2009 the world experienced the second most serious
financial crises after 1929, and if look at how high some would say irrational 14
P/E ratios15 had become in 1999, however, even this minus 20% could appear
to be not so impressive. Despite the superficiality and abstractness of this consideration, it is interesting to note that an investor who had bought the S&P
Composite at any time before December 1998, when the dot com bubble was
already swelling, by March 2012 would have received a positive real return.
From an investor perspective anyway, it is not only important to consider
absolute performances, but also returns compared to substitute investments. It
is essential, in particular, to understand how risk-free investments did perform
12
The sample used by Siegel for the U.S. stock market is actually even larger than the one
used by Shiller, going back to 1802. Siegel 2008 (op cit)
13
According to our calculations, the S&P 500 total return index lost 75% of its value from
September 1929 to February 1932
14
See Shillers Irrational Exuberance (op. cit).
15
We will discuss about this ratio and about ways to use it as a fundamental value indicator
in chapters 3 and 4.
13
historically. The rating agency Standard & Poors, with its recent downgrade,
has removed the United States government from its list of risk-free borrowers.
Despite this decision and despite the tightness of the concept of risk free asset,
for our purposes we will consider the 10-years U.S. treasury bonds as a safe asset.
If we compare the returns from the 1999 peak to March 2012 of both the
S&P 500 index and 10-years government U.S. bonds, for example, we see that
the minus 20% loss becomes a minus 33% with respect to the risk free asset. In
the last 10 years, moreover, the geometric average of real returns on t-bonds has
slightly outperformed by an yearly 0.18% the S&P Composite.
If we consider longer periods, anyway, the situation becomes much more
favourable for the equity market. Lets compare, for example, returns of Portfolio
E and Portfolio B on different 20 years periods. Portfolio E is made by the only
S&P Total Return Index and Portfolio B by a 10-years zero coupon U.S. t-bond
bought at time t, payed back after 10 years, and reinvested into another 10-years
t-bond.
The geometric average of real yearly returns on B on a twenty years period
are equal to:
rB, =
p
(1 + y )10 (1 + y +10 )10 1
20
Where y is equal to the real annual yield of a 10-years zero coupon U.S.
treasury bond at year 16 .
Table 1.1 shows the geometric and arithmetic averages or total real returns
of the S&P Composite portfolio and the Risk Free Portfolio bonds from 1872
to 2011 and on twenty-years sub-periods. Even though there have been others
20-years periods when t-bonds did perform better than the S&P Composite, in
the considered sample the extra return of equity on t-bonds has always been
positive.
From what we see, the S&P Composite performed well in the long run not
only in absolute terms, but also when compared to risk-free investments.
If we take U.S. t-bonds with an even higher maturity and yearly yield, it
is interesting to analyse how many times an equity investment did outperform
treasuries depending on the length of the holding period. Taken the 30-years
U.S. government bonds as the benchmark for long term risk free rate, and taken
a period going from 1871 to 2006, Siegel17 shows that the percentage of times
16
In order to compute these yearly real ratios, we take into account the average inflation
rate over the maturity periods of both the t-bonds
17
See Siegels Stock for the long Run (op. cit.)
14
Period
1872-2011
1872-1891
1892-1911
1912-1931
1932-1951
1952-1971
1972-1991
1992-2011
S&P Composite
Geometric Mean
6,47%
8,40%
6,86%
4,91%
5,37%
9,21%
4,76%
5,68%
S&P Composite
Arithmetic Mean
8,22%
9,35%
8,18%
7,07%
9,01%
10,35%
6,15%
7,26%
Risk-Free Portfolio
Geometric Mean
2,5%
7,38%
1,79%
1,37%
-0,32%
0,98%
3,71%
3,47%
Table 1.1: Geometric and aritmetic averages of total real returns on the S&P
Composite Index and on 10-years U.S. treasury bonds.
that stock returns outperformed bond increase dramatically as the holding period
increases. For 10, 20 and 30 years horizons stocks outperformed 30-years bonds
respectively 82.4, 95.6 and 100 times out of 100.
According to Siegel (2009):
The high probability that bonds and even bank accounts will outperform stocks in the short run is the primary reason why it is so
hard for many investors to stay in stocks.
If one accepts the fragile assumption that past evidence is a predictor of
future events, hence, the presented data shows that the equity market should
be considered a good buy-and-hold investment for an operator with long-term
perspectives and who is willing to accept the potential short-term losses. Equities should definitely be, thus, a relevant part of the diversified portfolio of any
operator.
1.2.3
Dividends and Capital Gains components in the

S&P Composite
Total returns have a dividend and a capital gain component. To analyse the
historical size of these components in the S&P, we decompose the Total Return
index in the product of a Dividend Only Index and the Price Index.

T RIt = T RIt1
Pt + D t
Pt1

Dt
Pt
= T RIt1 1 +
Pt Pt1
t
t
Y
Di Y Pi
=
1+
= DRIt P It
Pi i=1 Pi1
i=1
(1.3)
(1.4)
Where Pt = PP0t , where P0 is set to 1, is the normalized price index and DRIt
is the Dividend Only Index. The first is the index which is commonly used by the
15
Media and that we have used to build the Total Return Index. The normalized
Price Index shows how much 1$ would have become, in real terms, by investing
in the S&P, if dividend payouts are not taken into account.
On opposite, the dividend real return index shows how much 1$ invested in
1871 would have become in 2012 if the real price of the S&P had stayed at the
same level i.e., if no real capital gains occurred and dividends were continuously
reinvested in the index.
Figure 1.4 shows the real normalized price, real dividend Only and total real
return indexes from 1871 to 2012. In order to linearise the exponential trends,
we present the data on a logarithmic y-axis.
From 1871, out of a geometric average of yearly total real returns of 6,46% and
with a geometric average of yearly real capital gain return of 1,94%, dividends
have been not only the less volatile, but also the most relevant component of the
total return index, with an average of 4,43% real return on a yearly base18 . This
evidence makes it difficult to understand why it is so rare to find total return
charts for stocks and indexes in the Media and in the Financial Press. From a
behavioural perspective, it could be argued that this emphasis on capital gains
and stock prices could lead several non-professional investors to overestimate
the importance of capital gains when they evaluate their investments and their
expected future returns.
The weight of the dividend component, however, has become less important
in time due to variations in the dividend payout policy of U.S. firms. If we repeat
the same analysis from 1946 to 2012, infact, out of an average yearly total return
of 6,49%, the dividend component has accounted for an yearly 3,48% and the
capital gain for an yearly 2,9%. In more recents year, moreover, capital gains
have surpassed dividend returns. From 1985 to 2012, infact, out of an average
total real return of 7,33%, yearly capital gains have averaged 4,89% on a yearly
base, while dividends have returned an yearly 2,38%. The second graph in figure
1.4 shows exactly this weight variation.
1.2.4
Equity, risk and volatility
Volatility is a measure for variation of price or of the total return of a financial

instrument over time. Two different kinds of volatility can be defined:
Historic Volatility, derived from time series of past market prices or past
equity total returns;
18
Data from personal calculations using the previously built real total return, real dividend
and real price indexes.
16
Figure 1.4: Real S&P Composite Stock. Comparison between Total Return,
dividend Return and price indexes on the 1871-2012 and the 1985-2012 periods.
Personal calculations from Shillers Data.
17
Implied volatility, derived from the market price of options having as underlying variable a stock or another financial instrument.
Both entities are used to quantify the risk of financial instruments over a
specified time period. Hereby we focus on the first concept and define historical
volatility from t k to t to as the standard deviation of total real yearly returns
over that period. We estimate the standard deviation of the population using a
sample of monthly observations of yearly rt . Formally:
s
r,t,tk =
Pi=t
i=tk
(ri rt,t+k )2
n1
(1.5)
Where rt,t+k is equal to the arithmetic average of returns over (t, t + k) and
n represents the number of monthly observations in the same period. We then
put k equal to 5, 10 and 20 years and plot the charts in figure 1.5 by computing
r,t,t+k for every monthly t from 1891 to 2011. We keep using the database on
S&P Composite made available by Shiller.
We repeat the same exercise with the 5-years standard deviations of dividend
returns, by simply substituting ri in equation 1.5 with the yearly real dividend
returns di .
Figure 1.5 and figure 1.6 highlight five different evidences.
The higher k, the lower the volatility of r,t,tk i.e. the volatility of the
yearly returns volatility. This evidence is strictly related to the way in
which r,t1 ,t2 in built in equation 1.5. The higher k, the more overlapping
periods exist and the smoother we expect the charts to be.
The standard deviations of ri are less volatile than yearly ri themselves. If
we consider chart A, we notice that 5-years standard deviations have been
fluctuating between 8% and 20% in 100 out of the 120 considered years.
Volatility seems to be positively autocorrelated. Once returns become
highly volatile, thus, they tend to stay volatile for some time. Some of this
autocorrelation derives of course from the way in which r,t1 ,t2 is computed:
r,1882,1887 will structurally be highly correlated with r,1881,1886 , as the two
statistics are computed over a sample where 80% of the observations are
identical.
Despite the low variance of volatility over most of the period, there have
been periods with a much higher than average uncertainty about returns.
Between 1929 and 1946, when both the most serious economic crises and
18
Figure 1.5: 5-years, 10-years and 20 years standard deviations of total real returns
on the S&P Composite from 1881 to 2012. Personal calculations from Shillers
Data.
19
Figure 1.6: 5-years standard deviations of dividends real returns on the S&P
Composite from 1881 to 2012. Personal calculations from Shillers Data.
the most dramatic war in history occurred, r,t,t600 5 years standard
deviation, with monthly observations reached a peak of 45,7%19 .
As we could expect, dividend smoothing policies make dividend returns
much less volatile than total real returns. The fact that 5-years volatility on
dividend returns has never been higher than 1,4%, and that its coefficient
of variation over the same period never exceeded 80%, tells us that almost
all the volatility is due to changes in prices and capital gain returns.
1.2.5
Future returns
Despite the quantity of historical data, one can never be certain that the underlying factors that generate asset prices have remained unchanged20 . As Nobel
laureate Paul Samuelson said, we have but one sample of history. In the impossibility to repeat controlled experiments, holding some factors constant while
estimating the value of the target parameters, past economical events are not
a guarantee of future events. Nothing guarantees, hence, the equity market
will continue to outperform in such a relevant way the bond market21 , or even
that the S&P Composite will never present a period longer than 17 years with
non-positive total returns. Even when past relations are statistically significant,
moreover, valuation benchmarks are valid only as long as underlying economic
and financial conditions do not change. Structural changes in the economy and
19
This peak was reached, in particular, in 1937

Siegel 2008, op. cit.
21
The relevance of this impressive performance is at the center of the debate on the Equity
Market Premium Puzzle. This term was coined in 1985 by Mehra and Prescott to show that,
to reconcile the much higher returns of stocks compared to bonds, individuals should have
implausibly high risk aversion according to standard economics models.
20
20
in financial markets should be, therefore, carefully analysed when attempting to

use the past to predict future returns.
21
Chapter
Pricing and Market Efficiency

The concept of market efficiency has become widely known through the work
of professor Eugene Fama and his colleagues in the late 1960s. The concept,
however, has been less formally known for decades1 , supported by the intuitive
evidence that it is extremely difficult to obtain abnormal returns by buying low
and selling high in the stock market. According to Jensens definition (1978):
A market is efficient with respect to information set t if it is
impossible to make economic profits by trading on the basis of information set t .
An economic profit is defined as the net adjusted rate of return, net of all
costs. It is, in other words, a net return that its higher than returns that are
required for a certain level of risk. In literature this is also called abnormal
return.
According to efficiency market hypothesis from now on EMH the price of
securities and, in aggregate, of markets should reflect perfectly all the available
information at any time. Whenever a new information is available, through
variations of demand and supply, markets are supposed to adjust in a short time
instantly, in theory and to eliminate every possible source of economic profit.
The efficient markets theory claims that no asset in the market can be either
overpriced or under priced and that, thus, the smartest investor will not be able
to outperform a casual investor in terms of final return for a taken risk. In
other words, financial markets are efficient when they do not allow investors to
earn above-average returns without accepting above-average risks2 . Expected
1
In 1889 in a book by George Gibson entitled The stock Markets of London, Paris and New
York, the author wrote that When shares become publicly known in an open market, the value
which they acquire may be regarded as the judgement of the best intelligence concerning them.
(Shiller, op.cit)
2
Malkiel 2003 (op. cit.)
22
2. Pricing and Market Efficiency

