Study Session 16: Stock Market Behaviour
Introduction: What to Expect
In this first study session for the Canadian Securities Course (CSC) Volume 2 exam, we
will focus on the various theories of stock market behaviour.
It is very likely that the exam will include a few questions on this topic, so make sure
you know the details of these theories and the differences between them.
Theories of Stock Market Behaviour
For many decades, academics and financial professionals have attempted to explain
why stock prices behave the way they do. Some believe that the movement of stock
prices depends on the behaviour of investors, while others believe the stock market is
efficient and examining the movement of historical stock prices is useless.
Let s take a look at the three most widely discussed theories.
Efficient Market Hypothesis (EMH)
Advocates of this theory maintain the following:
o Investors are rational and are able to react quickly to new information in the
market (and prices will adjust accordingly).
o Security prices reflect intrinsic value because all information is taken into
account.
o At any given time, the stock price is the most accurate valuation of a company.
The concept of market efficiency is important and gaining a thorough understanding of
the underlying concepts will help you succeed in this section on your exam, so we
recommend you read the article below. It discusses the EMH in detail and looks at how
an investor s decisions may be influenced by his or her views on the theory.
Weblink 16.1
Article:  What is Market Efficiency?
http://www.investopedia.com/articles/02/101502.asp
Rational Expectations
o This theory assumes that people are rational and use information to their
advantage.
o It also assumes that all people have access to all necessary information.
Both the efficient market hypothesis (EMH) and rational expectations theory
believe people are rational. However, it is the rational expectations theory that
highlights people as being the reason behind an efficient market, while the EMH
suggests intrinsic value is the reason.
Random Walk Theory
o Proponents of this theory maintain that stock price changes are unpredictable
and move independently of each other.
o They also believe that analyzing historical prices is useless because future prices
are unrelated to the prices in the past.
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 Study Session 16: Stock Market Behaviour
What Factors Drive Investor Behaviour?
We have looked at three theories that attempt to explain why the stock market behaves
the way it does. According to the EMH and the rational expectations theory, the stock
market s behaviour partly depends on the behaviour of investors. So, what factors
affect how investors behave?
In this section, we will discuss how various economic factors such as government
policy, the actions of the Bank of Canada, the flow of funds, and changes in the inflation
rate affect the attitudes of Canadian investors. If you are having difficulty with the
following material, make sure you review Study Session 8 of the CSC Volume 1 Exam
study guide to review the basics of monetary and fiscal policy.
Fiscal Policy
Fiscal policy allows the government to affect the amount of disposable income
individuals and businesses have to spend. However, keep in mind that a time lag
exists between legislation, action, and results, and this reduces the effectiveness of
fiscal policy.
o Government spending and/or tax reductions will stimulate the economy. (For
example, a dividend tax credit encourages investing.)
o A reduction in government spending and/or an increase in taxes will contract the
economy.
o Government debt as a percentage of the GDP must be considered before
implementing expansionary fiscal action. Increasing government spending may
produce benefits in the short run, but it can also create too much debt, which
can hurt the economy in the long run.
Monetary Policy
Monetary policy is the process by which the central bank (Bank of Canada)
modifies interest rates in an effort to affect the money supply. The currency and
bond markets influence the bank s decisions.
o Currency Market
- The rate of inflation in Canada is very important to the strength of the
Canadian dollar. For example, higher real interest rates draw more foreign
investment, which increases demand for Canadian currency and increases the
strength of the dollar.
- The level of inflation a country is likely to incur will be reflected in the T-bill
interest rates.
- Therefore, higher inflation will be reflected by higher T-bill rates.
Be sure to review the concepts of nominal and real interest rates: the differences
between the two are important to know to understand the relationship between
inflation and T-bill rates.
Remember that the most important factor that affects the Canadian dollar vis-a-
vis the U.S. dollar is anticipated inflation, which is reflected in the rate offered by
Treasury bills.
