GSB | Chicago: Efficiency Survives an Attack of the Anomolies

EUGENE F. FAMA, ROBERT R. McCORMICK DISTINGUISHED SERVICE PROFESSOR, EXPLORES LONG-TERM MARKET EFFICIENCIES

A GROWING BODY of research on stock prices focuses on anomalies–that is, long-term abnormal returns following an event or announcement. Efficient markets theory predicts that the market would react to information about such events quickly and prices would adjust accordingly. Viewed one by one, some of the recent studies seem to suggest market inefficiency–specifically, long-term underreaction or overreaction to information. It is time to ask whether this literature, viewed as a whole, in fact suggests that efficiency should be discarded. My answer is a solid no, for two reasons.

First, an efficient market generates categories of events that individually suggest that prices overreact to information. But in an efficient market, apparent underreaction will be about as frequent as overreaction. If anomalies split randomly between under- and overreaction, they are consistent with market efficiency. It turns out that identified anomalies fall in a roughly even split between apparent overreaction and underreaction.

Second, and more important, we find that the long-term return anomalies are sensitive to methodology. They tend to become marginal or disappear when exposed to different models for expected (normal) returns or when different statistical approaches are used to measure them. Thus, even viewed one-by-one, most long-term return anomalies can reasonably be attributed to chance.

Below, I review existing studies without questioning their inferences. My conclusion is that, viewed as a whole, the long-term return literature does not identify overreaction or underreaction as the dominant phenomenon, while the random split predicted by market efficiency holds up rather well.

OVERREACTION AND UNDERREACTION:AN OVERVIEW

Werner F. M. DeBondt and Richard Thaler published one of the first papers on long-term return anomalies in 1985. They found that when stocks are ranked on three- to five-year past returns, past winners tend to be future losers, and vice versa. They attributed these long-term return reversals to investor overreaction. In forming expectations, investors give too much weight to the past performance of firms and too little to the fact that performance tends to revert to the mean. DeBondt and Thaler seem to argue that overreaction to past information is a general prediction of the behavioral decision theory Daniel Kahneman and Amos Tversky proposed in 1982. Thus, one could take overreaction to be the prediction of a behavioral finance alternative to market efficiency.

I also classify the poor long-term postevent returns of initial public offerings (IPOs) and seasoned equity offerings (SEOs) in the overreaction camp. SEOs have strong stock returns in the three years prior to the issue. It seems safe to presume that these strong returns reflect strong earnings. It also seems safe to presume that IPOs have strong past earnings to display when going public. If the market does not understand that earnings growth tends to mean revert and overreacts to past earnings, stock prices at the time of the equity issue (IPO or SEO) are too high. If the market only gradually recognizes its mistakes, the overreaction to past earnings growth is corrected slowly in the future. Finally, some have argued that the long-term negative abnormal stock returns of firms after they first list on stock exchanges are due to overreaction. Firms list their stocks to take advantage of the market’s overreaction to their recent strong performance.

If apparent overreaction was the general result in studies of long-term returns, market efficiency would be dead, replaced by the behavioral alternative of DeBondt and Thaler. In fact, apparent underreaction is about as frequent. The granddaddy of underreaction events is the evidence that stock prices seem to respond to earnings for about a year after they are announced. Other recent event studies suggest that underreaction produces positive postevent abnormal returns for stock splits, stock tenders, and open market share repurchases. In these cases, the abnormal returns are attributed to underreaction to positive information. Finally, stock prices seem to underreact to the negative information in dividend omissions and to the positive information when dividends are initiated.

UNDERWHELMING EVIDENCE

The important point is that the literature does not lean cleanly toward either as the behavioral alternative to market efficiency. This is not lost on behavioral finance researchers, who acknowledge the issue: “We hope future research will help us understand why the market appears to overreact in some circumstances and underreact in others,” Thaler and coauthors Roni Michaely and Kent L. Womack wrote in 1995.

The market efficiency hypothesis offers a simple answer to this question–chance. Specifically, the expected value of abnormal returns is zero, but chance generates apparent anomalies that split randomly between overreaction and underreaction.

