Fads, Martingales, and Market Efficiency
NBER Working Paper No. 2533 (Also Reprint No. r1377)
Much of the theoretical basis for current monetary and financial theory rests on the economic efficiency of financial markets. Not surprisingly, considerable effort has been expended to test the efficient markets hypothesis, usually by examination of the predictability of equity returns. Unfortunately, there are two competing explanations of the presence of such predictable variation: (1)market inefficiency, and stock price 'overreaction' due to speculative 'fads' and (2) predictable changes in expected security returns associated with forecasted changes in market or individual security 'fundamentals?. These explanations can be distinguished by examining equity returns over short time intervals since there should be negligible systematic changes in the fundamental valuation of individual firms over intervals like a week in an efficient market. This study finds sharp evidence of market inefficiency in the form of systematic tendencies for current 'winners' and 'losers' in one week to experience sizeable return reversals over the subsequent week in a way that reflect apparent arbitrage profits. These measured arbitrage profits persist after corrections for the mismeasurement of security returns because of thin trading and bid-ask spreads and for plausible levels of transactions costs.
Published: The Quarterly Journal of Economics, Vol. CV, Issue 1, pp. 1-28, (February 1990).