FINA 3010: FINANCIAL MARKETS

Wenxi JIANG
(Fall 2015)

Lecture Note 9:
Aggregate Asset Market

© Wenxi Jiang

1
Outline

1. Overview

2. Excess volatility

3. Predictability of long-run returns

2
Overview
Course content
Part I: Financial Assets and Instruments
- Debt
- Stock
- Insurance, futures, and options
Part II: Investor in Financial Markets
- Individual investors
- Institutional investors
Part III: Prices of Financial Assets
- Efficient market hypothesis (EMH)
- Departure from EMH
- Aggregate asset market return
- The cross-section of asset return
- Bubbles

In this lecture note, we try to understand the fluctuations of the

aggregate price of financial assets
• E.g., the stock market index, average yield of long-term bonds
• We focus on two facts:
- Excess volatility
- Return predictability

3
Excess volatility

Aggregate stock market

In an economy with rational investors and no frictions, the price
of the aggregate stock market will equal
𝐸(𝐷"'( ) 𝐸(𝐷"'- )
𝑃" = + +⋯
1+𝑟 (1 + 𝑟)-
where 𝐸(𝐷) represents investors’ expectation of dividends.
• The right-hand side of the equation is the fundamental value
of the aggregate stock market
• Efficient market => price equals fundamental
• Hard to test this directly, since we do not observe E D1'( at
time t

Robert Shiller did a very simple, but super smart test

• Shiller just uses the realized 𝐷"'( as a proxy for 𝐸 𝐷"'(
• Then, calculates an ex post hypothetical price, 𝑃 ∗ ,
𝐷"'( 𝐷"'-
𝑃"∗ = + +⋯
1 + 𝑟 (1 + 𝑟)-

If the investor has rational expectation on future dividends, we

should see 𝑃" is close to 𝑃"∗ over the time
• However, empirically, this is not true
• The aggregate stock market has historically been too volatile
relative to its fundamental

4
 422 THE AMERICAN ECONOMIC REVIEW

Index
300- Index
2000-

225!
1500
p

150- *
1000-

75-
500-

0 I year
0
1870 1890 1910 1930 1950 1970 1928 1

FIGURE 1
Source: Shiller (1981)
Note: Real Standardand Poor'sCompositeStock Price Note:Realmo
Index (solid line p) and ex post rationalprice (dotted line p) and
line p*), 1871- 1979,both detrendedby dividinga long- 1928-1979,bo
run exponentialgrowth factor. The variablep* is the exponentialg
present value
Long-term bond of actual subsequentreal detrendeddi-
market value of actu
vidends, subject to an assumptionabout the present subject to an
In anvalue
economy withofrational
in 1979 investors
dividends and no
thereafter. friction,
Data the holding
are from 1979of divid
Data Set 1, Appendix. Appendix.
yield of a long-term corporate bond over a year should equal the
yield of a short-term bond. That is,
(6
growth path for 𝐸 𝑃Standard
the - + 𝐶- and Poor's that p, =E,
1 + 𝐻(,- ≡ = 1 + 𝑟
series, 16-38 percentbelow 𝑃((6 the growthpath expectatio
for the the holding
where 𝐻(,- isDow Series) only
yield from for a few
year 𝑃((6 and 𝑃-(6 are availablea
depression
1 to 2,
years: 1933, 1934, 1935,and 1938.The mov- the optima
the price of a 10-year
ing average bonddetermines
which at the end of p*yearwill
1 and 2,
smooth the foreca
out such
respectively, andshort-run fluctuations.
𝐶- is the coupon the year.the
paid duringClearly mental pri
stock marketdecline beginningin 1929 and the foreca
ending in 1932 could not be rationalizedin with the fo
terms of subsequentdividends!Nor could it tween
5 p, a
be rationalizedin terms of subsequentearn- error show
To see if this is true in data, Shiller used the same trick:
• Use the realized long-term bond price as a proxy for 𝐸 𝑃-(6
• Then, calculate an ex post hypothetical holding return of
∗
long-term bonds, 𝐻(,- ,

∗
𝑃-(6 + 𝐶-
1+ 𝐻(,- =
𝑃((6

If the investor has rational expectation on future bond prices, we

∗
should see 𝐻(,- is close to the short-term interest rate, r, over the
time
• However, empirically, this is not true
• The aggregate long-term bond price has historically been
too volatile as well
1 192 JOURNAL OF POLITICAL ECONOMY

60-

45-

30-

'5-

0-

-15-

-30- I
1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977

FIG. 2.-Approximate one-quarter holding yield (H) on the long-term bonds from
fig. 1 (solid line) and the short-term interest rate (r) (dotted line) quarterly, 1966:1-
1977:11. See Appendix B, data set 1, and n. 2.

