CHAPTER The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis LE A RNI NG OB J ECTI VES After studying this chapter you should be able to illustrate how stocks are valued as the present value of dividends determine how information in the market affects asset prices: the theory of efficient capital markets, according to which current asset prices fully reflect all available information PRE VI EW 140 Rarely does a day go by that the stock market isn t a major news item We have witnessed huge swings in the stock market in recent years The 1990s were an extraordinary decade for stocks: the S&P/TSX Composite in Canada and the Dow Jones and S&P 500 indexes in the United States increased more than 400%, while the tech-laden NASDAQ index rose more than 1000% By May 2002, these indexes had reached record highs Unfortunately, the good times did not last, and many investors lost their shirts in the recent spectacular decline of the stock market Because so many people invest in the stock market and the price of stocks affects the ability of people to retire comfortably, the market for stocks is undoubtedly the financial market that receives the most attention and scrutiny In this chapter, we look first at how this important market works We begin by discussing the fundamental theories that underlie the valuation of stocks These theories are critical to understanding the forces that cause the value of stocks to rise and fall minute by minute and day by day Once we have learned the methods for stock valuation, we need to explore how expectations about the market affect its behaviour We so by examining the theory of rational expectations, which has more general implications for how markets in other securities besides stocks operate When this theory is applied to financial markets, the outcome is the efficient market hypothesis The theory of rational expectations is also central to debates about the conduct of monetary policy, to be discussed in Chapter 27