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Study Session 16: Stock Market Behaviour
o Bond Market
- Economic growth (higher demand for currency) results in a rise in bond
yields, which ultimately leads to an increase in inflation.
- To curb the rate of inflation and slow the rate of growth, central banks must
increase short-term interest rates. Increasing interest rates reduces borrowing
and increases saving, thereby increasing the money supply.
- If long-term rates fall, the policy of higher short-term rates has had the
desired effect.
Let s see how an examination of the bond yield curve can demonstrate if the
Bank of Canada s decision to increase short-term interest rates has produced
the desired effect.
ª% Inverted Yield Curve
The yield curve is inverted (tilted) when short-term debt instruments are
yielding more than long-term debt instruments. Other factors to consider:
- As short-term rates increase, bond yields do not increase proportionately.
- Economic growth slows as short-term rates continue to increase.
- When long-term rates begin to fall, it indicates bond market approval of
this slowdown.
Figure 16.1: Inverted Yield Curve
For your exam, the most important thing to remember when it comes to the
inverted yield curve is that it demonstrates how an increase in short-term interest
rates produces a decrease in long-term bond yields.
Flow of Funds
Looking at the flow of funds involves an examination of what financial assets the
majority of investors are putting money into or out of. This class of financial assets
includes stocks, bonds, and money market funds.
- The most desirable investments will experience a large injection of money within
a short period of time, while less favourable assets will see an outflow of
investment.
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 Study Session 16: Stock Market Behaviour
- The level of interest rates determines where funds will flow. For example, if
interest rates are declining, money will flow out of money market funds and
into equities.
- Foreign investment also affects the flow of funds; however, it is considered to
be a lagging indicator of market direction because foreign funds can continue
to flow into an asset class that is becoming less attractive to domestic
investors.
Inflation
We have touched on inflation within the macroeconomic variables outlined above,
but here we will lay out a few more important points to consider when examining
the reasons behind investor behaviour.
o Inflation heightens uncertainty about the future of a company s stock prices both
because there is an inverse relationship between the P/E ratio and inflation and
also because it creates higher inventory and labour costs.
o An increase in costs will usually increase pre-tax profits and result in a higher
tax liability.
o The negative effects of inflation continue as consumers of the company s
products or services decline (due to higher prices), and the company
experiences a continual decline in profit margin and share price.
Conclusion
In this study session we have outlined the various theories regarding stock market
performance and investor behaviour, as well as the driving forces behind investor
behaviour. In the next few study sessions, we will be examining the qualitative and
quantitative methods an investor can use to determine the value of specific
investments.
Here is a brief summary of the topics we have just discussed:
Theories of Stock Market Behaviour
- The theories which deal with stock market efficiency include the efficient
market hypothesis (EMH), the random walk theory, and the theory of rational
expectations.
- In reality, there is evidence to suggest the stock market is efficient, but it
can also be affected by unpredictable events.
What Factors Drive Investor Behaviour?
- The government uses fiscal policy in order to control the growth of the
economy. These policies affect the amount of money individuals and
companies have to spend.
- The Bank of Canada uses monetary policy in order to control the money
supply. These policies affect the willingness of companies and individuals to
spend vs. save and are directly related to the currency and bond markets.
- Interest rates affect the movement of investment between equities, fixed-
income securities, and money market instruments.
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- Inflation increases the uncertainty of investments and, when left to
accelerate, normally produces negative effects on a company s profit margin
in the long run.
Top 15 Terms You Must Know:
1) Bank of Canada
2) Dividend Tax Credit
3) Efficient Market Hypothesis (EMH)
4) Fiscal Policy
5) Gross Domestic Product (GDP)
6) Inflation
7) Intrinsic Value
8) Inverted Yield Curve
9) Lagging Indicator
10) Monetary Policy
11) P/E Ratio
12) Random Walk Theory
13) Rational Expectations
14) T-bill
15) Yield
Notes:
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