Source: Shiller (1979)

holding yield on long-term bonds, as computed from the long-term
interest rate series from figure 1 (solid line),2 and the same short-term
interest rate (dotted line). Note that the vertical axis in figure 2 has
6
smaller units than that of figure 1, because the one-period holding
yield is so volatile. The standard deviation of the holding yield is in
fact 18.6 percentage points, and the holding yield ranges in this
Note:
(1) Researchers find similar phenomenon in most developed
countries
(2) There is thought to be puzzlingly high volatility in the housing
price
• The housing price appears to be too volatile relative to the rent

Explanations
(1) Rational framework
• Excess volatility unnecessarily indicates that investors have
wrong expectation of future dividends or that prices are not
right
• It may be due to the fluctuations in the discount rate, r

7
(2) Behavioral framework: over-extrapolation of past returns
• Idea: some investor form beliefs about future returns by
extrapolating past returns
- If the stock market has been rising, they expect it to keep
rising
- If it has been falling, they expect it to keeping falling
• Such beliefs are incorrect
- After good (bad) past returns, the stock market performs
poorly (well)
- But it is nonetheless plausible that some investors might
hold such beliefs
- E.g. they may stem from the psychological bias “law of small
numbers”
• Over-extrapolation can explain why the stock market is so
volatile
- If the stock market performs well, some investors think it
will keep rising
- They buy it aggressively, pushing it even higher

8
 Predictability of long-run returns

Stock market
The future return of the stock market can be predicted in
advance, to some extent
- E.g. using the stock market’s P/D or P/E ratio
- Years with a high P/E ratio are followed by low returns
- Years with a low P/E ratio are followed by high return
- indicates that the stock market price is not a random walk;
Fact 2: The future return on the stock market can be
at long horizons, it is quite predictable
predicted, to some extent, in advance

Source: Campbell and Shiller (1998)

• why is this the case?
– and how should investors respond to this evidence?
9
Stock market volatility
• “the most important fact” about price
- high prices are followed by low returns
- and low prices, by high returns
• High P/E ratios eventually turn into moderate P/E ratios
- This cannot be due to a rise in earnings (E)
- Shiller showed that high prices are not followed by high
earnings
- Thus it must be due to low price growth, i.e., low returns

Long-term bond market

The yield of long-term bonds can be also predicted in advance, to
some extent
- E.g. using the yield spread between the long-term bond and
the short-term bond
- When the yield spread is relatively high, the yield of the
long-term bond tends to fall over the life of the short-term
bond

Explanations
(1) Rational framework: changes in risk aversion
- If risk aversion goes down, the P/E ratio goes up
- Since investors are less risk averse, they accept, and
subsequently receive, a lower average return

10
(2) Behavioral framework: over-extrapolation of past returns
• If some investors form beliefs about future returns by
extrapolating past returns, this can explain this fact
• If the stock market does well, some investors think it will keep
doing well
- This pushes up the P/E ratio
- But now that the market is overvalued, it will subsequently
do poorly
- A high P/E is followed by lower returns

Summary
• We have discussed two central facts about the aggregate asset
market
- Excess volatility
- Future market returns are predictable
• We all agree on these facts
- But the academic still has the dispute about its
interpretation

11
Suggested readings

Sections 4.2, Barberis, Nicholas, and Richard Thaler. "A survey of behavioral finance."
Handbook of the Economics of Finance 1 (2003): 1053-1128.

Reference

Campbell, John Y., and Robert J. Shiller. "Valuation ratios and the long-run stock market
outlook." The Journal of Portfolio Management 24.2 (1998): 11-26.

Shiller, Robert J. "The volatility of long-term interest rates and expectations models of the
term structure." The Journal of Political Economy (1979): 1190-1219.

Shiller, Robert J. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in
Dividends?." The American Economic Review 71.3 (1981): 421-436.

12