34 PagesPosted: 16 Jun 1997
See all articles by Lynn A. Stout
Lynn A. Stout
Cornell Law School - Jack G. Clarke Business Law Institute (deceased)
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How Efficient Markets Undervalue Stocks: CAPM and Ecmh Under Conditions of Uncertainty and Disagreement
Number of pages: 34Posted: 16 Jun 1997
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How Efficient Markets Undervalue Stocks: CAPM and Ecmh Under Conditions of Uncertainty and Disagreement
Cardozo Law Review, Vol. 19, No. 2 (1997) (Symposium on the Essays of Warren Buffett)
Posted: 09 Apr 1997
Date Written: 1997
Abstract
Taken together, the Efficient Capital Markets Hypothesis (ECMH) and the Capital Asset Pricing Model (CAPM) appear to predict that the market price of a security in an efficient market should reflect the best possible estimate of its fundamental value. Although this notion once exercised great influence among both finance theorists and legal scholars, closer inspection reveals it to be tautological: because the CAPM rests on an assumption that all investors make identical estimates of securities' future risks and returns, it naturally predicts that market prices reflect that consensus. More recent work in finance examines what happens to securities prices when investors hold disagreeing expectations for the future. This "heterogeneous expectations" literature offers to resolve a number of the mysteries that have plagued scholars who rely on the conventional ECMH/CAPM. In illustration, this paper presents a simple heterogeneous expectations pricing model premised on investor disagreement, risk aversion, and short sales restrictions. The model explains at least the following market puzzles: (1) why many investors don't diversify; (2) why target shareholders receive large premiums in corporate takeovers while bidding firms' share prices remain relatively unchanged; (3) why certain anomalous classes of securities, including neglected stocks, low P/E stocks, and low- beta stocks, offer superior risk-adjusted returns relative to the market; (4) why stock buyback programs and dividend payments support stock prices while stock issues depress market prices; and (5) how certain actively managed investment funds, Berkshire Hathaway chief among them, can consistently beat the market over long periods.
JEL Classification: G11, G12, G14
Suggested Citation:Suggested Citation
Stout, Lynn A., How Efficient Markets Undervalue Stocks: CAPM and Ecmh Under Conditions of Uncertainty and Disagreement (1997). Available at SSRN: https://ssrn.com/abstract=23263 or http://dx.doi.org/10.2139/ssrn.23263
Lynn A. Stout (Contact Author)
Cornell Law School - Jack G. Clarke Business Law Institute (deceased)
As a seasoned expert in finance and investment, my extensive background allows me to delve into the complexities of market efficiency and valuation models. With a profound understanding of the subject matter, I've come across an enlightening article authored by Lynn A. Stout, a distinguished figure from Cornell Law School's Jack G. Clarke Business Law Institute. This paper, titled "How Efficient Markets Undervalue Stocks: CAPM and ECMH Under Conditions of Uncertainty and Disagreement," was first presented in 1997, and it stands as a pivotal piece in the Symposium on the Essays of Warren Buffett.
Stout critically examines the Efficient Capital Markets Hypothesis (ECMH) and the Capital Asset Pricing Model (CAPM), asserting that their combined predictions may not hold true under conditions of uncertainty and disagreement among investors. The article challenges the notion that an efficient market accurately reflects the fundamental value of securities, highlighting the tautological nature of the CAPM assumption that all investors share identical estimates of future risks and returns.
Drawing on more recent developments in finance, particularly the "heterogeneous expectations" literature, Stout proposes a pricing model based on investor disagreement, risk aversion, and short sales restrictions. This model aims to explain several market puzzles that traditional ECMH/CAPM fail to address. The article addresses perplexing phenomena such as investors' reluctance to diversify, the large premiums target shareholders receive in corporate takeovers, the superior risk-adjusted returns of certain anomalous securities (e.g., neglected stocks, low P/E stocks, low-beta stocks), and the impact of stock buyback programs, dividend payments, and stock issues on stock prices.
Furthermore, Stout sheds light on the consistent outperformance of certain actively managed investment funds, citing Berkshire Hathaway as a prime example. The article navigates through the intricacies of the market, offering insights into why these funds can beat the market over extended periods.
In terms of classification, the article falls within the JEL codes G11, G12, and G14, signifying its relevance to financial economics and general financial markets.
This seminal work by Lynn A. Stout is a valuable contribution to the understanding of market dynamics, challenging established notions and providing a foundation for further exploration into the nuances of stock valuation under conditions of uncertainty and disagreement among investors. For those keen on unraveling the complexities of financial markets, this article serves as an indispensable resource.
