a THE THEORY OF STOCK MARKET EFFICIENCY: ACCOMPLISHMENTS AND LIMITATIONS hirty years have passed since Eugene Boe fem introduced the idea ofan efficient stock market to the financial economics literature, and it continues to stimulate both insight and controversy. Put simply, the idea is that investors compete so fiercely in using public information that they bid away its value for earning additional returns. In so doing, they quickly incorpo- rate all publicly available information into prices. Harvard economist Benjamin Friedman has dismissed the idea as a “credo’—a statement of faith, not scientific research." Warren Buffett, whose le; endary investment performance and. philosophy have caused some soul-searching among efficient markets theorists, has described the stock market as “a slough of fear and greed untethered to corporate realities.”? In my view, the concept of efficient stock markets is one of the most important ideas in economies In the theory of stock market efficiency, public information that has not been fully reflected in stock pricesis like gold lying in the streets; reports of either are treated with equal skepticism, Take the case of a company reporting a $3 increase in annual EPS when the consensus forecast at the beginning of that year was a $2 increase. How should such informa tion, which is essentially “free” for investors to acquire the momentitis placed in the public domain, affect the company’s stock price? In an efficient market, the expected part of the earnings increase ($2 of the $3, in this case) should already be reflected in the price, and investors by Ray Ball, University of Rochester* should trade on the new information (the extra $1, or the earnings “surprise” until all the gains from so doing are competed away. The stock price adjust ment to the information should be rapid Gf not instantaneous”), and the new price should make the stock a “fair game’—one which promises new investors a normal rate of return In the mid-1960s, while working together at the University of Chicago, Phil Brown and I set out to test these propositions by exploring how the stock market actually responds to announcements of annual earnings. We examined some 2300 annual earings reports by about 300 New York Stock Exchange companies over the nine-year period 1956-1964. After classifying each of the 2300 reports, as containing either “good news” or “bad news based on past earnings, we calculated the stock returns to an investor holding each of the two groups of companies from one year before to six months after the announcement. What we found provided stronger support for the theory than practitioners in finance and account ing—not to mention most of our academic col- leagues—had expected. The results of our study,* which are summarized graphically in Figure 1, suggested that the market had already anticipated roughly 80% of the “surprise” component in annual earnings by the time the earnings were announced. There was some further upward “drift” following the announcements of eamings increases and small downward movements following decreases. But, over the entire six-month period after the announce- “This article draws heavily on aiy earlier article, “On the Development Accomlishinents and Limitations of the Theory of Stock Market Efcleny,” Managerial Finance 20 (1994, ss4e n0.2/3), pp. 3-48. Permission from the editor and publishers gratefully acknowledge 1 Cited in R, Thaler ed, adswances i Bebactoral Finance New York: Rossel ‘Sage Foundation, 1999), p13 4 2. The New York Times Febnaary 1, 1995, p35. 3. R- Ball and P. Brown, “An Empirical Evaluation of Accounting Income Numbers” fourial of accounting Research 6 (1958), 159-178 BANK OF AMERICA a JOURNAL OF APPLIED CORPORATE FINANCEFIGURE 1 STOCK PRICE CHANGES IN RELATION TO ANNUAL EARNINGS ANNOUNCEMENTS" = = EPS Increases Marker index EPS Decreases Price Change Relative to Market Index (%) iz af} 0 2 6 ‘Month Relative to Earnings Announcement re flows ino the market, Prices also all plstnnes price movements ree Ball and Brow 1 firms announce EPS increases info ne price ration athetie of the announcement. The fin, Fins with larger EPS ctangestendto experience anger rice merch Nock prices rise during the see Det fuvance of EPSdeervaves. There ments, investor returns from holding each of the two performance measurement criteria) and industrial groups of firms (those with unexpected EPS in- corporations (in setting their investment rate-of- creases and those with decreases) would have been return targets). The Black-Scholes model is one of close to zero, Thus, prices had incorporated the _ the most popular, if not the dominant, procedure for information released in annual earnings reports ina valuing stock options, as well as many other deriva- way that virtually eliminated future opportunities to “contingent claims.” And wide- profit from that news. (And, since publication of our spread practices such as indexing, performance study in 1968, these results have been replicated by measurement, and asset securitization are all un- many other studies of different time periods in 15 thinkable without the idea of well-functioning secu: different countries.) rity markets. The impact of the simple idea of market effi- Our current understanding of how information ciency has been extensive and enduring, Stimulated _ is incorporated into stock prices has also influenced in large