performance indicators such as the Sharpe Ratio 3 , thus, should be equal among
all investors.
Depending on how wide the information set t is, three different market efficiency forms have been introduced in financial literature.
1. The Weak Form of the Efficient Market Hypothesis, in which the information set t is taken to be solely the information contained in the past price
history of the market as of time t. If markets are efficient in the Weak
Form, it should be impossible to make economic profits by exploiting recurrent price patterns and technical analysis cannot work. Its interesting
to note that is weak form efficiency holds, the terms bull and bear market,
which are often used among Media, professional and casual investors to
describe expected upward and downward market trends, completely lack
of sense4 .
2. The Semi-Strong Form, in which t represents all the information that
is publicly available at time t. This includes not only past prices, but
also information about fundamental indicators, companies balance sheets,
financial reports, macroeconomics public research etc. In this form fundamental analysis, which is the evaluation of securities, firms and markets
mispricing based on the analysis of economic and financial factors, should
not provide abnormal returns.
3. The Strong Form of the Efficient Market Hypothesis, in which t is taken
to be all information known to anyone at time t, including thus all information which has not been published but that is available to companies and
insiders. Price gains due to a takeover or a merger, for instance, should be
priced well before the official announcement is made.
Under the various forms of EMH, price variations can be accounted only to
the availability of purely new information. If it is impossible to forecast future
information and events happen randomly, a consequence of EMH is that the
underlying stochastic process for price formation, after adjustments for required
returns, is a martingale. In probability theory, a martingale is a model of a fair
game where no knowledge of past events can help to predict future winnings. In
3
The Sharpe ratio is the amount of expected extra return an investor receives for every
t
unit of standard deviation of its portfolio. Formally: S = E( rt rf
), where is the standard
deviation of the portfolio, rt its return and rft the risk free rate of return.
4
The same applies to the famous Wall Street phrase The trend is your friend or to
relative-strenght and momentum strategies.
23
particular, a martingale is a sequence of random variables for which the expectation of the next value in the sequence is equal to the present observed value
even given knowledge of all prior observed values at a current time. Formally:
E(Pt+1 |(t)) = Pt (1 + cgt ).
Where pt and pt+1 are the prices of a security at time t and t+1 and cgt is
the required capital gain return on the asset for period (t-1,t). The rate cgt , in
particular, is independent from Pt . We will turn back to cgt and required returns
in the following section.
2.0.6
Why should the equity market be efficient?
The efficient market hypothesis relies on the assumption that, whenever an existing abnormal profit opportunity is discovered, investors will take advantage of
it and adjust the demand and the supply on the security and bring its price at its
rational level. Investment strategies intended to take advantage of inefficiencies
are actually the fuel that keeps a market efficient.5 .
In order to make this happen, the following conditions should be respected:
the market has to be liquid;
information has to be available in terms of accessibility and cost and should
be released to investors at the same time. In other words, information
efficiency has to hold;
rational investors must have enough funds to take advantage of inefficiency
until it disappears.
It is important to note that, if markets become efficient through the continuous exploitation of abnormal returns, EMH does not rule out small abnormal
returns, before fees and expenses. Grossman and Stiglitz (1980) claim that analysts should still have an incentive to acquire and analyse valuable information
as, without any incentive to do so, no one would spend time to acquire the information needed for markets to be efficient. The profits derived from speculation,
hence, are the result of being faster in the acquisition and correct interpretation
of existing and new information6 .
5
To make sense, the concept of market efficiency has to admit the possibility of minor market
inefficiencies. The evidence accumulated during the 1960s and 1970s appeared to be broadly
consistent with this view. Dimson and Mussavian (op. cit.).
6
Cuthbertson and Nitzsche 2004 (op. cit).
24
Shleifer (2000) claims that as soon as investors begin to understand the existence of an anomaly and learn something about fundamental values of securities,
they quiclky respond to the new information and eliminate the anomaly7 .
Another important aspect regards the presence of irrational traders into the
market. EMH does not require tat all participants in the market are efficient
and well informed.
The EMH only requires that there are sufficient smart money traders who recognise mispricing and, by either buying or short selling the asset, will arbitrage the
opportunity an bring back prices to their fundamental values.
Arbitrage is one of the fundamental concepts of finance and has been defined
by Sharpe and Alexander as the simultaneous purchase and sale of the same, or
essentially similar, security in two different markets for advantageously prices 8 .
Theoretically, investors could even try to pursue an inter-temporal arbitrage by
taking simultaneously short and long positions in the same market on securities
that have the same risk profile but different current prices.
An arbitrage is such if it requires zero initial outlay of capital to be exploited
and if it generates a positive return with probability one regardless of future
events. In chapter 4, however, we will analyse in which situations arbitrage
opportunities could either be risky or difficult to exploit due to the presence of
various frictions.
2.0.7
Testing market efficiency and the joint stock hypothesis
Financial Literature has tested the Market Efficiency hypothesis in its various
forms9 .
Weak form efficiency tests have been performed by evaluating how distant
price patterns have historically been from the null random walk hypothesis.
Studies on the semi-strong form of the efficient markets hypothesis, differently, are tests of the speed of adjustment of prices to new information, in
the form of event studies. An event study computes the cumulative abnormalperformance of stocks from a given number of time periods before an event to
a given number of periods afterwards. Semi-strong form tests include looking
for trading strategies (such as the value and growth strategies) that, after taking
account of their transaction costs and their systematic risk, could outperform the
rest of the market. In chapter 3 we will focus on the semi-strong form efficiency
7
An example of anomaly which has diminished over time, for example, is the January effect.
Shleifer and Vishny 1997 (op. cit.)
9
For a comprehensive review on these tests, see Dimson and Mussavian 2000 (op cit).
8
25
and test if market timing through the fundamental P E10 ratio can generate abnormal returns.
Another kind of efficiency test checks if market prices always equal fundamental value. These tests use past data and dividend discount models to compute,
ex-post, the perfect forecast fundamental value of a stock or of an index. After
doing this, these tests compare the ex-post fundamental value volatility with
variations of the actual prices: in chapter 4 we will show such a test by repeating
Shillers variance-bound test.
As it is difficult to observe information that are not publicly available, tests of
the strong form efficiency consider the performances of operators who are considered more capable of obtaining this kind of information: investment professionals
and mutual funds.
Jensen stated in 1978 that testing market efficiency in all its three forms has
an intrinsic problem. In most cases, tests of market efficiency are tests of joint
hypotheses: market efficiency and the pricing models chosen to predict returns.
The magnitude of abnormal returns of a stock or an index depends critically
on the choice of benchmark and this makes it difficult to interpret the results.
The tests can fail either because one or both the hypotheses are false or because
both parts of the joint hypothesis are false. In other words, as we cannot be
sure about which kind of risk is priced by markets and about the effectiveness of
pricing models, a market efficiency test could give negative results simply because
our pricing model is wrong. On the one hand, anomalous behaviour may be an
indication of market inefficiencies. On the other hand, even if there is no bias
in computed abnormal returns, the regularity in returns may be indicative of
shortcomings in the underlying asset pricing model.
It is important to note that prices, even when market accurately reflect the
available information, could be not representative of fundamental values simply
because the information is not reliable or not sufficient. Even if markets are
efficient, then, some EMH empirical tests could give negative results because of
some kind of information inefficiency.
2.1
The Net present Value
EMH states that demand and supply should adjust at any time to give the correct
price to any traded stock. But what is the rationale behind the formation of a
certain price level?
The fundamental sources of stock valuation are earnings and dividends. Stocks,
in other words, have value only because of the cash flows that current investors
26
receive or the price appreciation caused by cash flows that future investors expect
to receive. In order to derive a share present value, future cash flows should be
discounted because cash received in the future is worth less than cash received
in the present. This fundamental assumption is based upon four reasons:
Time preferences of consumers. Consumers are supposed to prefer consuming today rather than wait for tomorrow.
Productivity. One amount of money today can be invested in productive
business activities which can create value and turn into an higher amount
of money tomorrow.
Inflation, which usually reduces the purchasing power of money through
time. Only nominal cash flows have to be discounted with a rate that takes
into account this variable.
Risk, for all cash flows which are uncertain in either their amount of their
payment date. Modern finance assumes that individuals are risk adverse
and, thus, are willing to take risk only if this risk is rewarded with higher
expected returns10 ..
The price of an asset should be equal to its Net Present Value NPV, which
represents the sum of all the future cash flows that the owner will receive in the
future, discounted using a yield that compensates the investor for the factors
mentioned above. This yield kt is the rate of return that is just sufficient to convince an investor, according to his preferences, to invest his money in an asset
from time t 1 to t. The term investor, in this case, refers to a representative
operator whose actions reflect the beliefs of those people who are currently trading a stock. This is also called the marginal investor, who is the operation with
the higher probability in a given moment to trade the considered asset and who
determines its price11 . Return kt should be such that, given an information set
0 at time 0, the stochastic behaviour of rt kt , where rt represent returns that
are really made on the market, assures that, on average, no abnormal returns
are made.
Given a cost of equity capital of kt over a (t-1, t) period, and given an infore
mation set t , expected return rt+1
should be equal to kt . At the same time, the
martingale price-generating process requires that, over the same periods, prices
should increase by an yearly amount (1+cgte ) equal to expected capital gains due
10
11

Damodaran 2009, op. cit.
27
to re-investments of retained earnings in corporations. Under these assumptions,

we can compute the expected yearly capital gain cgte :
Pte + Dte = (1 + kt )Pt1

Pte
Dte
= (1 + kt )
Pt1
Pt1
cgte = kt det
Which is equal to the difference between the required cost of capital and
the expected return from dividends, due to re-investments of retained earning in
firms. The resulting process should than generate prices following an exponential
trend which grows faster as the dividend yield dt is reduced.
NPV of expected future cash flows.
Before introducing a model to determine the required return k, we show how
to price assets with a generic discount rate. If both the payment date and
the amount of the cash flows from an asset are certain, under the no arbitrage
condition we can price the risk free asset in this way:
Prf,0 =
=
n
X
CF2
CFn
CF1
+
+ + Qn
=
(1 + krf,1 ) (1 + krf,1 )(1 + krf,2 )
i=1 (1 + krf,i )
CFi
j=1 (1 + krf,i )
(2.1)
Qi
i=1
Where CFt represents the asset cash flow at time t; kf r,t the required return
of a risk free asset at time t and n is the period in which the last cash flow is
paid.
As weve seen in chapter 1, an investment in equity presents a given level of
variance and does not guarantee neither the amount nor the payment date of
its future cash flows. In order to price such a risky asset, then, equation (2.1)
should be changed into:
P0 =
X
CF1e
CFne
CFie
+ + Qn
=
Qi
(1 + k1 )
i=1 (1 + ki )
j=1 (1 + ki )
i=1
(2.2)
Where e are the expectations of the operator based on the information set 0
28

at time 0, E(CFt |0 ) = CFte and ki are the yearly returns required from operator,
which reflect the risk of the investment.
In the case of a share of a stock or of an ETF, we know that its cash flows
derive either from dividends or from selling of the share at a future time. Consider
the case of an operator investing in a share at time t 1 and willing to sell it at
time t. From his point of view, the correct price should be equal to:
Pt1 =
Dte + Pte
1 + kt
If the operator is consistent, anyway, he will expect Pte to be derived exactly

in the same way that it does for Pt1 . By repeated forward induction, each
investor with a one-period horizon should believe the same. For a generic equity
share, hence, EMH asserts that its price in each period should be equal to the
net present value of its expected dividends:
P0 =
Die
= N P V (De )
(1
+
k
)
j
j=1
Qi
i=1
(2.3)
NVP with constant cost of capital or constant growth expectations.

If at time 0 dividends and real total returns are expected to remain constant in
the future, then Dte = D0 t and kte = k t. We can use simple algebraic passages
to simplify this equation:
D0
D0
+ ... +
=
(1 + k)
(1 + k)n

1
1
1
= D0
+
+ ... +
1 + k (1 + k)2
(1 + k)n

1
1
P0 (1 + k) = D0 1 +
+ ... +
1+k
(1 + k)n1
P0 =
By subtracting P0 from P0 (1+k), all but two of the elements of the geometric
progressions are eliminated:
29
P0 (1 + k) P0 =
1
1
1
1
= D0 (1
+
... +
1+k 1+k
(1 + k)n1 (1 + k)n
!
1
1 (1+k)
n
P0 = D0
k
If we set n = , we get the perpetual rent formula:
P0 =
D0
k
(2.4)
As we are considering real dividends and real rates of return, note that the
above formula is actually considering nominal dividends which grow at the same
rate of the inflation.
Another particular case of NPV formula is determined by the assumption
that future dividends will grow, in real terms, at a certain constant rate g. If
information about future changes in the economy that will affect earnings, such
as changes in the tax rates or in the share of GDP of corporate profit, are
not available, it could be reasonable for example to assume for the S&P 500
dividends a future growth equal to the expected growth of the national GDP12 .
We introduce hereby the Gordon Constant Growth model. Formally:
D0 (1 + g e )
D0 (1 + g e )n
+ ... +
1+k
(1 + k)n

1+k
1
1
e
P0
=D 1+
+ ... +
1 + ge
1+k
(1 + k)n1
P0 =
With a procedure identical to the one used to get (2.4), we get the sum of
the geometric series from t = 1 to t = n, which is equal to:
P0 = D0 (1 + g e )
1
k
1
(1+k)n
ge
!
(2.5)
With n = we get the Gordon model :

12
As U.S. corporation open more and more international branches around the world, we
could also consider the expected global GDP growth in order to get the expected growth rate
of dividends in the S&P 500
30
Figure 2.1: Price of a share at time 0, function of the future expected returns
at time 0 -Figure A- and of the future expected growth rate of real dividends.
Dividend level at time 0: 100. Future expected growth rate in Figura A: 1.5%.
Future expected returns in Figure B: 6.5%. Personal calculations.
P0 =
D0 (1 + g e )
k ge
(2.6)
Where:
+
P0 = f (D0 , g e , k )
In this model the actual price of a share becomes function of three factors:
the current level of dividends, the expected growth rate and the required rate
of return. In the following paragraphs we will analyse all these three elements.
Before doing that it is useful to do a simple sensitivity analysis of the three
factors in order to understand how much the price should fluctuate when these
parameters change. In particular, the elasticities of P to D0 , g e , k are equal to:
P0
D
0
gPe0
kP0

1 + g e D0
P0 D0
=
=
D0 P0
k g e P0

P0 g e
D0 (1 + k) g e
=
=
g e P0
(k g e )2 P0

P0 g e
D0 (1 + k) g e
=
=
k P0
(k g e )2 P0
In the first case, P is directly proportional to the level of dividends at time

0. Regarding the expected steady state growth rate and the cost of capital,
differently, their impact of rational prices are represented in 2.1. Note how very
small variations in both the variables can justify important fluctuations of the
31
Figure 2.2: Ratio of the current price of a share due to actualized future cash
flows from time 0 to time x. A constant expected real growth rate of dividends
of 1.5% and a 6.5% real cost of capital are used. Personal calculations.
value of P0 . In particular, as the expected future growth rate gets near to the
cost of capital, the denominator of the Gordon model tends to zero and prices
strongly rise.
2.1.1
The long run matters
The return rate k used to discount future cash flows makes payments made later
in time less important than near ones. While pricing an asset, anyway, one must
not undervalue the importance of cash flows which are very distant in time.
To highlight this importance, we compute how much of the current price of
a share is due to cash flows paid before a future date, displayed of the x-axis
of figure 2.2. From the Gordon Growth Model we know that a share paying a
real dividend of 100$ every year, with a constant expected growth rate of real
dividends of 1,5% and with a real cost of capital of 6.5% should be priced today
2000$. Figure 2.2 shows that the cumulated actualized cash flows from year 1
to year 10 account for just 38% of this value. Actualized cash flows from the
first 20 years account for about 61% of the total and, after 50 years of actualized
flows, 10% of the value is still due to the following periods.
This inherent property of the NPV model has important consequences for
investors when pricing a share or evaluating the impact of new information on
market value. In particular, investors should carefully try to understand which
news will have a structural and long lasting impact on corporations and which
are only contingencies.
32
Example: positive shock on the dividend level

Suppose that the previously considered share, with a current dividend level of
100, is expected to experience a positive shock that will make earnings and
dividends deviate from their natural trend for the first 10 years. Lets suppose a
shock that adds 10 to D1 , 9 to D2 . . . 1 to D10 . Then:
(100)(1, 015) + 10 (100)(1, 015)2 + 9
(100)(1, 015)11
+
+
.
.
.
+
+ ...
1.065
1.0652
1.06511
(100)(1, 015)n
... +
= 2043, 2
1.065n
Pi =
.
This 10% initial shock on the dividend level should impact price of asset i by
43, which is about 2% of the pre-shock value. This simulation shows that relevant
but temporary shocks on earnings and dividends level should not influence an
asset price considerably. Any variation greater than 2%, in the given example,
would be a sign of investors over-reaction to positive news.
Example: negative monetary shock
We now consider the effect of a negative monetary shock. Lets suppose that
the market premium on risk free assets required from investors is 4.5% and that
the central bank suddenly rise real interest rates from what investors think is
the structural interest rate, for example 2%, to 7%. Lets than suppose that it
is unreasonable to think that this rate will be kept this high forever and that
reversion will start after 5 years by 1% per year. Interest rates, thus, are expected
to reach 2% again at t=10. In this case, the shock affects not only discounts rate
for dividends paid before time 10, but also the way in which all future dividends
are discounted. Formally:
(100)(1, 015)6
(100)(1, 015) (100)(1, 015)2
+
.
.
.
+
+
+
1.115
1.1152
(1, 115)5 (1.095)
(100)(1, 015)7
(100)(1, 015)n
+
+
.
.
.
+
= 1519, 5
(1, 115)5 (1.095)(1.085)
1.065n
Pi =
.
The shock produced a significant 25% variation on the rational price level
according di NPV. This example clearly shows how relevant monetary policy is
in determining financial markets valuations and how large its impact on current
stock prices can be.
33
2.1.2
Dividend policy
It could be argued that several corporations do not distribute dividends and that,
consequently, it is not always possible to use the Gordon growth model to price
shares. Even if this claim is correct, anyway, one must not be confused and try
to use future earnings instead of future dividends when pricing an asset. Firstly,
as long as firms earn the same return on its retained earnings as shareholders
demand on its stock, then future dividend policy should not impact market
value of the firm13 . Retained earnings should generate future higher dividends
that have the same actualized value at t=0 as dividends that would have been
otherwise paid.
Evaluating stocks as the present discounted value of future earnings, then,
greatly overstates the value of a firm. As Miller and Modigliani argued14 , this
method would counts earnings benefits twice: earnings are discounted as if they
were distributed to shareholders and ready to be used for other investments
when they actually are retained, generating an additional growth in future
earning which is priced as well. In order to show this, we price two different
firms A and B that, at time 0, are identical, have in equilibrium a cost of equity
of 10% and have a real earning per share of 100. Suppose now that firm A
chooses to distribute all its earnings while firm B decides to re-invest all of them
and obtain the 10% yearly return. If everything else remains stable, firm A will
continue to earn 100$ per year and distribute everything, while firm B earnings
will grow in a geometric progression. Pricing A and B by using their future
earnings instead of their future dividends would bring to the following paradox:
100
100
100 100
+
+ ... +
=
= 1000
2
1.1
1.1
1.1n
0.1
100 110
(100)(1.1)n
(100)(1.1)
PB =
+
+
.
.
.
+
=
=
2
1.1
1.1
1.1n
0.1 0.1
PA =
Thus, not only two identical firms would have different valuations, but also
the valuation of B would not lack of sense. This example confirm the fact that
only future dividends and cash flows for the investor should be considered when
pricing a share.
13
We will see in chapter 4 that this, if taxation is taken into account, could be untrue due
to a deferall benefit.
14
Shiller 1981, op.cit
34
2.2
The market equity premium
In the introduced N P V pricing model, weve seen how important the required
cost of capital k is in determining the current price of an asset or of a share of
equity, as very small movements of k can determine huge fluctuations in these
value. It is essential, then, to understand how to compute this rate in order to
price any kind of asset.
The notion that riskier investments, under risk aversion should have higher
expected returns than safer investments, is central to modern finance theory.
Considering this assumption we can expect the return on any investment to be
equal to the required risk free rate of return rrf plus a premium rate i for the
risk taken. Then:
ki = krf + i
The same applies to the market in aggregate and for the S&P Composite
proxy. The difference in any particular period between the actual rate of return
on a risky asset and the risk-free rate is called excess return 15 . The disagreement
among both academics and practitioners remains on both:
how to measure risk of an investment and how to forecast future risk;
how to price this risk and convert it into a risk premium i that compensates
investors for the variance of future returns.
Regarding the first point, finance theories agree on the fact that the risk of
any investment has an idiosyncratic component, due to specific characteristics
of the asset itself, and a systematic part, which affects all the assets in the
market and which cannot be further diversified. Risk should be measured from
the perspective of a well-diversified investor who, consequently, will measure and
price only the latter component.
We can define the risk that cannot be further diversified in terms of variance
in actual returns around an expected return16 . Excess return on the market
portfolio, in particular, can be seen as proportional to the expected standard
deviation of its returns.
e
e
t = rm,t+1
krf = (m,t+1
)
15
16
Bodie, Kane, Marcus 2009 (op.cit.).