Is the weight of the evidence on long-term return anomalies so overwhelming that market efficiency is not a viable working model even in the absence of an alternative that explains both under- and overreaction? My answer to this question is no, for three reasons.

First, I doubt that the literature presents a random sample of events. Splashy results get more attention, and this creates an incentive to find them.

Second, some apparent anomalies may be generated by rational asset pricing. Kenneth French and I have found that the long-term return reversals of DeBondt and Thaler and the contrarian returns of Lakonishok, Shleifer, and Vishny are captured by a multifactor asset pricing model. In a nutshell, return covariation among long-term losers seems to be associated with a risk premium that can explain why they have higher future average returns than long-term winners. We acknowledge quarrels with our multifactor model, but our results suffice to illustrate an important point: Inferences about market efficiency can be sensitive to the assumed model for expected returns.

Finally, but most important, a roughly even split between overreaction and underreaction would not be much support for market efficiency if the long-term return anomalies are so large they cannot possibly be attributed to chance. However, most anomalies tend to disappear when reasonable alternative approaches are used to measure them.

VANISHING VARIANCES

This summary of long-term return studies accepts the conclusions of the research at face value. However, examining long-term return anomalies one at a time, I find that most are fragile. Abnormal returns often disappear with reasonable changes in the way that they are measured.

A few well-studied anomalies have survived robustness checks, but overall, most anomalies are on shaky footing, and it is reasonable to suggest that they are fragile illusions. Consistent with the market efficiency hypothesis that the anomalies are chance results, apparent overreaction of stock prices to information is about as common as underreaction. And postevent continuation of preevent abnormal returns is about as frequent as postevent reversal.

Subjected to scrutiny, the evidence for anomalies does not suggest that market efficiency should be abandoned.

This article is excerpted with permission from “Market Efficiency, Long-Term Returns, and Behavioral Finance,” forthcoming in the Journal of Financial Economics.

A full version of the article with citations can be downloaded in PDF format from the GSB web site at http://gsbwww.uchicago.edu/fac/finance/papers/