part by a new research design known asthe _ corporate disclosure policy, For example, it is now “event study” (introduced in a 1969 study by Fama, common for corporations to release between two Fisher, Jensen, and Roll that I discuss later), a large and six different earnings numbers (for example, body of empirical research in the 1970s provided those including and excluding earnings from bu: consistent evidence of the stock market's ability to nesses that were sold during the period, both before process information in a rational, in some cases and after the effects of accounting method changes) ingenious, fashion. This research so transformed our Whereas the pre-efficiency mentality of accountants view of stock markets that contemporary observers (and the SEC) was to distrust investors’ judgment and cannot begin to appreciate the general suspicion of _ thus to choose the earings number for them, the and ignorance about stock markets that prevailed 30. dominant corporate practice today, with the blessing years ago. of the SEC, is to present and then leave it to users to At the same time it was expanding our knowl digest the full range of information. edge of how the stock market processes informa- In short, the theoretical developments of the tion, the early work on market efficiency helped to “60s and ‘70s have helped transform the practice of establish a receptive climate for three other major finance. And, in addition to these theoretical and developments in financial theory: the Miller- practical achievements, the early empirical testing of Modigliani theories of corporate financial policy; the _ market efficiency coincided with the more general Sharpe-Lintner Capital Asset Pricing Model (CAPM); _ emergence of interest in and respect for free markets and the Black-Scholes option pricing model. Each of _ that began in the 1970s, first among economists and these theoretical developments has in turn affected then later among politicians. Indeed, the market financial practice in important ways. The CAPM, for efficiency literature has helped pave the way for example, is widely used today both by institutional what has proved to be a worldwide “liberalization” investors (in establishing their asset allocation and of financial and other markets 5 VOLUME # NUMBER 1 #- SPRING 1995Despite its insights and accomplishments, how- ever, the theory of efficient markets has obvio limitations. For example, it treats information as a commodity that means the same thing to all inves- tors, Italso assumes—with potentially serious con- sequences, in my view—that information is costless/ incorporated into prices. In reality, of course, inves tors interpret events differently; they face consider- able uncertainty about why others are tracing; «and especially in the case of smaller firms, they face high costs (asa percentage of firm value) in acquiring and processing information. Given these limitations, itis not surprising that researchers soon began to acet mulate evidence that appeared to contradict the theory, Whether the existence of such “anomalous findings indicates fatal flaw in the theory—or, more likely, the value of incorporating greater realism— only time and more research will tell My aim in this article is to provide an admittedly somewhat personal perspective on the aecomplish- mentsand limitations of the theory, and to offer a few suggestions about how the theory might he modified toexplain some of the contradictory evidence. Briefly put, my view is this: the theory of efficient markets was an audacious and weleome change from the comparative ignorance about stock market behavior that preceded it; and despite its now-obvious theo- retical and empirical flaws, it has profoundly infl enced both the theory and practice of finance THE IDEA THAT MARKETS ARE “EFFICIENT” When Phil Brown and [ started the research for our 1968 paper. academics in finance and economics conducted little or no research on stock prices, and we were strongly discouraged by highly skeptical colleagues. The prevailing view among academic economists, even at the University of Chicago, was that the stock market was not a proper subject of serious study. While part of the skepticism about our research stemmed from economists’ reservations about the way accountants calculate earnings, much more could be traced to a deep suspicion of stock markets, Indeed, the notion of modelling the stock market ii rational economic terms was academic heresy at the time. What little research had been conducted on stock prices up to this point had been performed for the most part by statisticians, The scant empirical literature that preceded the efficient market hypoth- esis modelled price behavior in statistical, not eco- nomic, terms, Successive daily stock price changes seemed for the most part “independent”; that is, they displayed no discernible trends or pattems that could be exploited by investors, Prices on any given day appeared likely to go up or down with roughly equal probability. Lacking an economic expkination for this result, researchers described it in statistical language as the “random walk hypothesis. Moreover, it was a statistician at the University of Chicago, Harry Roberts, who first saw the poten- tial import for economics of the “random wall literature. In an important paper published in 1959, Roberts mused, "Perhaps the traditional academic suspicion