e
An investment is riskless if rt = krf,t
t.
35
(2.7)

e
e
Where rm,t+1
is the expected return of the market. If EMH holds, rm,t+1
=
kt+1 and:
e
kt = krf,t + (m,t+1
)
(2.8)
While we have models, such as the CAPM 17 , to estimate the return of a

single asset as a function of its correlation with the market portfolio and the
market risk premium, it is difficult to create models that predict the future risk
of the market in aggregate and its future excess return. Systematic risk depends
upon different sources that impact the whole economy, such as fiscal, monetary,
and regulatory policy, natural disasters, international conditions or technological
innovations. As there is no natural level of risk in the market, what we can do
is to look again at figure 1.5 and estimate future risk as a function of past
standard deviations. We need to keep in mind that, even though the 5-years
standard deviation on returns has been fluctuating for most of the past century
between 8 and 10%, there have been past periods when m of total real returns
have diverged significantly from its historical average. The evidence from the
1929-1946 period, in this sense, is emblematic. Nothing guarantees that future
e
,
standard deviation will remain almost stationary18 . When we determine m,t+1
so, we should also take into account the eventuality of this future periods of high
uncertainty.
e
If we manage to compute e realistic m,t+1
, we still need to convert this
e
measure into a risk premium. From equation (2.8) we see that, given a m,t+1
and a krf,m , i is ultimately determined by the parameter . Note that this
parameter is equal to the definition of Sharpe Ratio, which indicates the amount
of extra return on the risk free asset required from investors for every unit of
standard deviation taken.
Damodaran suggests three approaches to simplify this approach and quantify
the t that investors will be likely to consider during their investments decisions:
survey investors or managers with the intent of finding out what they require as a premium for investing in equity as a class, relative to the risk-free
rate;
back out an equity risk premium from market prices today;
look at the premiums earned historically by investing in stocks, as opposed
to risk-free investments.
17
Note that the CAPM, despite its wide diffusion among academics and financial operators,
is capable of predicting only a fraction of the total variation in asset returns.
18
This evidence is better analysed in chapter 1
36
In the following sections we will focus on the latter methodology. Using the
categorization suggested by Damodaran, we examine some of the factors that
e
.
influence and m,t+1
(1) Risk aversion
The first and most important influencing factor of the market premium is investors aversion to standard deviations of future returns. Risk aversion varies
among investors depending on elements such as their age, their different preferences for consumption and their education.
Regarding age, for example, people have distinct financial needs at different periods of their life, typically borrowing when young, investing in stocks
and bonds for retirement when middle-aged, and disinvesting during retirement.
Early literature on the subject claimed that individuals become less risk prone
as they get older: according to this view, the younger the average investor, the
lower the aggregate market risk premium should be19 . Even though this point
is controversial20 , demographic trends are still considered to have a huge impact
on market premiums. According to Geanakoplos and Quinzii (2000):
It seems plausible that a large middle-aged cohort seeking to save
for retirement will push up the prices of securities, and that prices
will be depressed in periods when the middle-aged cohort is small.
Bakshi, Chan and others argued that price-earnings (PE) ratios have moved
over the last century proportionally to the ratio of middle-aged to young adults
in the U.S. Note that if markets were not myopic and did forecast and consider
the impact of demographic trends in advance21 such a relation should not exist.
As far as consumption preferences are concerned, differently, we expect equity
risk premiums to be lower in markets where individuals prefer to consume tomorrow rather than today and are net savers than in markets where individuals
are net consumers. Equity risk premiums, hence, should be a positive function
of investors marginal propensity to consume today.
In determining the market risk premium and, in particular, factor , we need
to consider how consumption preferences vary in aggregate over time in order to
understand which are the preferences of the theoretical marginal investor.
19
Bakshi and Chen examined risk premiums in the United States and noted an increase in
risk premiums as investors aged. See Bakshi and Chan 1994, op. cit.)
20
The observation, exploited by Bakshi and Chen, that young people are more risk-tolerant
than old people, suggests that the equity premium should be smallest when the proportion of
young people is highest. But this is exactly contrary to the historical record. Geanakoplos and
Quinzii (2000)
21
Demography is the future that already happened. - Peter Drucker.
37
(2) Inflation
The equity risk premium should be lower in an economy with lower expected
e
. Predictable inflation, stable interest rates and stable economic growth
m,t+1
are amongst the factors that reduce this variable.
Literature examined the relationship between equity risk premium and inflation but did not reach any definitive conclusion. Brandt and Wang (2003)
present evidence that risk premiums in equity markets tend to increase when
inflation is higher than expected and decrease when it is lower than expected.
According to Damodaran (2011), it seems reasonable to conclude that it is not
so much the current level of inflation that influences equity risk premiums but
uncertainty about that level.
(3) Information asymmetries
If all existing information was available with high transparency to every operator in the economy, investors could evaluate their investments by only considering expected fundamental values and their expected volatility. This volatility,
anyway, does increase as information asymmetries arise and as we move from
markets where the quantity and quality of information available is good to stock
exchanges where information cannot be considered reliable. Differences in the
level of information efficiency may be one reason why investors demand larger
risk premiums in some emerging markets.
Changes in both the quantity and quality of information available to investors
can occur also in time, as regulators improve their controls and ITC makes
information transmission easier. According to Damodaran, during the market
boom in the late 1990s, there were some operators who argued that the higher
market prices observed in that period reflected the fact that investors had access
to more information about their investments and were thus requiring lower risk
premiums than before.
(4) Liquidity
Liquidity represents the degree to which a security can be rapidly traded in the
market without affecting its price. Market liquidity is strictly related to the
concept of market deepness: the deeper a market is, the higher the volume of
investors willing to trade in both directions and the larger is the number of shares
that can be bought and sold without changes in current market price.
When volumes or the presence of market markets in a stock exchange are not
sufficient to provide liquidity, investors may have to accept large discounts on the
current market value to promptly liquidate equity positions and, consequently,
38
they will be willing to pay less for equities. It should not be a surprise that higher
risk premiums and average higher returns are observed on stocks which are not
publicly traded or in the private equity industry. The same can be said about
young stock exchanges in developing economies or small capitalization stocks,
where prices may be determined by the actions of a relatively small amount of
investors.
The notion that developed markets for publicly traded stocks are wide and
deep has led to the argument that illiquidity should not have an high impact
on the prices of an aggregate portfolio, such as the S&P Composite. However
according to Damodaran (2011), we need to be sceptical about this argument.
The cost of illiquidity in aggregate, in fact, can vary over time as a consequence
of economic cycles. During a period of financial crisis, for example, credit crunch
phenomenons can lead financial operators to sell their equity positions all at the
same time to avoid internal illiquidity and, if there are not enough counterparts
willing to buy at current market prices, this can highly increase equity market
risk premium.
(5) Black Swan Risk
When investing in equities, there is always the potential for events that occur
infrequently but can cause dramatic consequences. The rise of Nazism, the great
29-32 depression in the U.S., WWII, the Japanese collapse of stock markets in
the late 1980s and the 11 September attack are amongst this kind of events.
Such once-in-a-lifetime circumstances may be so difficult to forecast and so rare
that the standard deviations of ex-post past returns could not be representative
of ex-ante expected standard deviations. Talebs Black Swanw are a general
extension of this kind of events.
A Black Swan is an event with the following three attributes.
First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. . . Rarity,
extreme impact, and retrospective predictability. A small number of
Black Swans explains almost everything in our world, from the success
of ideas and religions, to the dynamics of historical events. . . 22
22
Quotation from The Black Swan: The Impact of the Highly Improbable. Nassim Taleb,
The New York Times Press, 2007.
39
Despite their low probability, this kind of events must be taken into account
when computing expected volatility and required risk premiums. Some argue
that it is due to the eventuality of this catastrophic shocks that risk premiums
and stock prices have been fluctuating more than they should have according to
what really happened in the past. We will come back on this point in Chapter
4.
Determine the Market premium from past history

Under adaptive expectations, in economics, people form their beliefs about future
events based on what has happened in the past, considering thus past values
as the best estimate of future values. In this section we analyse how, under
this assumption, future market premiums and future returns should expected
depending on how much in the past we go.
Figure 2.3: Geometric average of the S&P Composite Total Return, computed
from time x, shown on the x-axis, to March 2012. Personal calculations from
R.J. Shillers Data.
Figure 2.3 shows the geometric moving average of past total real yearly returns computed from time periods on the x-axis to March 2012. This average
can be computed either by compounding return rates from a year t to 2012, or
by more simply using the previously Total Real Return index T RI. Formally:
40
rt,2012 =
2012
Y
1
! 2012t
(1 + ri )

1=
i=t
T RI2012
T RIt
1
2012t
Where ri is equal to the total real return from year i1 to year i. As we could
expect, the longer the period, the less the geometric moving averages change and
the nearer they get to the historical geometric average rate of total real returns
of 6.46%.
In order to derive the historical equity risk premium t,2012 from t to January
2012 we compute, according to equation (2.8), the geometric moving average of
past risk free rates an subtract it from rt,2012 for every t in the sample. Formally:
t,2012 = rt,2012
t,2012 = rt,2012 rf
2012
Y
1
! 2012t
(1 + rfi )
i=t
Where rf
t,2012 is the geometric moving average of past risk free rates from
year t to 2012 and rfi is the one year yield of 10-years U.S. t-bonds at time i.
Figure 2.4 shows how the market premium varies depending on how much we
go back in time. Regarding risk premiums, if we dont consider the negative
values from the last 15 years, they have been fluctuating between a low 2,7%
for t = 1973 and an high of 5,8% for t = 1982, with an historical geometric
average from 1872 of 4.2%.
If we want to use past market performance to predict the future, we must
be aware of two main issues. Firstly, the nearer we go in the past, the more the
exact date in the past from which we start considering returns is relevant for the
determination of the geometric average. This is evident from the volatility of
figure 2.3, which gets higher as we get nearer to the current date. We get rid of
this problem if we consider a geometric average going sufficiently back in time.
What we have to consider, on the other hand, is that the more we go back in
time, the more is probable that preferences, rules and the structure of the economy have significantly changed. Risk premiums computed at the end of the XIX
century could be no longer reflective of premiums of a developed economy with
mature and regulated financial markets. As we mentioned before, for instance,
the lower transaction costs and the higher availability of information as made
possible by the ICT revolution could have lowered the required market premiums
over the last 20 years.
41
Figure 2.4: Average historical risk premium on the S&P Composite, computed
from time x, shown on the x-axis, to January 2012. Personal calculations from
R.J. Shillers Data.
With notions on market efficiency, pricing models and methods to estimate
future risk premiums the base of past values, in the following chapters we will
analyse how much the real behaviour of the S&P Composite can be considered
a reflection of the fundamental value of the equity market in aggregate. If this
is not the case, than abnormal returns opportunities could be identified ex-post
and interpreted in the light of the behavioural finance literature.
42
Chapter
Abnormal returns from fundamental

analysis
A number of tests on the semi-strong form of market efficiency measure the
reactivity of prices in response to new useful information. Even when price
adjustments occur rapidly, it still remains possible that securities remain persistently over- or under-valued over long periods of time. It is more difficult to test
whether prices conform to fundamental values, than it is to test whether prices
respond appropriately to information. Financial literature, nonetheless, has also
evolved in this direction.
Considerable empirical tests have been conducted to determine the predictability of market returns on the basis of different initial valuation parameters. Fama
and French (1988) and Campbell and Shiller (1988) analysed the relation between future returns and initial dividend yields, concluding that as much as 40
percent of the variance of future returns for the stock market in aggregate can be
explained by different levels of initial dividend yields. As dividend payout ratios
have been continuously declining over the last half century, however, Malkiel
(2003) claims dividend yield may not be as predictive of future returns as in the
past.
In his book Irrational Exuberance, Shiller (2009) analysed the historical negative relation between the Price-Smoothed Earnings ratio and subsequent returns
from a long-term buy and hold investment His hypothesis is that extreme PriceEarning values could be an indicator of market mispricing and that, hence, reflect
the tendency of operators to over-react to information and to be subject to irrational behaviours. Hereby we reproduce Shillers analysis and extend it to
consider also extra returns and dividend returns.
43
3. Abnormal returns from fundamental analysis
3.1
The P/E10 ratio
Price earnings are amongst the most used indicators in fundamental analysis and
represent the ratio between the market price of a share and the earning per share
level at in a certain period. Given the previously defined net present value of a
share, we can compute the Price-Earnings ratio from the Price-Dividends ratio
which, over an infinite period and under the assumption of stable future growth
of dividends is equal to the Gordon growth model:
Pt
=
Dt
1 + ge
k ge
Where ke is the cost of equity and g the constant expected growth of dividends. In the long run, anyway, the company sooner or later will have to distribute all its earning. Under market efficiency and over and infinite period,
hence, we expect the P/E of a stock to be function of the same factors that
move the Price-Dividend indicator: the cost of equity and expected growth. As
the cost of equity is directly influenced by the return of a risk-free asset, such
as inflation-linked government treasuries or t-bills, we expect the P/E ratio to
vary accordingly to changes in the interest rates from monetary authorities as
well. In order to consider all this, we can rewrite equation (3.1) introducing the
dividend payout ratio in t:
prt =
Dt
Et
(3.1)
to obtain
(prt )(1 + g e )
Pt Dt
=
Dt Et
k ge
When this approach is used to price an high-growing corporation or a developing country, it can be useful to evolve the model into a two stages dividend
discount model where, before using a constant future growth of g e , a few years
of higher growth are assumed. Despite the presence of high-growing developing
countries around the world, however it is difficult to assume that the world is
currently experiencing in aggregate a period with growth rates which, in one way
of in the other, will change significantly in time. Even if this was the case, it
would be hazardous to make projections on changing growth rates for the next
10 or 20 years. For our purposes we will use the standard Gordon model.
The main difference in the short run between the Price Dividend and the Price
Earnings ratios consists in the much greater volatility of the second indicator,
44
Figure 3.1: Real Earnings, Real Dividends and 10 years Real Earnings Moving
Average from January 1871 to March 2012. Earning in 1871 are set to 100 and
Dividends to 65, coherently with 1871 dividend payout ratio.
due to the higher variance of earnings than dividends. This result are due to the
general preference of CEOs for a dividend smoothing policy, in order to guarantee
to their shareholders yearly cash flows which are as stable as possible. While
earning change significantly in the short run due to changes in the real business
cycle and due to the effect of financial and operative leverage, the dividends
volatility is kept low by limiting the dividend payout ratio when earnings are
low or by using reserves, eventually, if they are negative and increasing the
retained earnings ratio when the business cycle is particularly strong.
This is evident if we look at figure 3.1. Campbell and Shiller (1988) showed
that dividends in the S&P tend to follow the moving average of corporate earnings
with a precision which increases in the number of years on which the moving
average of earnings is computed.
Note that the high earnings volatility could eventually bring the P/E ratio,
computed on yearly earnings, in negative territory: a non-sense value as fundamental value cannot be lower than zero. Even though individual stocks often
show negative P/E ratios, empirical evidence on the S&P Composite shows that
the lowest level of this indicator was 4,47, reached during WWI in 1917. As
we can see in the reported chart, anyway, the high cyclicality of yearly earnings in the S&P Composite makes the classic P/E ratio, computed using yearly
earnings, particularly noisy and difficult to use as market value indicator. Such
a usage would not consider earnings cyclicality and would erroneously suggest,
for example, that the market is highly over-valued whenever negative temporary
conjunctures make earnings drop violently. This is exactly what happened in
late 2009, with the P/E ratio at its historically highest level above 70 due to
45
the highest fall in the aggregate S&P real Earnings -91% from June 2007 to
June 2009 in history.
3.1.1
Price-Earnings as fundamental market-timing indicators
We have just seen that the price-earnings ratio of a stock or of the market as
a whole is function of the expected growth of dividends and earnings of the
underlying asset over time. Higher P/E ratios can be perfectly justified into a
rational EMH framework for firms and markets which will are likely to increase
their businesses faster than others. This is the case of star 1 firms, such as a fast
growing hi-tech like Apple corp., or of emerging markets such as BRICs.
When we take the market of a mature economy in aggregate, however, we
should be much more skeptical of forecasts in which either growth rates or risk
premiums are expected to deviate significantly from their historical trend.
Several scholars and investment professionals have argued that value strategies, consisting in buying stocks that have low prices relative to earnings, dividends, historical prices, book assets, or other measures of value, can over-perform
the market. What we argue here, following Shillers ideas, is that the PE ratio
could be used as a value indicator even for the market in aggregate. Violent
fluctuations this ratio in the S&P Composite, therefore, could be interpreted
as market long-term mispricing indicators. In order to test the effectiveness of
contrarian strategies based on Price-Earnings, however, we need to get rid of its
high level of short term volatility.
A good way to smooth cyclicallity and use the Price Earnings ratio as fundamental value indicator is, as suggested by Shiller, to use the moving average
of earning at denominator instead of yearly earnings2 .
We will use a 10-years moving average of earnings indicator, e10t , showed in
figure 3.1 and defined as:
9
E10
1 X
Etk
=
10 i=0
Thus, we define Shillers P E10 as:

1
Such a denomination is frequently used by practitioners referring to the BCG Matrix

Taxonomy.
2
The use of an average of earnings in computing the earnings price ratio was already used in
1934 by Graham and Dodd. In their book Security Analysis, they recommended an approach
that shifts the original point of departure, or basis of computation, from the current earnings
to the average earnings, which should cover a period of not less than five years, and preferably
seven to ten years. (Campbell and Shiller, op.cit)
46
Figure 3.2: Price Earnings ratio computed on yearly earning from 1881 to 2011.
Personal calculations from R.J. Shillers Data.
High date
July 1916
July 1929
Jan 1937
Sept 1968
Sept 1972
Sept 1999
July 2007
Low date
July 1918
April 1932
March 1942
June 1970
June 1974
July 2002
Feb 2009
P E10 at High
11,97
32,40
22,18
22,24
18,64
44,02
27,24
P E10 ratio at Low

6,16
5,58
8,5
14,10
8,67
22,4
13,42
TRI Variations
-42%
-75%
-50%
-40%
-55%
-50%
-50%
Table 3.1: 5 years highest negative variations in the S&P 500 Total Real Return
Index. Personal calculations from Shillers Data.
P E10 =
Pt
E10,t
Figure 3.2, computed in order to update the charts from Shillers Irrational
Exuberance, presents the P/E10 ratio of the real S&P Composite from 1881 to
2011.
One evidence offered by the graph is that during the three main stock market
crashes in the period examined, the fell was preceded by an impressive raise in
47
the P/E10 ratio. In table 3.1 we examine all the periods in which, in less than 5
years, the total real return index lost more than 40% of its value from January
1871 to April 2012.
From both figure 3.2 and table 3.1 we can highlight three stylized facts:
Price Earning Ratios have been moving with a slightly upward trend in
the last 140 years. The arithmetic average of the historical P E10 ratios is
around 16,40 points, corresponding to an average earning yields of 6,09%.
Note that the average of the PE ratio computed on early earning is 15,65:
a lower value than P E10 as earnings have historically been growing and,
therefore, have on average been higher than their 10-years moving average.
The three highest levels in the P rice Earning10 on 32,40 - 44,02 - 27,24
have all been followed by a subsequent violent decrease, with a magnitude
greater than 50%, in the total return index;
the opposite is not necessary true, as not every crash in the stock market
was preceded by a significant increase in the level of the Ratio. In September 1972 for example, before the -55% fall in the Total Return index due
to the first oil crisis and to the Kippur War, Price Earning Levels where
only slightly above their historical average
It is impossible to prove the assertion that some speculative effects were
behind many of this violent fluctuations of the P/E10 ratio, as one can always
argue that there were valid fundamental reasons offered by investors to justify
prices at a certain time. This piece of historical evidence, nevertheless, shows
that whenever price/earnings got very distant from their historical trend, as it
happened in 1929, in 1932, in the late 70s and in 2000, they tended to reverse
afterwards. According to Shiller (2009), this mean reversion effect shows that
there is some evidence that these supposed fundamental reasons were, ex-post,
not that realistic. From the presented evidence we could claim that whenever
P E10 ratios go too far away from their historical trend, investors and regulators
should consider the possibility that some kind of speculative bubble is swelling.
3.1.2
Test on Total Real Returns
Has the P/E10 ratio been an indicator of fundamental value over past decades?
One interesting way to understand the potential importance of the P/E and, in
particular, of the P/E10 ratio as indicator of over valuation or undervaluation
of the stock market at a given time t is to analyse the correlation between this
indicator and average yearly total returns of an investment from t to t + k.
48
Figure 3.3: The graphs displays, for the entire century 1892-1991, the correlation
between average real yearly returns on a 20-years investment on the S&P 500
total return index and P/E10 level when the investment is initiated.
What we attempt to find with this method is whether or not investments in the
U.S. stock market in years where the P/E10 ratio suggested undervaluation have
generated subsequent higher returns than investments initiated in years with
very high P/E10 ratios. In other words: have there been periods in past history
when it would have been possible to get abnormal returns through market timing
based on the P/E10 ratio? The notion is that if stocks are under-priced relatively
to fundamental value, returns tend to be high subsequently and that the converse
holds if stocks are overpriced.
Hypothesis 3.1 20-years buy-and hold investments initiated when the P E10 ratio was low have outperformed, on average, investments with the same duration
initiated when the P E10 ratio was higher.
To test hypothesis 3.1, we then compute the gross total real return Rt,t+240
on the S&P Composite for a 20-years holding period beginning at time t, where
each period (t, t + 1) represents one month:
Rt,t+240 =
T RIt+240
T RIt
(3.2)
where T RIt is the level of the S&P Composite Total Return Index in month
t. We then compute the geometric average of yearly net real return on the same
index and on the same investing period.
rt,t+240 =
p
Rt,t+240 1
20
49
(3.3)
We use the data from Shiller and compute rt,t+240 monthly t from March
1882 to March 1992 on a monthly base. We then perform a linear regression,
where P E10 ratios are used as regressors and the geometric average of subsequent
Figure 3.4: The graphs displays, for the four 20-years periods from 1891 to 1992,
the correlation between average real yearly returns on a 20-years investment on
the S&P 500 total return index and P/E10 level when the investment is initiated
50
total real returns from 20-years investments rt,t+240 are the dependent variable.

rt,t+240 = +
Pt
Et,10

+
Figure 3.3 plots the corresponding rt,t+240 and initial P E10,t for every month
in the considered period. Returns fluctuated between around 0% and 14%, with
a clear negative correlation with price-earnings. The model, in particular, seem
to explain around 58% of the total variance of returns over the entire sample.
In order to see if this correlation has been persistent over time, we repeat this
exercise for each 20-years period from 1892 to 1992.
The results are quite noticeable. Figure 3.4 shows that the same negative
relation is present in all the considered sample periods, even though its magnitude
varies from time to time. The beta coefficients of the regressions show that the
geometric average of total yearly real returns from a 20 years investment on
the S&P Composite were lowered -0,62% to -0,29% for each additional unit of
the initial P E10 value, depending on the time period. Over the whole sample
of 140 years, the average negative regressor coefficient is -0,52%: that means
that, on average, a 20-years investment initiated when the P E10 ratio was at 10
overperfomed a 20-years investment initiated when P E10 where at 20 by 5,2%
on a yearly base. Compounded over the 20-years period, this makes up for a real
175% difference in return. Even if we take time periods when the coefficient has
a lower magnitude ( = -0,29%), investments initiated when P E10 where at 10
and at 15 over-performed investments when P E10 where at 20 respectively by
77% and 33% over 20 years.
This difference in returns becomes even more accentuated for extreme values
of Price-Earnings, such as the values above 30 during 1929 of the 5 to 10 values
reached in the early 20s, in 1932, in 1942 and in the early 80s. We cant
unfortunately perform this ex-post test for years after 1992 and for the dot com
bubble, as no 20-years period does exist after that date.
The coefficients of determination R2 , measuring the percentage of the total
variation of the dependent variable explained by the linear relation and, thus,
how well the regression line does fit the data, varies between 60% and 75% in
each of the considered periods except from 1932-1951. In this period, when both
the deepest recession and the most serious war ever stroke, R2 is only 27%.
Unfortunately, the fact that the observations of the dependent variables are
not i.i.d. undermines the analysis of the statistical significance of the performed
test. We will address this matter later in the disservation. Despite this issue,
the persistence and the magnitude of the negative coefficients seems to support
51
Figure 3.5: Black line: Ratio between real S&P 500 price index and the 10-years
moving average of real yearly earning from 1881 to 2012. Red line: interests on
U.S. 10 years tresuries. R. Shillers Data.
hypothesis 3.1 and the fact that the P E10 has been an useful indicator of market
value.
3.1.3
Test on Extra Returns
In Chapter 1 we said that investors, when they consider how much to invest in
the equity market, should be interested not only in the equity market real total
returns, but also in their relative performance with respect to risk free assets. The
reason to invest in stocks rather than bonds is that the former have historically
outperformed the latter in the long run and, in particular, there has never been a
period longer than 30 years where the equity market has underperformed bonds.
After having considered the relation between total real returns and the P E10
indicator, we now analyse the relation between total extra returns and the P E10
ratio.
The theory that P/E ratios and nominal interest rates should be inversely
correlated came to be known as the Fed model in the mid 90s. Although the
Federal Reserve has never accepted it officially, the model has been often used
to measure the relative attractiveness of equity compared to bonds. The idea
is that when the equity earnings yield in aggregate is above the government
52
Figure 3.6: The graphs display, for whole 1891-1992 period, the correlation between average extra yearly returns on 20-years investments on the S&P 500 total
return index and P E10 level when the investment is initiated. Extra returns
computed using 10 years U.S. tresuries yields.
nominal bond yield, investors should shift funds from bonds into equity. Figure
3.5 shows how this rule of thumb seemed to hold from from 1970 to the end of
the century.
Economic theory, however, suggests that there should be a relation between
the real, and not the nominal interest rate and the price-earning ratio. The price
earning, infact, is a pure number, computed as the ratio of two variables which
should equally be effected by inflation. The presence of a relation with nominal
interests is an anomaly and can be explained only under money illusion and if
investors systematically confuse nominal and real variables. Estrada3 empirically
shows that the correlation between Price Earning and 10-years nominal has been
of 0.75 between January 1968 and Jun/2005 but 0.19 between January 1871 and
December 1967, and only 0.10 over the whole 1871-2005 period. The evidence
in support of the Fed Model, moreover, is limited not only from a temporal
perspective, but also from a cross-sectional and international perspective.
Even if we reject the Fed Model, the Net Present Value pricing model suggests
that changes in the real interest rates can well justify fluctuation of prices and
different returns from the stock market. The return reversals analysed in the
previous section for the market as a whole could be quite consistent with the
efficient functioning of the market if they were due to the volatility of interest
rates and to their tendency to mean reverting.
What we attempt to do in this section is to understand whether the relation
presented in figures 3.3 and 3.4 can be totally explained by the occurred variations
in the real interest rates or if the negative correlation between the initial P E10
3
Estrada 2005 (op. cit).
53
ratios and subsequent real returns should be attributed to other factors.

Hypothesis 3.2 20-years buy-and hold investments initiated when the P E10 ratio was lower had higher Extra Returns on risk free assets than investments with
the same duration initiated when the P E10 ratio was higher..
In order to test our hypothesis, we compute the extra return ert for every
month from 1881 to 1991 as:
ert = rt yt
where rt and yt represent respectively the total real return of the S&P Composite and the interest rate on 10 years U.S. t-bonds at time t4 .
Having done this, we compute the geometric average er
t,t+240 of the yearly
extra returns over 20-years investment periods initiated in t, for every monthly
t from March 1881 to March 1991. Formally:
er
t,t+240 =
! 201
t+240
Y
(1 + ert )
At this point, we perform a linear regression where we try to explain er

t,t+240
as a linear function of P E10,t ratios.

er
t,t+240 = +
Pt
Et,10

+
Both the regression coefficients and the coefficient of determination R2 have

a lower magnitude than before, suggesting that real interest rates mean-reversion
does explain some of the considered mean reversion of Price-Earnings. Figures
3.6 and 3.7, however, show that interest rates variations cannot explain all the
anomalous correlation. Even if they have a lower magnitude, the coefficients
are still negative, with an average of -0,39% on the whole sample and an high level
of 0.51% from 1952 to 1991. A variation of 10 points in the initial Price-Earning
Ratio, thus, seems still to impact subsequent average yearly extra returns from
a 20-years investment by 1,5% to 5,1%.
4
To test extra-returns for 20-years investments we could have simply used 20 years zero
coupon rates on treasuries. As only data on the 10 years zero coupon rates on US treasuries
are available for the period 1871-2012, we use these as a proxy for the 20 years zero coupon
rates.
54
Figure 3.7: The graphs display, for the four 20-years periods from 1891 to 1992,
the correlation between average extra yearly returns on a 20-years investment on
the S&P 500 total return index and P/E10 level when the investment is initiated.
Extra returns computed using 10 years U.S. tresuries yields.
The levels of the coefficient of determination R2 show that, except from the
1932-51 period, when the coefficient is just 9%, the linear relation seems to
explain 36 to 70% of the total variance of the observations. Such a result is
55
Figure 3.8: The graphs display, for whole 1891-1992 period, the correlation between average extra yearly returns on 10-years investments on the S&P 500 total
return index and P E10 level when the investment is initiated. Extra returns
computed using 10 years U.S. tresuries yields.
coherent with Shillers (2009) hypothesis:
In order to be sure that such a relationship does hold even for holding periods
which are different from 20 years, we repeat the regression with 10 years buyand-hold investments. The results, shown in figure 3.8, confirm the negative
correlation between extra returns and P E10 ratios. They show, in particular,
that investments initiated when Price-Earnings were lower than 17,5 have never
underperformed t-bonds by more than 2% a year. At the same time, the greatest
extra returns above 20% on a yearly base have been achieved for investments
initiated when the S&P Composite was trading at multiples that were much
under their historical average. Even though the linear model can explain, over
the whole sample, just 30% of the variance of 10 years average extra returns,
such an evidence supports Shillers position.
3.1.4
Test on Real Dividend Returns
Another interesting analysis in the study of abnormal returns is to understand

whether both real capital gains and real dividend returns or just the first component are correlated to price earnings. If we believe in bubble formations and in
herd behaviours that influence people to buy regardless of the fundamental value
of a stock, but just because of increasingly higher price, we should expect to see
only the real capital gain component of total returns to be affected by different
initial P/E10 ratios over a 20 years holding period. W henP E10 ratios are very
high, if this indicates the presence of over-valuation, we will expect prices to
mean revert and subsequent capital gains to be lower than normal. This claim
is equal to the following hypothesis:
56
Figure 3.9: The graphs displays, for the four 20-years periods from 1891 to 1992,
the correlation between average dividend real yearly returns on a 20-years investment on the S&P 500 index and P/E10 level when the investment is initiated.
Personal calculations from Shillers data.
57
Hypothesis 3.3 Investments initiated when P E10 ratios are lower are more
profitable due to their higher capital gain component, as P E10 ratios tend to
mean-revert in time.
As total returns are made by both dividend returns and capital gain returns,
we test hypothesis 3.3 by analysing the relation between dividend returns and
Price-Earnings. Using the previously introduced total real dividend index, built
as the composed capitalization of yearly dividend yields, we plot for every month
from 1892 to 1992 the initial P E10 indicator and the subsequent average annual
real return dt,t+240 of a 20 years investment initiated in year t on the dividend
only index. Formally:
dt,t+240 =
r
20
DRIt+240
1
DRIt
The resulting linear regression model will be:
dt,t+240 = +
Pt
Et,10

