STRONG EVIDENCE OF SHORT-TERMISM IN THE UK STOCK MARKET
There is strong evidence that investors give too little weight to future dividends in their pricing of UK stocks: dividends expected only two years ahead are typically valued at 50% of what they should be. In short, it is by no means clear that the UK stock market is efficient. That is the conclusion of Simon Hayes of the Bank of England, and Professor Keith Cuthbertson and Dirk Nitzsche of the University of Newcastle-upon-Tyne in an article published in the latest issue of the Economic Journal.

The researchers note that one of the simplest rule-of-thumb trading strategies is to buy stocks with low price-earnings ratios (high dividend-price ratios) and sell stocks with high price-earnings ratios (low dividend-price ratios). Such a rule was given scientific support by Eugene Fama and Kenneth French, who found that stocks with high dividend-price ratios today will produce higher returns in the future.

But this seems too easy. Why should such a simple rule produce consistently good results? Hayes et al find that the answer lies in the relationship between dividend-price ratios and the volatility of the market. Higher dividend-price ratios predict higher volatility. If investors require higher returns to holding stocks when the market is more volatile, it is perfectly sensible that dividend-price ratios help to predict future returns. This is no free lunch: the higher returns predicted by high dividend-price ratios are simply compensation for greater risk.

But what of short-termism? Previous research by David Miles has concluded that investors give far too little weight to dividends in the distant future. Of course, cash flows accruing in the distant future should be given lower weight than those accruing in the near future. The payment of interest makes £100 today more valuable that £100 in one year’s time - this is precisely what discounting is all about.

The issue is more subtle: are dividends being discounted ‘too much’? According to the model used here, payments that have a greater amount of uncertainty attached to them - when the market is more volatile - are valued below identical payments in a tranquil market. If volatility changes over time (which it certainly does), the weights applied to future cash flows will also vary, taking account of this time-varying risk.

Is this sufficient to reverse the finding of short-termism? These researchers find that it is not. Although their volatility model performs extremely well in tracking movements in stock prices, they find that dividends expected only two years ahead are weighted at 50% of what they should be.

Taken at face value, these results give statistical credence to those who call for intervention in financial markets to correct short-termist biases. But this conclusion may be premature. The more plausible interpretation is that, although much improved on earlier models, the volatility model does not sufficiently capture the risks inherent in stock market investments. One serious flaw is that it is unable to distinguish between upside risk and downside risk. It may be that better risk measures will, in the not-too-distant future, be able to silence the critics of short-termism.

Note: ‘The Behaviour of UK Stock Prices and Returns: Is the Market Efficient?’ by Simon Hayes, Keith Cuthbertson and Dirk Nitzsche is published in the July 1997 issue of the Economic Journal. Hayes is in the Monetary Instruments and Markets Division of the Bank of England; Cuthbertson and Nitzsche are in the Department of Economics at the University of Newcastle-upon-Tyne.

For Further Information: contact Simon Hayes on 0171-601-3552/5797 (home: 0148-347-5229); or Melanie Dean of the RES/ESRC Economists in the Media Initiative on 0171-878-2913 (email: mdean@cepr.org