about the stock market as an object of scholarly research will be overcome.” And, as he went on to say, there is a plausible rationale [for the random wath. model). If the stock market behaved like a mechani- cally imperfect roulette wheel, people would notice the imperfections and, by acting on them, remove them. This rationale is appealing, if for no other reason than its value as counterweight fo the popular view ofstock market “irrationality, butitisobviously incomplete." Among financial economists and other students, of the stock market, statistical dependence in returns came to be viewed as valuable information just sitting there in the public domain, that is, as so much gold in the streets. Any predictable trends in prices over time would mean that knowledge of past returns Gwhich is essentially costless to acquire) could be used to predict future returns. In short, dependence across time was viewed as inconsistent With rational behavior in competitive markets and thus as evidence of what later became known as “market inefficiency ‘The first use of the term “efficient: market appeared in a 1965 paper by Eugene Fama, who defined it as: "CHIN, Rabon, Sock Market -Patcrns and Vinca Analyse Mette cal Suggestions, furl of Fonance 1459} p Fears evieof the ran wall Herat ail precedents, se Fa cient Capa Mieke: A Review of Theory nd Bprcal Wen foal of JOURNAL OF APPLE 6Stimulated by a new re empirical research in the 1970s provided consistent e ational, i formation i ability to process is a market where there are large numbers of rational, profit-maximizersactively competing, with each ty- ing to predict future market values of individual securities, and where important current information is almost freely available to all participants, “In an efficient market,” Fama argued, on the average. competition will cause the full effects of new information on intrinsic values to be reflected instantaneously” in actual prices! The economies underlying this model are very simple. Publicly-available information by definition is accessible to all investors at zero cost. While earnings reports, for example, are costly for firms to produce, once made public they are nearly costless to obtain (though not necessarily costless to inter- pret, as I discuss iter), And since revenue and cost are equated in competitive equilibrium, the implica- tion of stock market efficiency is that if the cost of reproducing public information is zero, then so are the expected gains, Security prices should therefore adjust to information as soon as Gf not before) it becomes publicly available. Ideas don't come much simpler in economics ACCOMPLISHMENTS OF THE THEORY OF STOCK MARKET EFFICIENCY It is difficult to trace the influence of ideas because their effects range from the direct and concrete (such as the effects on financial practice 1 noted earlier) to the more subtle and abstract (for example, their influence on how we think about issues, and on the concepts aind linguage we use) To gain some appreciation of how thoroughly the research on market efficiency has changed our thinking about stock markets, imagine the mindset of an observer of stock markets prior to the r that began in the late ‘60s, Ordinarily we view the market's reaction to information through the lens of chronological time, Reading the daily financial press, for example, we observe the market's response at at single point in time to what is often a bewildering variety of events and circumstancesatlecting comps search (6. EA, Fama, Radon Walks iv Sewk Market Prices” Cnancua Aas Jon, epee U9). 4 TF tana. 1 ashe, MC: ensensand Rll “The Adasen Now Price earch design known as the “event stud: ” a large body of idence of the s ious, fashion. tock market's some cases ing nies’ values, There are announcements of earnings and dividend, new promotional campaigns, labor disputes, staff retrenchments, new debt and equity issues, management changes, proxy contests, asset write-offs, bond rating changes, and changes in interest rates, money supply figures, and GDP data. Thus, what we sce with the unaided eye are price reactions to many events at once, without seeing the underlying pattern for any one of them, In 1969, however, a study of the stock market reaction to stock splits by Eugena Fama, Lawrence Fisher, Michael Jensen, and Richard Roll (hereafter *FEJR") introduced the conceptof“eventtime,” which may well have been the single most important break- through in our understanding of how stock prices respond to new information,” In attempting to isolate the market's reaction to stock splits (by eliminating the surrounding “noise” of other events), FEIR took many instances of the same event occurring in many different companies at different times, and “stan dardized” them all in terms of a single “event” date (designated in the literature as “t=0"), In so doing, they were able to provide an “event-time” view of the market's reaction of the kind presented in Figure 2 What does Figure 2 tell us? Conventional wis- dom held then, «ts it does today, that stock splits are good news for investors (and, although why stock splits should be good news has long been something ofa puzzle to economists, FFJR reported a plausible reason in their 1969 study: namely, 72% of the splitting firms in their research sample announced dividend increases above the NYSE average in the year afier the split). What the conventional