+
Figure 3.9 shows the correlations between dt,t+240 and P/E10,t in 5 different
time periods in history. The flat angle with never higher than 0,05% of the
regression line in each of these shows that dividend returns of 20-years investments have historically been independent from initial P E10 ratios. Hence, Price
Earnings have hardly any explanatory power for the future growth in dividend
yields and all the abnormal returns analysed in the previous sections are due
to higher or lower than normal capital gains and to fluctuations of the S&P
Composite Price Index. This evidence supports hypothesis 3.3.
58
Regression Results
Hereby we report the linear regression model results, as performed using both
SAS Enterprise Guide and the Excel data analysis add-on.
Average yearly Total real returns
Time period
Intercept Regressor
All: 1892-1991
13,96%
-0,56%
(<.0001)
(<.0001)
1892-1911
13,2260%
-0,3952%
(<.0001)
(<.0001)
1912-1931
9,93%
-0,3400%
(<.0001)
(<.0001)
1932-1951
13,60%
-0,29%
(<.0001)
(<.0001)
1952-1971
12,69%
-0,50%
(<.0001)
(<.0001)
16,09%
-0,62%
1972-1991
p-values
(<.0001)
(<.0001)
Average yearly Extra returns
Time period
Intercept Regressor
All: 1892-1991
10,35%
-0,39%
(<.0001)
(<.0001)
1892-1911
11,35%
-0,44%
(<.0001)
(<.0001)
1912-1931
5,1%
-0,16%
(<.0001)
(<.0001)
1932-1951
12,09%
-0,15%
(<.0001)
(<.0001)
1952-1971
10,91%
-0,51%
(<.0001)
(<.0001)
1972-1991
10,92%
-0,47%
p-values
(<.0001)
(<.0001)
Average yearly Real dividend returns
Time period
Intercept Regressor
All: 1892-1992
6,320%
+0,0001%
(<.0001)
(.8163)
1892-1911
5,76%
0,03%
(<.0001)
(.0049)
1912-1931
5,54%
0,00%
(<.0001)
(.0822)
1932-1951
3,89%
0,07%
(<.0001)
(<.0001)
1952-1971
2,75%
0,06%
(<.0001)
(<.0001)
1972-1991
3,57%
-0,05%
p-values
(<.0001)
(<.0001)
R2
0,6103
0,6158
0,7718
0,2694
0,6115
0,7719
R2
0,286
0,60
0.369
0,089
0,70
0,69
R2
0,000
0,0305
0,0128
0,1367
0,4143
0,0521
Table 3.2: Intercept and coefficient estimates, coefficients of determination

and p-values for the three performed regressions. P E10,t ratios are used as predicting variable for the average yearly total real returns, average yearly extra
returns and average yearly real dividend returns from a 20-years investment on
the S&P. Personal calculations with SAS Enterprise Guide from Shillers data.
59
3.2
Statistical Significance issues with the P/E10

test
Shiller published the first edition of his book Irrational Exuberance in the middle of the dot com bubble, suggesting that, at that time, markets were highly
overvalued compared to their fundamentals. In his opinion, the extreme values
reached by the P E10 ratio were to be considered by both regulators and investors
as an early warning system for excessive speculation. But even though Shillers
ratio accurately predicted that the bubble was soon going to burst, there have
been several critics that refuse to consider his message and to argue that the
analysis done so far lacks of statistical significance.
The fact that in the considered period, which is the largest on which stock
data exist, only five non-overlapping 20-years periods exist, makes it inappropriate to conclude that past negative correlations will continue to exist in the
future.
In order to correctly use the linear regression model, infact, observations of
both independent and dependent variables should be independent and identically
distributed. In probability theory and statistics, a sequence or other collection
of random variables is i.i.d. if:
1. each variable has the same probability distribution;
2. the random variables are all are mutually independent: hence, the occurrence value of one random variable makes it neither more nor less probable
that the other assumes a certain value.
In the considered linear regression models, in order to have i.i.d. observations,
we should have that each couple (Returnsi , P Ei ) is independent from (Returnj ,
P Ej ) and has its same distribution for all i 6= j and for each kind of considered
return Either Total Returns, Extra Returns or Dividend Returns. Both the
used regressors and dependent variables, however, are not i.i.d. P E10,t ratios
are correlated as they are computed on Moving Averages of Earnings. The
denominator of P E10,t and of P E10,t+1 , hence, will be computed on 9 out of 10
observations of earning which are identical. The same problem exists with the
dependent variables. rt,t+240 , for instance, is computed on observations which
are for 239/240 identical to rt+1,t+241 .
Using monthly data and a return over 20 years means that we really have
1
of the observations we think we have, so the significance coefficients the
240
p-values on the computed regressions will be all biased5 .
5
Cuthbertson and Nitzsche 2004 (op. cit.)
60
In the next section we will try to get rid of some of this limitations by combining regressions on total returns that are i.i.d.
3.3
An approach to solve the overlapping problem
In this section we attempt to solve the periods-overlapping problem and test the
relationship between average extra returns from a years investment and initial
P E10 levels. Every year, the extra return is set equal to:
er, +1 = r, +1 y
where r, +1 and y represent respectively the total real return of the S&P
Composite and the interest rate on U.S. t-bonds at time . Note that each yearly
er, +1 is independently and identically distributed. We call gross extra return
ER, +1 = er, +1 +1. The average extra return er
, + from year to year +,
will be equal to
1 + er
, + =
! 1
ER +k, +k+1
(3.4)
k=0
where represent different years. If we compute the linear logarithms on

each equation and we use their properties, this relation becomes
1X
ln(1 + er
, + ) =
ln(ER +k, +k+1 )
k=0
(3.5)
where the last equation represents the sum of all the logarithmic yearly gross
extra returns from the beginning of the investment in to the end in + .
Note that, for small values of yearly returns, ln(1 + er
, + ) is approximately
6
er
, + .
6
We hereby use the identity: ex =
xn
n=0 n! .
In particular:
, + )
eln(1+er
=
1
1
=1 + ln(1 + er
, + ) + ln(1 + er
, + )2 + ... + (1 + er
, + )n
2
n!
ln(1 + er
, + )
61
Having relations (3.5) in mind, we can take the ER, +1 independent yearly
observations and try to explain them through a linear regression model where
P E10, ratios are used as regressors. What we attempt to do, in other words, is
to answer the following question: if someone begins an investment in , how will
P E10, affect, on average, yearly extra returns from to + 1, from + 1 to
+ 2 and so on? Which is the average relation between P E10 ratios at a certain
period and yearly extra returns after k years? In particular, we use a vector of
regressors P E with all the yearly observations P E10, in a certain time period.
For simplicity, we will write P E10, as P E
P E0
P E1
..
.
PE =
P E
n1
P En
and one vector of dependent variables ERk for each forward period k from 0
to , consisting of all the observations of yearly extra returns from er, +1 .
ERk,k+1
ERk+1,k+2
..
.
ERk =
k
ER
k+n2;k+n1
ERk+n1;k+n
We then look for a linear correlation between ln(ERk ) and P E, performing
the following linear regression for every k-forward return:
ln(ERk ) = k + k (P E) +
(3.6)
Once we have estimated the various coefficients k and k, we can use them
to compute the linear logarithm of years of the average geometric extra
return 1 + er
, + from to + by using equation (3.5). Using the estimated
coefficients, we will have that:
Note that all the terms [ln(1 + er
, + )] with an exponent greater than 1 are approximately
zero. Hence:
1 + er
, + 1 + ln(1 + er
, + )
62
er
, + ln(1 + er
, + )
ln(1 + er
, + ) =
1X
1X
1X
ln(ER +k, +k+1 ) =
k +
k (P E)
k=0
k=0
k=0
Considering that P E is independent from k we get:
1X
1X
ln(1 + er
, + ) =
k + (P E)
k
k=0
k=0

P

P
We call 1 k=0 k and 1 k=0 k respectively and and get the
cumulative linear relation:
ln(1 + er
, + ) = + (P E)
(3.7)
If high P E ratios are representative of market over-valuation, then prices

should mean revert and k should be negative at least for initial values of k.
If k are negative on average, then , representing the correlation coefficient
between initial P E and the linear logarithm of the average yearly extra returns
for a subsequent -years investment, will be equally negative.
Table 3.3 shows the values of for = 20 years computed taking observations from the whole sample and from 20-years subsets.
What we see is that in each of the considered sub-periods, and for both
the time lengths, the negative correlation exists. In particular, in the whole
considered sample, the average yearly extra return on 20-years investments has
decreased 0.40% for each additional level of price earning when the investments
were initiated. This is consistent with the -0.39% coefficients computed with
the previous analysis.
10
10
20
12,18% -0,41% 11,89 -0.40%
(<0.1%)
(<0.1%)
(<0.1%)
1892-1945
8,00%
-0,20%
9,5%
(0,22%)
(13,92%)
(<0.1%)
1946-1991
18,2%
-0,74%
15,5%
p-values (<0.1%)
(<0.1%)
(<0.1%)
Period
1892-1991
20
(37,63%)
-0.25%
(2,54%)
-0.62%
(<0.1%)
Table 3.3: Estimates of the intercepts coefficient of the linear relation

between average yearly extra returns on a 10 years and a 20 years investment
and the initial P E10 ratio.
63

At this time, it is interesting to see how coefficient have historically changed
depending on a generic length of the considered investment. Figure 3.3 shows
the k estimates of the single regressions, where the dependent variables are
yearly k-forward average extra returns from the whole historical sample 18811981. Figure 3.9 shows how the of the cumulate regression, computed on the
same 1881-1971 samples, change as a function of . Note that each point on the
chart 3.11 is equal to the average of k for k going from 0 to .
We compute the standard error of the coefficient from the standard error
Figure 3.10: k estimates of the single regressions, where the dependent variables
are yearly k-forward average extra returns and initial P E10 ratios are used as
regressors, in function of k. Dotted lines are distant respectively one and two
standard errors from the estimates. Data on the whole 1881-1971 S&P Composite
sample.
Figure 3.11: coefficient estimates of the linear relation between -years average
yearly extra returns and initial P E10 ratios, as a function of the considered lenght
of the buy-and-hold investment. Dotted lines are distant respectively one and
two standard errors from the estimates. Data on the whole 1881-1981 S&P
Composite sample.
64
of the estimates of the various coefficients k . It can be demonstrated that, as

know that is equal to the average of k with k from 0 to , and that the latter
are independently and identically distributed, the following property applies:
1X
=
k
k=0
SE2
SE
1 X
= 2
SE2k
k=0
v
u
X
1u
= t
SE2k
k=0
Note that as the holding period increases, the standard error decreases
and our estimates become more precise. Even though the single k are not
significantly diverse from zero, the fact that their estimates are always smaller
than zero at least for 1 < k < 18 increases the probability that their average is
different from zero and increases, hence, the statistical significance of coefficient
.
Figure 3.11 shows dotted lines, representing beta plus and minus respectively
one and two standard errors. If + 2SE is still below zero, then we can reject
the hypothesis that beta is equal or higher than zero with more than 97,5%
probability.
The results of the analysis are coherent with our previous tests. On the whole
considered sample, the correlation between initial P E10 ratios and subsequent
k-forward yearly extra returns has been negative for any k between 1 and 18.
In other words, higher P E10 levels in year t has an average negative impact on
yearly return for each period from (t, t + 1) to (t + 18, t + 19). When this is
aggregated into figure 3.10, the cumulate impact of P E10 on -years investments
is significant and negative even for 25-years investments. The negative impact,
however, becomes lower in magnitude for longer holding periods, as returns are
smoothed in time.
It is interesting to note that 1 , differently from the others regression coefficients, is significantly higher than zero. This could be coherent with the presence of momentum abnormal profits in the short run: an inter-temporal version
of the cross-section anomalous momentum strategies, as presented by Jegadeesh
and Titman (1993).
We repeat the exercise with observations from two different historical periods:
before and after the end of WWII. Figure 3.12 shows that, despite structural
65
Figure 3.12: coefficient estimates of the linear relation between -years average
yearly extra returns and initial P E10 ratios, as a function of the considered lenght
of the buy-and-hold investment. Dotted lines are distant respectively one and
two standard errors from the estimates. Data the 1881-1945 and on the 19461991 periods from the S&P Composite data.
changes in the economy and in financial markets, the mean reversion tendency
of Price-Earnings has been persistent through history.
To conclude, we confirm the negative impact of initial P E10 ratios on extra
returns from investments with an holding period of 20 years and, in general,
between 2 and 25 years.
66
3.4
Where could the PE ratio go?
According to what we have seen, the a negative correlation between total real
returns and P/E10 ratios existed and persisted for the last 140 years. This
negative relation exists, with a lower magnitude, for extra returns as well. At this
time, anyway, it is important to understand if investors and regulators can use
this indicator as an early warning system for speculative bubbles formations or as
a signal of market excessive pessimism and under-valuation. In other words, if we
believe that risk premiums and expected growth rates of the economy should not
vary much from year to year in the economy in aggregate, we need to understand
at which range of P/E10 ratios the equity market is considerable correctly priced
in a certain historical period.
If we consider a single stock, such a reasoning would lack of sense: an equilibrium PE ratio of a single company shares can vary considerably from year to year
in function of specific changes in its performance, risk level and expected growth
rate. If we consider the equity market in aggregate, however, it is reasonable
to expect much lower changes in the equilibrium level of the price earning ratio
over time.
We have seen that the historical total yearly real return on equity has been
of 6,46%, and that the historical average a P E10 ratio of about 16,40. Even in
aggregate, anyway, this ratio depends upon the variables that we have seen in the
Gordon model. Even if the risk aversion of operators, interest rates and expected
growth of the economy remain stable, anyway, several changes of structural factors in the economy could justify PE ratios which are higher or lower than the
historical average.
Factors include:
lower taxes on capital gains and dividends;
lower inflation;
progressive increases in the deferral benefit due to corporations decreasing
their dividend payout;
higher expected growth of dividends due to the lower dividend payout;
lower transaction costs.
In this section we quickly analyse these variables in order to understand which
could be the equilibrium level as on April 2012, with its important implications
for both regulators and investors.
67
Taxes and inflation

Capital gains taxes are usually paid on the difference between the price of an
asset when it is purchased and its price when it is sold. This nominally based tax
system makes inflation relevant when considering how much to invest on stocks.
Suppose that a share, which is paying no dividends, is bought at a nominal price
of 100 in t and sold at nominal 110 in t + 1 and suppose that inflation from t to
t + 1 is 10%. Even if no real capital gains where made, the investor will have to
pay taxes on the 10 nominal capital gain, ending up with a negative real return
due to this fiscal payment. A combination of high tax rates on capital gains and
high inflation, thus, has a negative effect of investors return who, in order to be
compensated for this inflation tax, will require an higher cost of capital. If an
investor buys the S&P Composite at time t and sells it after an year, the total
after tax return rt will be equal to:
rt

=
Dt
Pt1

(1 d ) +
Pt Pt1
Pt1

(1 cg ).
Where d and cg are respectively investors tax rates on dividends and capital
gains. Under market efficiency, we should have that:
kt

=
Dte
Pt1

(1 d ) +
Pte Pt1
Pt1

(1 cg ).
(3.8)
It is reasonable to assume that investors, when they evaluate an investment,

are interested in their net-after tax return kt and not much in their pre-tax return
k. If individual preferences stay stable, kt should be constant and, hence, higher
tax rates can highly influence investors required after-tax total real return. In
any equilibrium model of asset pricing more favourable tax factors for equities
suggest that stocks should be priced at a higher multiple of earnings7 .
In chapter 2 we said that, under market efficiency, the dividend payout policy
should not have impacts a firm valuation. When taxes are considered, however,
this situation might change. Firstly, dividend tax rates have historically been
higher than capital gain tax rates. All other factors being equal, then, there is
bias for firms to deliver capital gains as opposed to dividend income. Secondly,
this bias is made higher due to the presence of what Siegel calls deferall benefit
of capital gains. Even when taxes on capital gains and on dividends are equal, in
fact, effective taxes on capital gains are still lower than on dividends since taxes
on capital gains are paid only when the asset is sold, while taxes on dividends are
7
68
paid at every dividend payout. Thus, returns from capital gains are capitalized at
the higher before-tax rate while re-invested dividends accumulates at the aftertax rate of return.
Figure 3.13: Average Dividend Payout ratio of S&P Composite firms from January 1871 to March 2012. Shillers Data.
According to Siegel, the reduction in taxes on equity return due to the reduction in marginal and capital gains tax rates8 and inflation have added more
than 2 percentage points to the return over the last half century. In other words,
if k has remained the same, we expect k to decrease by approximately 2 points.
In chapter 1 we have seen how the highest part of total real returns volatility
is due to volatility of capital gains, which are highly related to operators expectations and are more influenced by potential irrational exuberance. It could
be argued that, as a consequence of decreasing dividend payout ratios, the most
volatile part of returns will account for an increasing part of total returns, increasing then their volatility. Paradoxically, this higher volatility would generate
an higher risk premium which could compensate, at least in part, the positive
effects of a lowering dividend payout on the Price Earnings ratio.
Transaction costs
Whenever an investor buys or sells a stock, he has to find a counterpart in the
trade and has, usually, to pay fees for the intermediation service offered by the
stock exchange or another financial institution. Trading costs include both the
fees paid to brokers and the bid-ask spread paid to market makers for their service
of providing liquidity. The higher these costs, the higher will be the required
8
In the U.S., the Jobs and Growth Reconciliation Act of 2003 reduced the highest tax rate
on qualified dividends and capital gain to 15 percent, a much lower value than the historical
average.
69
cost of capital by operators to invest in stocks. Jones (2002) reported that the
deregulation of brokerage fees in the U.S. made the average cost to either buy
or sell a stock drop from over 1 percent of value traded in 1975 to less than 0.18
percent today. Together with the creation of ETFs that allow passive replication
of stocks indexes with at an extremely low cost, this has helped investors to
create more diversified portfolios and should have lowered their required cost of
capital k. All things being equal, hence, we expect the market as a whole to
trade at higher Price-Earnings multiples as trading costs continue to decrease.
Higher retained earnings and growth rate in dividend
From equation (3.1) we have seen how Price Earning Ratios of the S&P Composite should be also function of the dividend payout ratio of the market in
aggregate.
(prt )(1 + g e )
Pt
=
.
Et
k ge
Note that, if the expected growth rate of dividends and the cost of capital
stays stable, then the Price-Earning ratio is a positive function of the dividend
payout ratio.
Firms, anyway, grow because they make investments. Investments are financed through three possible channels: new debt issuing, new equity issuing or
retained earnings. If a firm, or the market in aggregate, does not increase its
financial leverage, then the expected growth rate in its earnings will be a negative
function of the dividend payout ratio. In particular, the sustainable growth rate
will be equal to :
g e = (1 prt )ROE
Where the ROE represents the return on equity achieved from the company
or the market. If market are efficient, however, the ROE and the required cost of
capital k should be equal. If this was not the case and if, for example, firms had a
ROE greater than their cost of capital, then if would be convenient for them not
to pay dividends and to issue more equity, in order to invest the obtained funds
in more profitable projects. If more investments are made, then it is reasonable
to expect that their marginal return will get lower and lower. In equilibrium,
this should ultimately bring the ROE level of the market to the level of the cost
of equity k. Hence:
g e = (1 prt )k
70
If we substitute this into equation (3.1) we get:
Pt
(prt )[1 + (1 prt )k]
=
=
Et
k (1 prt )k
(prt )[1 + (1 prt )k]
1 + (1 prt )k
1
=
=
= + (1 prt )
k(prt )
k
k
(3.9)
(3.10)
Stable decreases in the dividend payout ratio, hence, if leverage stays constant
should ultimately increase growth rates and increase, hence, the equilibrium
Price-earnings level.
From what we have seen, we expect the cumulative effect on equilibrium PriceEarnings of lower taxes on capital gains and dividends, lower inflation, higher
expected growth due to the lower dividend payout and lower transaction costs,
to be positive. The analysed factors, infact, contribute both to decrease the
required cost of capital and to increase the expected growth rate in dividends.
A deeper analysis and further work would be necessary in order to estimate the
exact final impact on Price-Earnings and on P E10 ratios. However, in its Stocks
for the long run, anyway, Siegel concludes that:
If inflation stays low, the tax policy remains favourable for equities, and the business cycle remains muted, one can justify priceearnings rations in the low 20s for the equity market - Siegel (2008).
This value of 20 is about 4 points more than the historical average of P E10
ratios of 16.6. The ultimate implication for investors and regulators, hence,
could be to be skeptical about the sustainability of market prices whenever P E10
get significantly distant from these values. 10 years and 20 years investments
initiated when P E10 were above 25, for example, have historically been associated
respectively with negative and around-zero extra returns. Moreover, whenever
the P E10 did exceed this value (in the late 20s, in the late 90s and in 2007),
the S&P Composite total return index has always experienced a subsequent fall
of more than 50% of its value. Despite the small sample bias that affects our
analysis, such an evidence is difficult to ignore.
71
Chapter
EMH and Behavioural Finance

