Question

Explain how in an imperfect capital market where there is risk, that a low price-earnings ratio strategy may be able to generate excess market returns. Please discuss the asset pricing models we have covered in answering the question.

Answer 1

In an imperfect capital market, low Price to earning ratios make the stock look cheap and less lucrative however sijce there is asymmetric information, there can be some investor who finds great value and buys back stocks heavily such tjat PE ratio jumps and so does the prices as other investors follow the herd and stock rallies.

This causes excess market returns for stock which has lackluster fundamental and technicals but has strong value proposition in future giving excess returns to market.

As per Arrow debreu Model, under perfect competition and demand independence there is always particular array of prices which leads to aggregate demand equaling aggregate supply for every Commodity in economy.

However for example asset prices cannot have equal supply and equal demand as it depends on multiple factors which are dyanmic and oscillating such as regulatory approval, global uncertainty, government subsidies, consumer willingness, low consumption appetite which wll together constitute different aggregate demand levels at particular aggregate supply and prices and thus the theory is impractical and not so useful.

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