wisdom may not have predicted, however, but what emerges in Figure 2, is the speed with which investors restore the market to its equilibrium or “fair game” condition after the announcement (as revealed by the imme- diate flattening of the line after 0). Thus, where we had previously seen only the chaos of daily stock price movements, FEJR'S re- search design enabled us to sce order, And the large empirical literature on market efficiency that came after FEJR both refined their “event study” technique and accumulited impressive evidence—unimagin- able before the ate “60s—that stock prices respond in apparently ingenious ways to information.” One 1 For sarvess wh cited analysis ob india tdi and eB sec Fama BPO} cea cir FF Fnac Capt Markets He fren. Finance 46 19911, 15-1017 anal SF tao, Eicken Capital Markets and Mamingikes- onal of tne Fieratine 2 99). TRS HOFIGURE 2 STOCK PRICE CHAN ’ ELATION TO. is STOCK SPLITS" BE 33} ag BE ol i i re ge =10 0 3 0 Month Relative to Split Date 20 30 “Stock prices rise daring the 50 months before sock splits, Hecause all the wformation in the spit public Knowledge bt the time occurs, the tick price eaction to the split fe complete Fy “nxn The graph shores price muvements for the verge firm, Firms wih larger splits lend 1o experience larger price movenBents, Source: FEE UID) surprising and illuminating example: announce- ments of new public stock offerings are associated with an immediate 3% average stock price reduction, ‘The prevailing explanation of this negative market response is as follows: Investors recognize that managers, as representatives of existing sharehold- ers, are more likely to issue new stock (rather than debt) when they think the company is overvalued; hence announcements of new stock offerings are interpreted, at least in the average case, as conveying managers’ private assessment of the firm's prospects relative (0 its current valuation.” Another example worth noting (in part for its touch of the bizarre) unexpected CEO deaths are associated with price decreasesin the case of professional managers, as we might expect in an economy where most companies are well run. But, in the case of those CEOs who are also the founders, death notices are accompanied by price increases, with the implication that_ many founders tend to hang on to their companies too long.” ‘There was one other notable factor contributing to the remarkable successes of efficient markets theory in the late 1960s and early 1970s. At that time, the stock market was one of the few areas in which a large amount of data could be used to testa simple competitive economic theory, And the data were unusually plentiful. The University of Chicago's Center for Research in Securities Prices (CRSP), which was established (with exceptional foresight) by James H. Lorie in 1960, provided comprehensive data on the universe of all NYSE stocks going back to 1926, Such a rich source of data—which, rare for the time, came in machine-readable form and were essentially error-free—was a luxury almost unheard- of among economists. Influencing the Climate for Other Financial Economic Theories Together, then, the new theory and evidence on market efficiency demonstrated to economists for the first time that share price behavior could be viewed as a rational economic phenomenon, And this development in turn helped set the stage for other breakthroughs ‘Two other broad areas of financial-economic enquiry were launched around the same time as efficient market theory. First were the “dividend” and “capital structure” irrelevance propositions formu- lated by Merton Miller and Franco Modigliani (first at Carnegie Mellon, laterat the University of Chicago) and presented in papers published in 1958 and 1961." Soon after came the capital asset pricing model (CAPM), which was developed separately by William Sharpe (at Stanford in a 1964 paper) and 9, Fora nice summary of how the marker responds Rew secunties iste, see GW. Smith, "Raising Capita: Theory and Pekkence.” Mullen Corporate Finance journal, Vol. No, LSprng 1986), 6-22, This stile ws sed in rn fon" investment Banking andthe Capi Acquistion Process fonrhalof Fetal Beanomies Vk. 15 985). pp 3-29. 10, W.8 Jolson, RP” Mage. NJ. Nagarajan andl H.A, Newnan, “An Analysis ‘of the Stock Price Reaction to Sudden Execitive Deaths,” formal of Acconontige fad Bonuses? ONS), 151-174, 8 TF Slight and MPH. Miler, “The Gost of Capa, Comp taal The Theory of Investment American Econ Revit 48 1958), 261 Sind MAL Miler and F Moxhgian. “Dividend Policy Grossah and the Valuation of Shares” froma nf Busines 311961) 81138 JOURNAL OF APPLIED CORPORATE FINANCEWhether the existence of such theory—or, more likely. the value of incorpo: John Lintner (at Harvard in 1965),!? The consistent evidence of market efficiency offered strong support for these concepts that shared similar assumptions about the working of financial markets. Indeed, without the impressive body of empirical research on efficiency as background, it is not clear that the equilibrium-based reasoning of the Sharpe-Lintne CAPM (and later the Black-Scholes option pricing model, introduced in 1973) would have been so well and so quickly received.'