According to Lewellen (2004), the evidence of subsequent returns being higher
when initial value indicators, such as the P E10 , are lower, can be interpreted
either in the mispricing view or in the rational-pricing view. According to the
mispricing view, the ratios are low when stocks are overpriced and, hence, they
predict low future returns as prices return to fundamentals. The rational-pricing
story says, instead, that the ratios track time-variation in discount rates: the
Price-Earnings, Price-Book Value and Price-Dividends ratios are low when discount rates are high and high when discount rates are low. After taking interest
rates fluctuation over time, the rational-pricing story tells us that these ratios
predict returns because they capture information about the risk premium. If we
accept this rational explanation, the inverse relation between Price-Earnings and
subsequent returns can be seen as natural and explained with the Gordon Model:
basically, if we think that expected growth rate will remain constant, EMH can
hold by simply believing that required returns k mechanically get lower as P E10
ratios get higher.
The efficient markets hypothesis asserts that all financial prices accurately
reflect all available information at any time. Prices may appear to be too high or
too low at times but, according to the efficient markets theory, this appearance
must be an illusion1 .
Many economists, psychologists and historians who have analysed the behaviour of financial markets over time, on the other hand, challenge the assumption of rationality that underlies much of efficient market theory. The formation
of speculative bubbles in financial markets, with millions of investors buying
into fads or get-rich-quick schemes, the crashes with these bubbles have ended
and violent collapses in stock prices such as the one in October 1987 suggest
that either in the short or in the long run, there is much about markets that
1
Shiller 2009 (op. cit.)
72
4. EMH and Behavioural Finance
we cannot explain with a rational investor model. The belief that psychological
effects should be taken into account to explain financial markets gave birth to
the behavioural finance school. Behavioural finance seeks to explain anomalies
in tests of market efficiency, such as the systematic mean reversion of the P E10
ratio over time, either by some kind of irrational behaviour or because rational
and fully informed investors are inhibited in some way from arbitraging away the
mis-pricing caused by irrational investors2 .
In this chapter, we present theories that go in favour of the presence of irrational behaviours and market inefficiencies.
4.1
Cross-section abnormal Returns on single

value stocks
Anomalies regarding market efficiency, such as the one analysed in chapter 3, are
not new in finance literature. Research in financial economics has identified a
number of cases in which particular investment strategies earned higher returns
than those justified by their systematic risk.
One such anomaly is that value stocks have historically earned higher returns
than glamour stocks. Value strategies, in particular, might produce higher returns because they are contrarian to strategies followed by noisy traders, such as
extrapolating past earnings and prices growth too far into the future, overreacting to good or bad news, or simply equating a good investment with a well-run
company irrespective of price. A value stock can be defined as a stock that has
had a low growth in the past and is expected by the market to continue growing
slowly.
The Price-Earning Ratio has been used as a mispricing indicator not only
with the market in aggregate, but also on a cross-sectional analysis of stock
returns.
In a study of 1400 firms over the period 1956-71, Basu (1977) observed low
PE securities outperforming their high PE stocks counterparts by more than
seven percent per year. Basu considered his results as indicative of a market
inefficiency:
Securities trading at different multiples of earnings, on average, seem to have been inappropriately priced vis-a-vis one another,
and opportunities for earning abnormal returns were afforded to investors. Basu (1977).
2
We will refer to this investors as Noisy traders.
73
Fundamental analysis tests on value-glamour stocks have been performed also

with Price to Book ratios, Price to Cash Flows ratio and Growth in sales rates.
For example, Fama and French (1992) show that market capitalisation and
price-book value ratio, closely related to Basus earnings variable, capture much
of the cross-sectional variation in stock returns over the period 1963-1990.
This is coherent with Lakonishok, Shleifer and Vishny (1994), who find that
the decile of stocks with the lowest Price-Book value in did overperform, on average, the decile of stocks with the highest Price-Book value by approximately 7%
a year for the 5 subsequent years. This high influence of book-to-market equity
may be the consequence of irrational behaviours: the glamour-value evidence on
single stocks is consistent with some investors extrapolating past earnings growth
of companies and failing to recognize that extreme earnings growth is likely to
revert to the mean in the medium-long run3 .
Lakonishok, Shleifer and Vishny also tested the relationship between PriceCash Flows ratios and subsequent 5 years returns, finding that stocks with the
lowest Price-Cash Flows multiples offered a return 8.7% a year greater than
glamour stocks.
One could argue that superior returns could be explained by a fundamentally
greater risk of value stocks compared to glamour stocks. Lakonishok, Shleifer and
Vishny, however, tested both betas and standard deviations of the two different
categories and find very little, if any, support for the view that value strategies
are riskier. Unless some other hidden source of risk is related to this ratios, thus,
a riskless arbitrage could have been made by simply short-selling glamour stocks
and buying value stocks.
However, as the joint hypothesis problem continues to hold, testing market
efficiency is intrinsically impossible, as we no unambiguous measure of risk pricing
is available.
4.2
Speculative Bubbles
Since the Tulipomania 4 in the first half of 1600 or the South Sea Company Bubble
in early 1700, the idea that self-fulfilling bubbles in asset prices exist has been
deeply discussed among both casual investors and professionals.
A way to explain the dynamics of bubble formation from a behavioural perspective5 is to consider the presence in the market of some noise traders, who
3
Dimson and Mussavian 2000 (op. cit)

The price of tulip bulbs in Netherlands rocketed between November 1636 and January
1637 only to suddenly collapse in February 1637 and, by 1639, the price had fallen to around
1/200th of 1% of its peak value. - Cuthbertson and Nitzsche (op. cit.)
5
People are rational in standard finance; they are normal in behavioural finance. Rational
4
74

can be subject in aggregate to some kind of Irrational Exuberance 6 . According
to Shiller (2009):
Irrational exuberance is the psychological basis of a speculative
bubble. A speculative bubble is a situation in which news of price
increase spurs investor enthusiasm, which spreads by psychological
contagion from person to person, in the process amplifying stories
that might justify the price increases and bringing in a larger class of
investors who, despite doubts about the real value of an investment,
are drawn to it partly through envy of others successes and partly
through a gamblers excitement.
To explain the potential formation of a bubble, assume that the market contains positive feedback noisy trader, whose demand for equities gets higher after
a price rise. If rational investors do not short sell the market quickly enough7
this higher demand will cause additional price rise and attract additional noisy
traders, which will bring prices more and more distant from their fundamental
value.
Such a price-to-price feedback could persist even in the case in which operators with short-term horizons do recognise that the market is highly overvalued.
This is the rational bubbles theory. The idea at the base of the rational bubbles
formation is that investors can be willing to pay a price above the fundamental
value because they believe that someone else will pay an even greater price in
the future. Suppose that at time t the price of the S&P Composite is equal to
the NPV of future discounts plus a bubble component:
Pt =
X
Dt+i
+ Bt
i
(1
+
k)
i=1
As there is no upper limit to stock prices principle, as long as the bubble

component of the current price is expected to grow at a rate equal to the required
cost of capital, the arbitrage principle holds as:
people care about utilitarian characteristics but not value-expressive ones, are never confused
by cognitive errors, have perfect self-control, are always averse to risk, and are never averse to
regret. Normal people do not obediently follow that pattern. Frankfurter, McGoun 2002 (op.
cit.)
6
The phrase was firstly used by the then-Federal Reserve Board Chairman Greenspan in a
speech given in 1996, during the dot com bubble.
7
We will see at the end on the chapter why this could be the case.
75
"
Pt+1 + Dt+1
X
Dt+i+1
=
+ Dt+1 + (1 + k)Bt = Pt (1 + k)
i
(1
+
k)
i=1
(4.1)
(4.2)
Such a mechanism can go on for months or years. However, if this is the case,
after a number o years the actual price of stocks will be made almost completely
made by the bubble component Bt . Thats because fundamental price will grow
at a rate cg which is lower than k, as every years part of the return is distributed
in form of dividends. In a way which is very similar to Ponzi-schemes, this game
of course cannot be sustainable for long periods.
Cuthbertson and Nitzsche (2004) argue that, in the real world, the increasing
weight of the bubble component will convince investors, sooner or later, to sell
their stocks, ending thus the feedback effect that was keeping the bubble alive.
When rational traders, thus, recognise this mispricing, they short sell the overvalued stock, the price quickly moves back towards its fundamental value. The
price-to-price feedback could be interrupted even without the action of rational
traders, if particularly severe news suddenly strikes markets.
If price-to-price feedback occurs, prices are therefore mean reverting. As
positive feedback traders massively purchase stocks, over short horizons returns
are positively serially correlated. Over long horizons, on the other hand, returns
are negatively serially correlated as the rational traders move prices back to their
fundamental value or speculative bubbles suddenly collapse. Such a vision could
be coherent with the analysed price patterns and with the sudden price drops
that the S&P composite has experienced over the last century.
New Era Economic Thinking
Speculative market expansions have often been associated with a general sense
of optimism about future stability or growth, due to some particular political
and economical stability or some technological innovation.
Consider for example the arrival of the internet in the mid 1990. The diffusion
of the web was interpreted by many investors as a fundamental change that would
radically change productivity of the economy. Despite the undeniable impact of
the Internet on the Economy, in order to understand the magnitude of this impact
and its rational effect on financial markets we have to compare it with similar
revolutions of the past, such as the arrival of rail roads, telegraph, telephones,
or cars. Is it sensible to think that the Internet is much more important to
the growth of our economy today than other revolutions were to the growth
76

of economies of the past8 ? Recent reports from Boston Consulting Group and
McKinsey claim that 10% of the GDP growth rate between 1995 and 2009 in
mature countries was due to the internet revolution and that this number rises to
21% in the period 2005-20099 . It is difficult to understand whether this measures
fully take into account the substitution effect of the internet or not. Even in the
very optimistic case in which the internet had really increased growth rates by
21% and in which this additional effect will last forever, this difference should
under no circumstances justify the explosive boom on the late 90s. If we use
the Gordon model and set a 6.5% cost of capital and a pre-internet steady-state
growth rate of real dividends of 1.5%, a rise in the latter from 1.5% to 1.815%
should justify only a 7% rise is real stock prices. This is interesting, since the
S&P 500 prices rose by more than 300% in real terms from 1995 to the end of
1999.
The dot come bubble, thus, could be partly seen as a consequence of this new
era economics thinking. According to Shiller:
Admittedly, there are too many times, such as the technology
bubble at the end of the last century, when speculators used new
era economics to justify unreasonably high prices... Whenever the
market reaches a new high, moreover, public speakers, writers, and
other prominent people suddenly appear, armed with explanations for
the apparent optimism seen in the market - Shiller (2009)
Significant price-rallies in equity markets and behavioural explanations are
certainly not new in economic history. Galbraith (1955) was already explaining
the 300% boom in stock prices from 1925 to 1929 in terms of madness, massive entrance of casual investors in the stock markets, excessive use of leverage,
misperception of risk and excessive diffusion of investment trusts.
Market booms are certainly not U.S. specific only. Between May 1985 and
May 1986 the italian stock market rose by 166% in real terms. Shiller (2009)
argues that, even though many investors did justify the higher prices because
economic growth was solid, that inflation remained low, and that the government
of Prime Minister Craxi was stable, none of this was really news. An analyst
interviewed by Repubblica on May 25, 1986, reported that
8
The general public is not usually thinking of these past historical episodes for the purpose
of comparison. Shiller 2009 (op. cit)
9
As the internet has an impact on a wide range of sectors, it is very difficult to quantify
exactly the impact of this technology. BCG and McKinsey tried to perform such an estimate
by using both the GDP Expenditure approach and cross section regressions where an internet
maturity index is taken as explaining variable for GDP growth. The considered mature countries were Sweden, Germany, UK, France, U.S., South Korea, Canada, Italy and Japan. See
Internet Matters (2011) and Fattore Internet (2011)
77
There are no explanations... Everyone has gone crazy and thats

it. This is a collective madness; total. It is useless to try to understand, to stop or quit - La Repubblica (1986)
By Semptember 1992, the Italian market has lost 68% in real terms.
According to Shiller, hence, the tendency of people to think of their own
era as very different from other periods has been recurrent over history. This
can well make investors justify unreasonable prices during market booms, even
when there is no concrete evidence of variations of fundamental variables such
as earnings and dividends.
Herd behaviour
Behavioural finance states that the classical economics assumption in which operators make their choices independently is basically false. The only existence of
noisy traders who follow irrational rules of thumb, infact, would not sufficient to
move markets in aggregate. If noisy traders acted as if they were independent
of each other, any singular irrational behaviour would tend to average out without any substantial effect on prices. People who communicate regularly with
one another, however, tend to think similarly. Irrational thinking, according
to behavioural finance, can hence spread by word of mouth over an impressively
large number of people, fuelling financial markets booms and causing subsequent
busts.
Herding instinct in stock markets is the tendency of individuals to adapt their
thinking to the prevailing opinion, regardless of what their actual fundamental
analysis would tell them.10
The internet ant technology bubble is a perfect example of social
pressures influencing stock prices. The conversations around the office, the newspaper headlines and the analysts predictions: they all
fed the craze to invest in these stocks. - Siegel (2008).
This combination of entrance of new investors in the market and of massive
attention of the society as a whole on the stock market can well produce a selfreinforcing feedback in which, like in epidemics models, more and more operators
start demanding for stocks. As Shiller argues in his book irrational exuberance,
10
In its book Memoir of Extraordinary Popular Delusions and the Madness of Crowd, Charles
Mackay was already claiming in 1841 that We find that whole communities suffenly fix their
minds upon one subject, and go mad in its pursuit... Sober nations have all at once become
desperate gamblers and risked most of their existence upon the turn of a piece of paper... Men,
it has been well said, think in herds... They go mad in herds, while they only recover their
senses slowly and one by one.
78
the power of social pressure on individual judgement can be such that even
cautious operators can be led to follow the mass in the belief that its sentiment
is a reliable indicator of what will happen in the future.
4.2.1
Overconfidence, Overreaction and trend extrapulation
According to behavioural finance, individuals seem to attach too much weight to

recent data and recent experience when they form their expectations. During
stock market booms, for example, investors frequently find themselves making
relevant capital gains for a certain time period. This high performance often
leads them to become overconfident in their forecasting ability and makes them
willing to take on excessive risk.
When agents do not know the true data-generating process, they often believe that small samples, such as the price time series of the last few months,
reflect the whole population and the long-lasting trend. When prices are soaring,
for example, individuals often increase, erroneously, their subjective probability
that prices will keep increasing, in contrast with what EMH and its underlying
martingale price-generating processes suggest. According to Shiller (2009) and to
Kahneman an Tversky, people tend to make judgements in uncertain situations
by looking for familiar patterns and assuming that future patterns will resemble
past ones, often without considering why the pattern did occur in the past and
how probable it is that it will repeat itself in the future. In the stock market,
this is called trend extrapolation, and it can support the existence of speculative
bubbles and explain why higher capital gains tend to mean revert, as soon as
operators understand that the trend will not last, in the medium run.
Trend extrapolation is also related to the tendency of operators to over-react
to information. De Bont and Thaler (1985), showed that over 3 to 5 years holding
periods stocks that performed poorly over the previous 3 to 5 years achieve higher
returns than stocks that performed well over the same period. What they argue is
that investors are subject to waves of optimism and pessimism that cause prices
to deviate systematically from their fundamental values and later to exhibit
mean reversion and that this is consistent with the behavioral decision theory of
Kahneman and Tversky, where investors are systematically overconfident in their
ability to forecast either future stock prices or future corporate earnings. This
effect could also be a consequence of a considerable part of investors focusing
more on relative strength trading rules than fundamental analysis11 . . .
11
A majority of the mutual funds examined by Grinblatt and Titman in 1991 show a tendency
to buy stocks that have increased in price over the previous quarter. Jegadeesh and titman
1993, op.cit.
79