E-Mail GSB Chicago - Front Page - GSB Home - Current Issue -Archive








					EUGENE F. FAMA, ROBERT R. McCORMICK DISTINGUISHED SERVICE PROFESSOR, EXPLORES LONG-TERM MARKET EFFICIENCIES A GROWING BODY of research on stock prices focuses on anomalies–that is, long-term abnormal returns following an event or announcement. Efficient markets theory predicts that the market would react to information about such events quickly and prices would adjust accordingly. Viewed one by one, some of the recent studies seem to suggest market inefficiency–specifically, long-term underreaction or overreaction to information. It is time to ask whether this literature, viewed as a whole, in fact suggests that efficiency should be discarded. My answer is a solid no, for two reasons. First, an efficient market generates categories of events that individually suggest that prices overreact to information. But in an efficient market, apparent underreaction will be about as frequent as overreaction. If anomalies split randomly between under- and overreaction, they are consistent with market efficiency. It turns out that identified anomalies fall in a roughly even split between apparent overreaction and underreaction. Second, and more important, we find that the long-term return anomalies are sensitive to methodology. They tend to become marginal or disappear when exposed to different models for expected (normal) returns or when different statistical approaches are used to measure them. Thus, even viewed one-by-one, most long-term return anomalies can reasonably be attributed to chance. Below, I review existing studies without questioning their inferences. My conclusion is that, viewed as a whole, the long-term return literature does not identify overreaction or underreaction as the dominant phenomenon, while the random split predicted by market efficiency holds up rather well. OVERREACTION AND UNDERREACTION:AN OVERVIEW Werner F. M. DeBondt and Richard Thaler published one of the first papers on long-term return anomalies in 1985. They found that when stocks are ranked on three- to five-year past returns, past winners tend to be future losers, and vice versa. They attributed these long-term return reversals to investor overreaction. In forming expectations, investors give too much weight to the past performance of firms and too little to the fact that performance tends to revert to the mean. DeBondt and Thaler seem to argue that overreaction to past information is a general prediction of the behavioral decision theory Daniel Kahneman and Amos Tversky proposed in 1982. Thus, one could take overreaction to be the prediction of a behavioral finance alternative to market efficiency. I also classify the poor long-term postevent returns of initial public offerings (IPOs) and seasoned equity offerings (SEOs) in the overreaction camp. SEOs have strong stock returns in the three years prior to the issue. It seems safe to presume that these strong returns reflect strong earnings. It also seems safe to presume that IPOs have strong past earnings to display when going public. If the market does not understand that earnings growth tends to mean revert and overreacts to past earnings, stock prices at the time of the equity issue (IPO or SEO) are too high. If the market only gradually recognizes its mistakes, the overreaction to past earnings growth is corrected slowly in the future. Finally, some have argued that the long-term negative abnormal stock returns of firms after they first list on stock exchanges are due to overreaction. Firms list their stocks to take advantage of the market’s overreaction to their recent strong performance. If apparent overreaction was the general result in studies of long-term returns, market efficiency would be dead, replaced by the behavioral alternative of DeBondt and Thaler. In fact, apparent underreaction is about as frequent. The granddaddy of underreaction events is the evidence that stock prices seem to respond to earnings for about a year after they are announced. Other recent event studies suggest that underreaction produces positive postevent abnormal returns for stock splits, stock tenders, and open market share repurchases. In these cases, the abnormal returns are attributed to underreaction to positive information. Finally, stock prices seem to underreact to the negative information in dividend omissions and to the positive information when dividends are initiated. UNDERWHELMING EVIDENCE The important point is that the literature does not lean cleanly toward either as the behavioral alternative to market efficiency. This is not lost on behavioral finance researchers, who acknowledge the issue: “We hope future research will help us understand why the market appears to overreact in some circumstances and underreact in others,” Thaler and coauthors Roni Michaely and Kent L. Womack wrote in 1995. The market efficiency hypothesis offers a simple answer to this question–chance. Specifically, the expected value of abnormal returns is zero, but chance generates apparent anomalies that split randomly between overreaction and underreaction. Is the weight of the evidence on long-term return anomalies so overwhelming that market efficiency is not a viable working model even in the absence of an alternative that explains both under- and overreaction? My answer to this question is no, for three reasons. First, I doubt that the literature presents a random sample of events. Splashy results get more attention, and this creates an incentive to find them. Second, some apparent anomalies may be generated by rational asset pricing. Kenneth French and I have found that the long-term return reversals of DeBondt and Thaler and the contrarian returns of Lakonishok, Shleifer, and Vishny are captured by a multifactor asset pricing model. In a nutshell, return covariation among long-term losers seems to be associated with a risk premium that can explain why they have higher future average returns than long-term winners. We acknowledge quarrels with our multifactor model, but our results suffice to illustrate an important point: Inferences about market efficiency can be sensitive to the assumed model for expected returns. Finally, but most important, a roughly even split between overreaction and underreaction would not be much support for market efficiency if the long-term return anomalies are so large they cannot possibly be attributed to chance. However, most anomalies tend to disappear when reasonable alternative approaches are used to measure them. VANISHING VARIANCES This summary of long-term return studies accepts the conclusions of the research at face value. However, examining long-term return anomalies one at a time, I find that most are fragile. Abnormal returns often disappear with reasonable changes in the way that they are measured. A few well-studied anomalies have survived robustness checks, but overall, most anomalies are on shaky footing, and it is reasonable to suggest that they are fragile illusions. Consistent with the market efficiency hypothesis that the anomalies are chance results, apparent overreaction of stock prices to information is about as common as underreaction. And postevent continuation of preevent abnormal returns is about as frequent as postevent reversal. Subjected to scrutiny, the evidence for anomalies does not suggest that market efficiency should be abandoned. This article is excerpted with permission from “Market Efficiency, Long-Term Returns, and Behavioral Finance,” forthcoming in the Journal of Financial Economics. A full version of the article with citations can be downloaded in PDF format from the GSB web site at http://gsbwww.uchicago.edu/fac/finance/papers/
	E-Mail GSB Chicago - Front Page - GSB Home - Current Issue -Archive