® Development of the CAPM (as I discuss later) was particularly important for subsequent research on market efficiency be- cause it provided researchers with a method of estimating investors’ “expected” returns—the re- turns passive investors would otherwise have earned in the absence of the information being tested. A considerable body of knowledge on corpo- rate capital structure has also been built on the work of Miller and Modigliani. The arbitrage-based argu- ments M&M used to buttress their “irrelevance propo- sitions” were novelty in corporate finance. They were developed over approximately the same pe riod that Roberts and Fama were formulating thei ideas on efficiency, and they relied in part on the same basic reasoning of competitive economic theory underlying market efficiency. Among other practical contributions, M&M's then revolutionary thinking on capital structure appears to have supplied an impor- tant part of the logic for the leveraged restructurings of the 1980s." As in the case of the CAPM, finance scholars were more receptive to the M&M proposi- tions in large part because of their consistency with the closely-related area of efficient markets. Summing Up Encouraged, then, by its initial accomplish- ments and reinforced by other theoretical develop- ments like the CAPM, research on market efficiency spread rapidly across the globe, with results that provided remarkably consistent support for the theory. This research had an enduring impact on our view of stock markets, of financial markets generally and perhaps of markets of all kinds, Because this 12, WF Shape Capital Asset Pies: A Theonyol Market Fqullbmunn under CGonalions of Risk earn of Finance 19 O96, 25-42 anal |. Untne, “The 1 Risk Assets and the Selection of Risk Investncne sn Slock Paolo Ides” Reeve af Foon and Statics 47 C1965). 1-57 sexe well Hefowe si fray teste hy Black Jensen nd Selle De? and Fama and Maclith in 1973), relying in pa on the sung evidence het ficiency ad on the perveivet overlapping of the #86 Kk VOLUME s SUM omatous® findings indicates Fatal thaw in the jag greater reaksie only time and tell evidence tended to contradict prior assumptions which were based on prejudice and casual observa tion rather than on systematic research, academic attention was quickly drawn to it. In a surprisingly short time, academic attitudes toward stock markets had shifted from one extreme to the other, from suspicion to almost reverence LIMITATIONS IN THE THEORY OF EFFICIENT MARKETS: It was not long, however, before researchers began to report evidence that appeared to contradict the theory. But, «ts I argue below, finance scholars should not have been completely surprised by such evidence, The theory of efficient markets has not influenced theory and practice because itis free of defects, Its influence has been due to the insights it provides, not those it fails to provide. The cup remains half full, even though it is half empty [now discuss a number of limitations of the theory that I have divided into three overlapping categories: () the theory's failure to explain certain aspects of share price behavior, referred to in the literature as “anomalies”; (2) detects in efficiency as a model of markets; and (3) problems in testing the efficiency model. Empirical Anomalies: Problems in Fitting the Theory to the Data No theory can explain all the data with which it is contronted, especially when the data are as abundant as stock prices. There is now a large body of anomalous evidence that at least appears to contradict market efficiency, The list of such “anoma- lies” includes: ™ Price Overreactions. There is evidence that the prices of individual stocks overreact to information and then undergo “corrections.” The resulting nega- tive correlations in prices appear to create profit opportunities for “contrarian” trading strategies."° = Excess Volatility. Robert Shiller, among others, has argued that the stock market in general overreacts to 1 Sce MEE Mille. “The Moxhian Miller Propositions Thiny Years Aicr awrnate-appiied Conporate Finance el. 2No, | tspaing 198) 1S, WRAL De Hoot, al RH. Uhl, “Dons the Mock Market Overteact bnrnal of Finance, O88), 795-80, seal WAST, De Bonkle and Rt Thalke, Investor vernetionanal Stock Maker Sexson furnal 9events because of investors’ pursuit of fads and other hercelike behavior. In support of his argument, he presents evidence suggesting that the volatility of stock prices is much too large to be explained by the volatility of dividends." ® Price Underreactions to Earnings. In seeming con- uadiction of the the tendency of prices to overreact to information in general, research indicates that prices underreactto quarterly earings reports, thus lend- ing support for “earnings momentum” strategies.” "= The Failure of CAPM to Explain Returns. The ‘apital Asset Pricing Model, as mentioned, has provided the primary means for measuring investors’ xpected returns; indeed, it was the workhorse for alculating discount rates for an entire generation of practitioners as well as researchers, But evidence that high-heta stocks do not earn higher returns than low-beta stocks has led some to pronounce the horse dead."