Even though the interpretation of these results are still being debated12 , these
findings seem to be consistent with the relations analysed in chapter 3 and seem
to support the hypotheses in which operators to over-react and that, hence,
contrarian strategies can be profitable in the medium to long run.
4.3
Shillers Variance Test
Tests reported in chapter 3 suggests that the P E10 has been useful in the past in
identifying bubble formations situations where prices were getting distant from
corporations fundamentals. This piece of evidence is, intuitively, in favour of
the idea that, at least in some periods, investors in aggregate tend to become
either euphoric or excessively pessimistic, tend to overreact to events, extrapolate
trends and under estimate mean reversion of returns.
Overreaction would be consistent with the common claim about stock price
indexes excessive volatility. Shiller (1981) argues, for example, that movements in
stock price indexes seem to be too big relative to actual subsequent events. Under
EMH, we have seen that real stock prices equal the present value of rationally
expected future real dividends and that, consequently, price movements should be
only attributed to new information about future dividends. Is this what really
happens in the stock market? In other words, the question is whether stock
price volatility systematically exceeds that justified by fundamental information
on dividends or not.
In order to answer this question, we replicate an ex-post exercise proposed by
Shiller and apply it to a time series which includes the most recent available data.
Our aim is to estimate the difference between how the S&P Composite prices
have historically moved and how they should have moved if investors had been
perfectly aware of future dividends level. We will show that, with an ex-post
view, real dividends did not vary far enough to explain price volatility.
Methodology to compute NPVs
According to EMH, the price of a share at the beginning of the time period t,
when future dividend values are still unknown, should be equal to what weve
previously seen in equation 2.3:
12
Some have argued that the De Bondt and Thaler results can be explained by the systematic
risk of their contrarian portfolios and the size effect. In addition, since the long-term losers
outperform the long term winners only in Januaries, it is unclear whether their results can be
attributed to overreaction. - Jegadeesh and Titman (1993), op.cit.
80
Pt =
Die
j=t+1 (1 + kj )
(4.3)
Qi
i=t+1
Where Die are the expectations of Dividends at time i and kj the cost of
capital in j. A perfect foresight price, on the other hand, should be equal to:
Pt
Di
= Pt + t
j=t+1 (1 + kj )
Qi
i=t+1
Where Di are the dividends which are effectively paid in i and t represents
the estimate error of the Net Present Value of future dividends by operators in
t. Formally, the expected value of this error should be zero, errors should not be
autocorrelated [E(j j ) = 0 i 6= j] and errors should not be correlated with price
observations [E(t Pt ) = 0]. If this last condition holds, according to equation
(4.4), the variance of the perfect forecast prices should be equal to the sum of
the variance of the estimate errors and the variance of observed prices. Thus:
P2 t = P2 t + 2t
As the variance of errors cannot be negative, Shiller concludes that if P2 t is
not higher than P2 t , then it means that the observed price volatility is excessive.
Ex post, we can compute the perfect forecast price Pt with an approximation
of the infinite horizon discounting model and use the observed values of Di . Taken
a year t and all the subsequent real dividends paid from t+1 to 2011, we calculate
the sum of their actualized values in t and add this to the current real price of
the S&P Composite. We compute this for every t from 1871 to 2011, on an
yearly base.
Pt =
2011
X
Di
Qi
j=t+1 (1 + kj )
i=t+1
P2011
+ Q2011
j=t+1 (1 + kj )
t (1871, 2011)
(4.4)
We need to use a terminal value because, of course, we do not know now what
dividends will be after the latest year for which data are available. Note that the
weight of the terminal value gets higher as we get nearer to the last observations
in the time series. We choose to use the current price as terminal value in order
not to make arbitrary assumptions on future growth rates of dividends and future
cost of capital. If we move in the past, note that P2011 is greatly discounted of
81

the obtained results for Pt get more independent from the chosen terminal value.
We repeat the variance-test two times using different sets of discount rates kt
in order to compute and plot the two perfect forecast prices P k and P ki . In
particular we use:
1. a constant discount rate, equal to the historical geometric average of total
annual returns on the S&P from 1871 to 2011:
2. different discount rates for each year, computed by adding a costant risk
premium to variable 10-years rates on U.S. t-bonds.
In case (1) Pk , represented by the large dotted line in figure 4.1, is computed
on constant discount rates, calculated as follows:
kt = r =
2012
Y
1
! 141
(1 + ri )
1 6, 5%
t (1871, 2011)
i=1871
Where ri represents the total real return achieved from year i 1 to year i on
the S&P Composite and r represents their geometric average from 1871 to 2011.
In case (2), we allow real discount rates to vary through time. Note that if
we dont make any assumption regarding varying kt , it will be always possible to
find a discount rate series which makes equation 4.3 hold identically. What we
can test, anyway, is whether the movements in the real discount rate that would
be required are different from what we might have expected through the pricing
model introduced with equation (2.7).
In Pk , represented by the small-dots line, we discount dividends with different
rates every year, in order to consider the variations that have occurred in the
yearly real risk free rate. We use the model introduced in chapter 2, with the
cost of capital from time i 1 to time i equal to
ki = rfi +
(4.5)
where is assumed constant in time and rfi is the real return on 10 years
u.s. treasury bonds, considered a risk free asset. is computed, using the same
model, as the difference between the historical geometric average of total real
returns of the S&P Composite and the historical geometric average of (1 + yi ):
82
Figure 4.1: Real S&P Composite Stock Price Index, 1881-2012, and NPV of
subsequent real dividends calculated by a costant discount rate equal to the
historical geometric average of cost of capital and by discount rates varying
in function of 10-years t-bonds rates. A logarithmic y-axis is used. Personal
calculation using Shillers data and methodology.
2012
Y
1
! 141
(1 + ki )
i=1871
2012
Y
1
! 141
(1 + yi )
6, 5% 2, 5% = 4%
i=1871
We use to compute all the yearly cost of capitals kt according to and equation 4.5, and then use the time-varying ki in equation (4.4) to get P (t, ki ) from
1871 to 2011 :
Figure 4.1 shows that the Real Prices of the S&P Composite have been fluctuating, over the last 140 years, much more than the perfect forecast ex-post prices
computed using both methodology (1) and (2). As Shiller notes in Irrational
Exuberance:
No definitive conclusions can be drawn about efficient markets
just by looking at this figure. Nonetheless the figure is quite informative about the lack of big-picture evidence for efficient markets in
aggregate U.S. stock market data - Shiller (2009).
In particular, Shiller (1982) noted that volatility from 1871 to 1981 appear
to be five to thirteen times too high to be attributed to new information about
future dividends, if uncertainty about future dividends is measured by the sample
standard deviations of real dividends return. The considered results support our
hypothesis on over-reaction of operators and on their tendency to be cyclically
83
subject to periods of excessive optimism or pessimism that can ultimately lead

to bubbles formation.
4.3.1
Reconciling excessive volatility with EMH
Several critiques have been addressed to the above methodology, especially regarding the fact that, as variances of prices are not stationary, a comparison of
variances loses parts of its sense.
One of the difficulties of interpreting the variance bounds tests is due to the
assumption that excess price volatility implies market inefficiency. One way to
reconcile the notion of efficient markets with the considered evidence would be to
say that the sample standard deviation of past dividends return understates the
true uncertainty about future dividends in past periods t. The market, in fact,
could have rightfully considered the eventuality of much larger movements than
the ones which actually materialized. The fact that such important events did not
actually materialize does not exclude the fact that they could have happened with
a given probability. This assertion is related to the survivorship bias problem.
The fact that the US market survived 1929, or the UK survived 1974, may well
imply excessive price volatility, on an ex post basis, over the sample period. But
In some periods, as during the great 1929-32 recession, operators could have even
considered the eventuality in which the stock market would have disappeared.
Goetzmann and Jorion (1999), for instance, reconstruct returns for equity
markets in 39 countries over the 1900-2000 century, including in their analysis not
only those markets that survived, but also those markets which experienced both
temporary and permanent interruptions. What they argue is that Long-term
estimates of expected returns derived from U.S. data are subject to a survivorship
bias as many others markets have historically failed to survive or have been
interrupted after a political turmoil, a war or hyperinflation. For these markets,
dividend volatility may have been infinite, and the (pre-failure) variance of stock
prices was therefore too low to be justified by subsequent dividend behaviour.
Assuming there was some probability of disruption and black swans for the U.S.
Market as well, the S&P Composite ex-post volatility computed on historical
data, hence, could be reflective real ex-ante rational estimate of future volatility.
Goetzmann and Jorion, moreover, argue that this survivorship bias could also
explain part of the Market Premium Puzzle, as returns as High as in the U.S. are
rather the exception than the rule: according to their research, infact, capital
gains in the U.S. market have been 3.5% higher than the international median13 .
13
Goetzmann and Jorion analysed the dividend component as well, concluding that U.S.
dividends yields have been comparable to international yields.
84
Anyway, this high volatility has been present not only in periods when a
market failure was highly probable, but almost in the whole century. We wonder,
thus, how catastrophic or grandiose expected events could have been in the U.S.
to justify price fluctuations which are much higher that the perfect-foresight
NPVs fluctuations.
Another efficient markets approach to explain anomalies is to use the joint
hypothesis problem and claim that, as higher returns must be due to higher
systematic risk, model of asset pricing that made the evidence look anomalous
could simply fail to capture all the dimensions of risk. EMH supporters say,
thus, that it must always be possible to explain anomalies by finding a covariance
between returns and some other fundamental risk factor. Higher P/E ratios, for
example, could simply be reflective of higher risk, where risk is to be measured a
way which is not considered by the used model. Considering that the historical
evidence does not show any relation between P/E10 ratios in year t and the
standard deviation of returns of the S&P Composite in the 5 subsequent years,
anyway, we wonder what kind of higher risk should be present in the market in
aggregate when P/E10 ratios are higher.
4.3.2
How can mispricing persist?
In chapter 2 we introduced the EMH and stated that its basic assumption is
that, whenever anomalies exists in a certain market, rational investors will have
incentives to profit through arbitrage, bringing prices back to their fundamental
value. EMH, hence, does not require that every investor in the market is both
rational and informed, but only that rational and informed investors will be able
to make efficiency hold. If high P E10 ratios imply lower subsequent returns,
rational investors should decrease their exposure in the stock market in high-PE
periods and do the opposite when multiples are trading at lower values. This
should ultimately eliminate the effect.
If all the anomalous phenomenons analysed by behavioural finance exist,
therefore, we wonder why such arbitrage opportunities managed to persist in the
long term. Various theories have been formulated to explain the persistence of
mispricing and the existence of frictions that prevent operators from exploiting
arbitrage opportunities:
(1) Limits to Arbitrage
Lets suppose that a professional investor believes, through his NPV analysis,
that a single stock in the Telecom sector is highly overpriced and that its does
not reflect its fundamental value. In order to take advantage of this arbitrage
85
opportunity and to make an economic profit without risk and without investing
capitals, the rational trader should short-sell that stock while simultaneously
hedging his exposure by buying a correctly priced security with an identical
risk profile. In such a way, if the covariance of returns of the two securities is
one, whatever happens to the Telecom industry and to the single securities, the
investor will make a profit with probability one as soon as the mis-pricing is
corrected14 .
In the real world, unlike in textbook models, arbitrage might anyway be
quite risky and require capital. First of all, Pension funds and several mutual
funds are not allowed to take short positions on assets. Even when professional
investors, such as Hedge funds, can freely short sell securities, they need to find
counterparts willing to lend them a sufficient amount of shares of security to
short sell, for as long as it takes the mis-pricing to mean-revert.
Even when such limitations do not exist, another relevant issue emerges: is it
possible to find a security where the returns are perfectly correlated to the stock
we want to short-sell? The ideal risk-free arbitrage would involve taking long and
short positions on the same security on two different markets one efficient and
one inefficient. If a perfect substitute security does not exist, however, the only
thing an investor can do is in the considered example to buy a stock from the
Telecom industry which has comparable level of systematic risk. This strategy
will hedge systematic risk, so that movements of returns in the whole industry
will not affect the strategy. However, this arbitrage will not be risk-free, as the
investor will be exposed to specific risk on both the stocks.
This lack of a perfect substitute asset becomes even greater when we deal
with indexes in aggregate, such as the S&P Composite. If we believe that the
market is overvalued and want to short-sell it, how can we find an hedging assets
with an identical risk profile? If we move from an index on the S&P Composite
to a global index, such a substitute simply cannot exist. Even when abnormal
profit opportunities on the market in aggregate exist, thus, making profits on
this mispricing will involve taking risk.
(2) Short-termism of the smart money
. Even when a perfect substitute asset exists and there are no limits on short
selling, professional investors may choose not to exploit arbitrage opportunities.
An example should clarify this claim. Suppose that, unrealistically, the S&P
14
Whenever the fundamental value of the stock decreases, for example, the investor will
simultaneously make a capital loss on the long-investment and a capital gain on the shortinvestments. If returns are perfectly correlated, the two effects will eventually compensate
each other.
86
Composite index is traded on two different markets. In the first, prices fully
reflect informations and are equal to fundamental values at any time. In the
second, prices are subject to noisy traders irrational exuberance, bubbles tend
to form from time to time and, at this time, prices are well over their fundamental
value due to an excessive optimism of investors. Suppose that it is possible to
invest or short-sell in both the markets, but that it is not possible to buy the
index in market 1 and resell it in market 2.
A professional investor could profit from the mispricing by taking a short
position on the S&P Composite of the inefficient market, a long position on the
correctly-priced index and waiting for the price to adjust. But how does a professional investor know how much it will take for the market to mean-revert?
Shleifer (2000) argues that the push to higher prices by noisy traders could be
so strong and persistent that the bubble could keep growing for a long time and
that the analysed strategy would make the investor lose money on its short position for a considerably long period. If the rational traders has long horizons
and knows that prices will eventually converge to fundamental value, then they
will not worry about this noisy traders risk as they know that their short-term
losses will eventually be rid out by the burst of the bubble. Professional investors,
however, generally manage other peoples money so, in case of prolonged weak
performances, could risk to either lose their job or their clients. Shleifer and
Vishny (1997) claim that this short-termism brings to a separation of brain and
capital which, if investors worry that mispricing may deepen in the short run,
could prevent arbitrage opportunities from being exploited15 . In extreme situations of irrational exuberance, arbitrageurs trying to eliminate the glamour-value
cross-section mispricing or the inter-temporal market mispricing as indicated by
the P/E10 , might lose enough money in the short run that they have to liquidate
their positions. Having to face this risk, investors could wait for long periods
before they start to go in contrast with the market trend.
(3) Model Risk
Chapter 2 showed how prices can rationally vary significantly even after small
changes in expected growth rate of dividends, interest rates or the cost on capital.
Even rational traders, however, can never be sure that their expectations are
correct and, hence, will be never be sure about the real fundamental value of a
15
When arbitrage requires capital, arbitrageurs can become most constrained when they have
the best opportunities, i.e., when the mispricing they have bet against gets even worse. Moreover, the fear of this scenario would make them more cautious when they put on their initial
trades, and hence less effective in bringing about market efficiency. This feature of arbitrage
can significantly limit its effectiveness in achieving market efficiency. Shleifer and Vishny
1997 (op. cit.)
87
single stock or the market level. This is reflected by the fact that professional
investors as a group are very likely to have heterogeneous beliefs on fundamental
values. At the same time, investors can neither be sure about the effectiveness of
the pricing model they are using to evaluate stock prices. This model risk may
well limit the positions taken by rational arbitrageurs whenever the mispricing
cannot be considered extreme.
(4) Professional investors trying to profit on the noise trader sentiment
If noisy traders are present into markets and if some of their behavioural patterns
can be studied and anticipated, it is possible that arbitrageurs themselves will try
to make abnormal profits in the short turn by simulating their actions. In their
attempt to pick stocks that noise-trader sentiment is likely to favour in a certain
period, professional investors could follow momentum strategies and amplify,
hence, irrational price fluctuations. The numerous dot com IPOs concluded by
investment banks in the late 90s could be an example of professional investors
trying to profit on the enthusiasm of noisy traders.
The analysed factors can ultimately limit the amount of funds invested in
positions that would bring prices to their fundamental prices and, in some cases,
even incentive rational investors to fuel market inefficiency in the short-term. If
there are enough noisy traders in a market and if rational investors cannot fully
arbitrage away their influence, then mispricing and the previously analysed long
term abnormal returns opportunities can persist.
88
Conclusions
If stock prices in certain periods either overreact or under-react to information

