All the early evidence supporting the efficient market hypothesis appeared to be overwhelming, causing Eugene Fama, a prominent financial economist, to state in his famous 1970 survey of the empirical evidence on the efficient market hypothesis, “The evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse.”However, in recent years, the theory has begun to show a few cracks, referred to as anomalies, and empirical evidence indicates that the efficient market hypothesis may not always be generally applicable.
Small-Firm Effect One of the earliest reported anomalies in which the stock market did not appear to be efficient is called the small-firm effect. Many empirical studies have shown that small firms have earned abnormally high returns over long periods of time, even when the greater risk for these firms has been taken into account.9 The small-firm effect seems to have diminished in recent years, but it is still a challenge to the theory of efficient markets. Various theories have been developed to explain the small-firm effect, suggesting that it may be due to rebalancing of portfolios by institutional investors, tax issues, low liquidity of small-firm stocks, large information costs in evaluating small firms, or an inappropriate measurement of risk for small-firm stocks.
January Effect Over long periods of time, stock prices have tended to experience an abnormal price rise from December to January that is predictable and hence inconsistent with random-walk behavior. This so-called January effect seems to have diminished in recent years for shares of large companies but still occurs for shares of small companies.10 Some financial economists argue that the January effect is due to tax issues. Investors have an incentive to sell stocks before the end of the year in December because they can then take capital losses on their tax return and reduce their tax liability. Then when the new year starts in January, they can repurchase the stocks, driving up their prices and producing abnormally high returns. Although this explanation seems sensible, it does not explain why institutional investors such as private pension funds, which are not subject to income taxes, do not take advantage of the abnormal returns in January and buy stocks in December, thus bidding up their price and eliminating the abnormal returns.
Market Overreaction Recent research suggests that stock prices may overreact to news announcements and that the pricing errors are corrected only slowly. When corporations announce a major change in earnings, say, a large decline, the stock price may overshoot, and after an initial large decline, it may rise back to more normal levels over a period of several weeks. This violates the efficient market hypothesis because an investor could earn abnormally high returns, on average, by buying a stock immediately after a poor earnings announcement and then selling it after a couple of weeks when it has risen back to normal levels.
Excessive Volatility A closely related phenomenon to market overreaction is that the stock market appears to display excessive volatility; that is, fluctuations in stock prices may be much greater than is warranted by fluctuations in their fundamental value. In an important paper, Robert Shiller of Yale University found that fluctuations in the S&P 500 stock index could not be justified by the subsequent fluctuations in the dividends of the stocks making up this index. There has been much subsequent technical work criticizing these results, but Shiller’s work, along with research that finds that there are smaller fluctuations in stock prices when stock markets are closed, has produced a consensus that stock market prices appear to be driven by factors other than fundamentals.
Mean Reversion Some researchers have also found that stock returns display mean reversion: Stocks with low returns today tend to have high returns in the future, and vice versa. Hence stocks that have done poorly in the past are more likely to do well in the future because mean reversion indicates that there will be a predictable positive change in the future price, suggesting that stock prices are not a random walk. Other researchers have found that mean reversion is not nearly as strong in data after World War II and so have raised doubts about whether it is currently an important phenomenon. The evidence on mean reversion remains controversial.
New Information Is Not Always Immediately Incorporated into Stock Prices Although it is generally found that stock prices adjust rapidly to new information, as is suggested by the efficient market hypothesis, recent evidence suggests that, inconsistent with the efficient market hypothesis, stock prices do not instantaneously adjust to profit announcements. Instead, on average stock prices continue to rise for some time after the announcement of unexpectedly high profits, and they continue to fall after surprisingly low profit announcements.
Small-Firm Effect One of the earliest reported anomalies in which the stock market did not appear to be efficient is called the small-firm effect. Many empirical studies have shown that small firms have earned abnormally high returns over long periods of time, even when the greater risk for these firms has been taken into account.9 The small-firm effect seems to have diminished in recent years, but it is still a challenge to the theory of efficient markets. Various theories have been developed to explain the small-firm effect, suggesting that it may be due to rebalancing of portfolios by institutional investors, tax issues, low liquidity of small-firm stocks, large information costs in evaluating small firms, or an inappropriate measurement of risk for small-firm stocks.
January Effect Over long periods of time, stock prices have tended to experience an abnormal price rise from December to January that is predictable and hence inconsistent with random-walk behavior. This so-called January effect seems to have diminished in recent years for shares of large companies but still occurs for shares of small companies.10 Some financial economists argue that the January effect is due to tax issues. Investors have an incentive to sell stocks before the end of the year in December because they can then take capital losses on their tax return and reduce their tax liability. Then when the new year starts in January, they can repurchase the stocks, driving up their prices and producing abnormally high returns. Although this explanation seems sensible, it does not explain why institutional investors such as private pension funds, which are not subject to income taxes, do not take advantage of the abnormal returns in January and buy stocks in December, thus bidding up their price and eliminating the abnormal returns.
Market Overreaction Recent research suggests that stock prices may overreact to news announcements and that the pricing errors are corrected only slowly. When corporations announce a major change in earnings, say, a large decline, the stock price may overshoot, and after an initial large decline, it may rise back to more normal levels over a period of several weeks. This violates the efficient market hypothesis because an investor could earn abnormally high returns, on average, by buying a stock immediately after a poor earnings announcement and then selling it after a couple of weeks when it has risen back to normal levels.
Excessive Volatility A closely related phenomenon to market overreaction is that the stock market appears to display excessive volatility; that is, fluctuations in stock prices may be much greater than is warranted by fluctuations in their fundamental value. In an important paper, Robert Shiller of Yale University found that fluctuations in the S&P 500 stock index could not be justified by the subsequent fluctuations in the dividends of the stocks making up this index. There has been much subsequent technical work criticizing these results, but Shiller’s work, along with research that finds that there are smaller fluctuations in stock prices when stock markets are closed, has produced a consensus that stock market prices appear to be driven by factors other than fundamentals.
Mean Reversion Some researchers have also found that stock returns display mean reversion: Stocks with low returns today tend to have high returns in the future, and vice versa. Hence stocks that have done poorly in the past are more likely to do well in the future because mean reversion indicates that there will be a predictable positive change in the future price, suggesting that stock prices are not a random walk. Other researchers have found that mean reversion is not nearly as strong in data after World War II and so have raised doubts about whether it is currently an important phenomenon. The evidence on mean reversion remains controversial.
New Information Is Not Always Immediately Incorporated into Stock Prices Although it is generally found that stock prices adjust rapidly to new information, as is suggested by the efficient market hypothesis, recent evidence suggests that, inconsistent with the efficient market hypothesis, stock prices do not instantaneously adjust to profit announcements. Instead, on average stock prices continue to rise for some time after the announcement of unexpectedly high profits, and they continue to fall after surprisingly low profit announcements.
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