and reflect fundamental values in an inappropriate way, then market timing
strategies capable of obtaining abnormal returns exist. By examining this profitability, one can investigate whether the efficient market hypothesis seems to
hold or not in the real world.
The performed test show not only that the U.S. equity market prices have
been more volatile than subsequent dividends volatility, but also that Shillers
P E10 ratios have historically influenced returns from subsequent buy-and-hold
investments on the S&P Composite. Despite the relevant changes in the structure of financial markets have modified its magnitude from time to time, this
relation has been negative in each of the considered 20-years sub-periods. In
addition, changes in interest rates can explain only part of this negative correlation, suggesting that the P E10 mean reversion is not related only to movements
by central authorities. These tests suggest that investors with long horizons
could ultimately try to perform more than the market by lowering their exposure
on stocks whenever Price-Earnings get significantly higher than their historical
trend, and by doing the opposite when the market as a whole trades at much
lower than average multiples.
It is impossible to prove the assertion that some speculative effects have been
behind many of the violent fluctuations of prices and of the P/E10 ratio, as
one can always argue that there were valid fundamental reasons or expectations
offered by investors to justify prices at a certain time. Lower P E10 ratios, for
instance, could simply be reflective of an higher degree of risk of the market as a
whole. Other EMH supporters would argue, differently, that lower P E10 ratios
are simply reflective, if growth expectations of future dividends remain constant
and after taking into account variations in interest rates, of higher risk premiums
required from operators in certain periods.
The presented historical evidence, nevertheless, shows that whenever price/earnings
got very distant from their historical trend, as it happened in 1929, in 1932, in
89
the late 70s and in 2000, relevant price drops occurred. According to Shiller
(2009), this mean reversion effect is more related to the presence of some irrational exuberance than to changes in fundamental variables.
The behavioural concepts of price-to-price speculative feedbacks, herd behaviour, new era economic thinking and over-reaction are consistent with this
theory, and could well explain much of the results of the performed tests.
Understanding whether EMH hold or not is important not only for investors
looking for abnormal returns, but also for regulators and institutions. The EMH
supports the ideology that markets in general, and not only equity markets, are
a near-perfect resource allocation instrument. Accordingly, the implication of
EMH for public policy is that the best institutions can do is not to interfere with
markets, as any limitation or incentive for certain operations such as limits to
short selling and leverage or limits to the issue of mortgage backed securities
would only have a distorting effect. If one supports the behavioural school and
interprets market movements as a result not only of fundamental analysis, but
also of irrational exuberance, implications for policy makers are relevantly different. Policy makers action could be essential, for instance, to limit excessive
speculation whenever prices are believed to move too far from their fundamental
value. If it is possible to identify bubbles before they collapse, then it is also
possible to limit the magnitude of financial shocks and, hence, their transmission
to the real economy variables on which social welfare depends.
Ultimately, even though the joint hypothesis does not allow any definitive
refusal of EMH, the evidence of anomalies in past history is such that accepting
this assumption acritically might seriously underestimate the impact of irrational
behaviours and arbitrage frictions on financial markets.
While one can never reject the metaphysical version of the risk
story, in which securities that earn higher returns must by definition
be fundamentally riskier, the weight of evidence often suggests a more
straightforward model Lakonishok, Shleifer and Vishny (1994).
A well known anecdote in finance states that if a follower of the efficient
market hypothesis saw a $ 100 bill lying on the ground, he would not take it as
he would think that, if the bill was not fake, someone else would have already
taken it. Behavioural finance suggests that, often in history, that bill could be
original.
90
Appendix A.
The linear regression
In chapter 3 we used the linear regression model to formally estimate the relation
between the initial EP10 ratio of the S&P Composite and subsequent average
returns. Given the model:
y = + x +
Where y is the vector of observations of the dependent variable, x the vector
of observations of the independent variable and is the vector of errors or white
noises. We estimate the parameters
and through the ordinary least squares
method, which minimizes the sum of squared residuals. In order to build a linear
regression model, the following assumptions should hold:
the error term is normally distributed, with a mean of zero (E() = 0) and
a constant variance (E(2 ) =
2 )
the modelled data should be independent from one another and identically
distributed (iid ) criterion. There is no temporal autocorrelation between
errors (E(t1 s1 ) = 0 t1 6= t2 ) and no correlation between errors and the
independent variable (E(xt t ) = 0).
If these conditions are satisfied, in order to find whether estimated parameters
are statistically significant or not, we compute R2 , standard errors, t-stats and
p-values.
An useful statistics to measure the goodness of fit of the linear regression
model is thecoefficient of determination R2 which we hereby define:
R2 = 1
SSerr
SStot
where SStot and SSerr are respectively the total sum of squares and the
residual sum of squares. These are equal to:
SSerr =
n
X
(yi yi )2
SStot =
n
X
(yi y)2
where yi are the single observations of the dependent variable, y the average
of these observations and yi the predictions of the linear regression model.
91

R2 is a fraction between 0.0 and 1.0 which measures the goodness of fit of a
linear regression. The higher R2 , the higher the proportion of variability SStot of
the dependent variable that can be explained through the model. An R2 value of
zero means that knowing X does not help predicting Y and that there is no linear
relationship between X and Y. When R2 is equal to 1.0, otherwise, all points lie
exactly on a straight line with no scatter. As we are using a linear regression
model with only one independent variable, the do not need to introduce the
corrected R2 coefficient.
The standard error of the regression estimate is the standard deviation of
observed values about the regression line; computed by dividing the unexplained
variation SSerr by its degrees of freedom. If we have only one regressor, then:
r
Se =
SSerr
=
n2
sP
n
i (yi
yi )2
n2
The standard error of the regression coefficient is an estimate of the standard

deviation of the coefficient and it measures the precision with which the regression
coefficient is measured. Formally:
Se
=
Sb = pPn
2
(x
)
i
i
Pn
(yi yi )2
P
(n 2) ni (xi x)2
i
where xi are the observations of the independent variable and x represents

their average.
If a coefficient is large compared to its standard error, then it is probably
different from 0. The tstatistic for a parameter measures this ratio and its
equal to the parameter itself divided by its standard error. The t-stat t on the
regression coefficient estimate will be equal to:
t =
Sb
The p-value represents the probability of obtaining a test statistic at least

as extreme as the one that was observed in the considered sample, assuming
that the null hypothesis holds. Taken a significance level of , we reject the
null hypothesis whenever p < . For our purpose, we have set = 0.05. In
order to compute p-value, we need to compare the t-stat on our variable with
the values in the Students t distribution, which describes how the mean of a
92
sample with n observations is expected to behave. If p < = 0.05, then 95%

of the t distribution or the sample is closer to the mean than the t-value of the
considered coefficient of the regression.
It is important to state that high levels of the coefficient of determination does
not imply causation of the dependent variable Y from the explanatory variable
Y . Correlation could simply provide a clue regarding the fact that both Y and
X are correlated to another set of variables.
93
Acknowledgement
I would like to express my sincere gratitude to the supervisor of this dissertation, Professor Giulio Bottazzi, for his guidance and his essential assistance in
reviewing the contents of this dissertation. His clear explanations have been of
great value for me and have deepened my knowledge on financial markets and
empirical analysis methodologies.
I am also grateful to my supervisor from University of Pisa, Professor Davide
Fiaschi, for his constructive criticism and suggestions on the topics on which to
focus during my presentation.
My thanks go to the University of Pisa and to the Scuola Superiore SantAnna
for the exceptional life experience that has provided me during the last three
years. Without their stimulating environments and without the example of their
brilliant students and alumni, I would have never had so many studying and
travelling opportunities in such a short amount of time. I am very grateful to
my academic tutor, Prof. Andrea Piccaluga, and to Dott. Alberto Di Minin for
their introduction to management themes and for their academic support. My
gratitude goes also to my university mates Mario and Matteo (aka Bibe) and
to my high-school mathematics professor Ivan Casaglia, who introduced me to
the Scuola SantAnna and who, with his exceptional culture and teaching style,
helped me developing my passion for quantitative subjects.
I owe my most sincere thanks to all the friends who have strongly supported
me during my studying and working path during these three years in Pisa. Without their daily encouragement and understanding it would have been impossible
for me to keep pace with all the challenges from recent years. My special gratitude goes to my friend Francesca (aka Fruffri), to her energy, and her generosity,
and to Giacomo (aka Spig), who has always been present as both an exceptional
friend and as a team-mate in all the most important moments of my life in these
years.
I am extremely grateful to all my closest friends from Florence, who have
never made me feel guilty for my absence and who continue stay as close to me
as brothers in every circumstance. My warm gratitude goes to Lorenzo (aka
Fatto), one of the most generous people I have every met, and to Lorenzo (aka
Peg) for their profound and loyal friendship. I also thank for their influence and
their presence my friends from my high school group (aka ASD) and Matteo,
Niccol`o and Lodovico, from my former P.R. group.
I am extremely grateful to Marco, Massimo, Mario and all my other teammates from my Web Start-up Kiwi s.r.l. for their exceptional skills, motivation
and entrepreneurial spirit. Building company with them and pursuing a common
94
project is not only an incredible business challenge, but also an unique human
experience.
My last and greatest thanks go to my family and, in particular, to my parents.
I feel extremely lucky and grateful for all the love, support, motivation and
suggestion received since I was a child and I owe most of the results of my life to
their presence and influence.
Pisa, 30 April 2012
95
Bibliography
[1] Clifford Asness. Fight the fed model. AQR Capital Management, LLC,
December 2002.
[2] S. Basu. Investment performance of common stocks in relation to their priceearnings ratios: a test of the efficient market hypothesis. The Journal of
Finance, 32:663, June 1977.
[3] Simone Borra; Agostino Di Ciaccio. Statistica. Metodologia per le scienze
economiche e sociali. McGraw-Hill, May 2008.
[4] Aswath Damodaran. Investment Fables: Exposing the Myths of Cant Miss
Investment Strategies. Pearson Education, 2004.
[5] Aswath Damodaran. Finanza Aziendale. Apogeo, seconda edition, 2009.
[6] Aswath Damodaran. Equity risk premiums. determinants, estimation and
implications. 2011.
[7] Javier Estrada. The Fed Model: A Note. November 2005.
[8] Rausas; Manyika et al. Internet Matters. The nets sweeping impact on
growth, jobs and prosperity. McKinsey Global Institute, May 2011.
[9] John Kenneth Galbraith. The Great Crash. 1955.
[10] Philippe Jorion; Willian N. Goetzmann. Global stock markets in the twentieth century.
[11] Michael C. Jensen. Some anomalous evidence regarding market efficiency.
Journal of Financial Economics, 6, 1978.
[12] Charles M. Jones. A century of stock market liquidity and trading costs.
2002.
96
BIBLIOGRAPHY
[13] Jonathan Lewellen. Predicting returns with financial ratios. Journal of

Financial Economics, 74:209, 2004.
[14] Zvi Bodie; Alex Kane; Alan J. Marcun. Investments. McGraw-Hill, eight
edition, 2009.
[15] George Frankfurter; Elton McGoun. Resistence is futile: the assimilation of
behavioral finance. Journal of Economic Behavior & Organization, 48, 2002.
[16] Elroy Dimson; Massoud Mussavian. Market Efficiency - The current state
of business disciplines. Spellboung Publications, July 2000.
[17] Keith Cuthbertson; Dirk Nitzsche. Quantitative Financial Economics:
Stocks, Bonds and Foreign Exchange. Wiley editors, 2004.
[18] John Geanakoplos; Michael Magill; Martine Quinzii. Demography and the
long-run predictability of the stock market. Brookings Papers on Economic
Activity, 1:241, 2004.
[19] John Y. Campbell; Robert J. Shiller. Stock prices, earnings, and expected
dividends. The Journal of Finance, 43:661, July 1988.
[20] Robert J. Shiller. Do stock prices move too much to be justified by subsequent changes in dividends? The Americal Economic Review, 71:421, June
1981.
[21] Robert J. Shiller. Irrational Exuberance. Broadway Business Books, second
edition, 2005.
[22] Robert J. Shiller. Tools for financial innovation: neoclassical versus behavioral finance. The financial Review, 41:1, 2006.
[23] Andrei Shleifer. Inefficient Markets: an introduction to behavioral finance.
Oxford University Press, 2000.
[24] Jeremy J. Siegel. Stocks for the long run. McGraw-Hill, fourth edition, 2008.
[25] R. Cesari; S. Susini. Introduzione alla Finanza Matematica. McGraw-Hill,
2005.
[26] Daniel G. Goldstein; Nassim Nicholas Taleb. We dont quite know what we
are talking about when we talk about volatility. The Journal of Portfolio
Management, 33:84, 2007.
97
BIBLIOGRAPHY
[27] Narasimhan Jegadeesh; Sheridan Titman. Returns to buying winners and

selling losers: implications for stock market efficiency. The Journal of Finance, 48, 1993.
[28] Andrei Shleifer; Robert Vishny. The limits of arbitrage. The Journal of
Finance, 52:35, 1997.
[29] Josef Lakonishok; Andrei Shleifer; Robert Vishny. Contrarian investment,
extrapolation, and risk. The Journal of Finance, 49:1541, 1994.
[30] Faraldi; Tardito; Vos. Fattore internet: come internet sta trasformando
leconomia italiana. The Boston Consulting Group, April 2011.
98

Market Efficiency in The Long Run

Загружено:

Сведения о документе

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

Market Efficiency in The Long Run

Загружено:

Авторское право:

Доступные форматы

Market Efficiency and Bubbles in the long run:

an empirical test on the S&P Composite

1 Historical evidence from Stock Returns

2 Pricing and Market Efficiency

3 Abnormal returns from fundamental analysis

4 EMH and Behavioural Finance

One of the fundamental assumptions of modern finance in that investors have

Historical evidence from Stock Returns

Defining returns in the equity market

Stocks are financial instruments that represent an ownership position in a certain

1. Historical evidence from Stock Returns

1. Historical evidence from Stock Returns

and we can then define total real returns as:

Returns and the S&P Composite

Idiosyncratic risk is often called specific risk as well.

1. Historical evidence from Stock Returns

S&P Composite as proxy for the world equity market.

Data from ETF Industry Association, March 2012.

1. Historical evidence from Stock Returns

1. Historical evidence from Stock Returns

1. Historical evidence from Stock Returns

Total Return Index

1. Historical evidence from Stock Returns

1. Historical evidence from Stock Returns

1. Historical evidence from Stock Returns

1. Historical evidence from Stock Returns

Dividends and Capital Gains components in the

1. Historical evidence from Stock Returns

Equity, risk and volatility

Volatility is a measure for variation of price or of the total return of a financial

1. Historical evidence from Stock Returns

1. Historical evidence from Stock Returns

1. Historical evidence from Stock Returns

1. Historical evidence from Stock Returns

This peak was reached, in particular, in 1937

1. Historical evidence from Stock Returns

in financial markets should be, therefore, carefully analysed when attempting to

Pricing and Market Efficiency

2. Pricing and Market Efficiency

2. Pricing and Market Efficiency

Why should the equity market be efficient?

2. Pricing and Market Efficiency

Testing market efficiency and the joint stock hypothesis

2. Pricing and Market Efficiency

The Net present Value

2. Pricing and Market Efficiency

Siegel 2008, op. cit.

2. Pricing and Market Efficiency

to re-investments of retained earnings in corporations. Under these assumptions,

Pte + Dte = (1 + kt )Pt1

2. Pricing and Market Efficiency

If the operator is consistent, anyway, he will expect Pte to be derived exactly

NVP with constant cost of capital or constant growth expectations.

2. Pricing and Market Efficiency

With n = we get the Gordon model :

2. Pricing and Market Efficiency

In the first case, P is directly proportional to the level of dividends at time

2. Pricing and Market Efficiency

The long run matters

2. Pricing and Market Efficiency

Example: positive shock on the dividend level

2. Pricing and Market Efficiency

2. Pricing and Market Efficiency