*(But recent research suggests that announce- ments of the death of beta may be premature.) = The Explanatory Power of Non-CAPM Factors. Stocks with (1) small capitalization, (2) low market- to-hook ratios, (3) high-dividend yields, and (4) low P/E ratios tend to outperform their expected returns (as estimated by the CAPM), thus providing justifica- tion for yield-tilted, small-cap, and other popular investment strategies. = Seasonal Patterns. Researchers have provided evidence of seasonal patterns of hourly, daily, monthly, and quarterly duration, Particularly puz- zling is the “weekend effect”: the tendency of stock returns to be negative over the period from Friday's close to Monday’s opening, Such seasonals could lend support to technical analysts’ claims to outper- form market averages As Largue below, however, it is difficult to tell whether such anomalies should be attributed to defects in markets themselves, to flaws in “market efficiency” as a way of thinking about competitive markets, or to problems with the research itself Defects in “Efficiency” as a Model of Stock Markets lure to Incorporate Information Acqui tion and Processing Costs. One of the most impor- 16. Siler, “osock Prices Mowe Too Much Changes in Divikenhe,” american Boonomtc Retin 71,98), 421-138, TV ermal and J Thomss,“Frience That Stack Prices Dy Not Fall Reflet the implications fl Curent mings Tor ure Easing” Jor of Heconoating ad Extaonnies 18 (1991, 305-40, to tant explanations of these anomalies is likely to be the neglected role of information costs. Information costs are neither new to economists nor inconsistent with competitive markets, Nevertheless, the costs of acquiring and processing information have received, scant attention in the theory and empirical research ‘on stock market efficiency The first “event studies” such as the FFJR study of stock splits and the Ball-Brown study of annual earnings reports investigated relatively simple cases, in which information is widely disseminated in the financial press and on the wire services to analys and other investors. The cost to individual inves- tors of acquiring such public information (as op- posed 1 the cost of producing that same informa- tion prior to disclosure) was assumed to be negli- gible. The information was also assumed to be simple to use, with negligible processing (or inter- ation) costs But what about those academic research de- signs that simulate trading strategies that in fact have substantial information acquisition and processing costs? In such cases, the abnormal returns reported hy the research could be significantly overstated, Consider the following: 1. If 1,000 professors of finance worldwide annually incur costs of $50,000 each Cncluding lary, computer costs, and overhead) in searching foranomalies, the expected return from their discov- ery of pricing errors in the market could be as much as 5% per year (or $50 million) on a St billion portfolio. And, if they have been searching for 20 years, the expected return from producing such private information could be many times larger. 2. But, if the expected returns from such strat- egies are this large, why have some researchers published theiranomalous evidence? Why have they not instead used that information for private gain? 3. More generally, what are the expected gains from producing and trading on private information? 4, What is the meaning of gains from a trading rule that is simulated using historical data together with modern computing and statistical techniques? (Does this differ from, say, the simulated gains from owning a helicopter gunship during the Middle Ages?) TRE monn, “The Collapse of the Efi Maker Hypuitesis Aah ae Fanta Anos of the TO” Select Readings Jose Monae nstsatvona beste, 1 19. For acne of Buta se SP. Reta and J. Saker in this seWarren Buffett who sits on the corporate board, is jor corporate dec 5. If an analyst forecasts the earnings of 25 stocks each quarter at an annual cost of $200,000 including salary and overhead), then the average cost of a forecast is $2,000. This is one ten-thou- sandth of 1% of the market value of a $2 billion firm, Itis one tenth of 1% of the market value of $2 million of stock in the firm held by clients. If we further assume that the gains from forecasting are approxi- mately equal to the costs, can we reliably detect such a low number in stock rates of return? We have no well-developed answers to such questions. To date, and for obvious reasons, re- searchers have tended to ignore informat and have relied on cases of publicly-disclosed information (whose cost we somewhat arbitrarily define as zero) in testing market efficiency The direction of the bias from ignoring informa tion costs is consistent with the anomalies evidence. For example, information costs area likely candidate for explaining the small-firm effect, the tendency of small-cap stocks to produce higher returns. Such firms tend to have small analyst followings, pres ably because the cost of acquiring and processing information is large relative to the amounts invested in them, Investors may rationally require higher returns (than those predicted by the CAPM) to compensate for their higher information costs (as a percentage of value), But little more can be said without knowing more about the size of such information processing, and acquisition costs, and how such costs are likely to affect actual (pre-cost) expected returns. More over, there can be significant differences among investors in the information they possess, in the extent of their effortsto seek information, andin their ability to process it. Although the CAPM is silent on, this issue, it would be logical to expect more sophisticated, hetter-informed, and more active in- vestors to earn higher returns. The question, how= ever, is: How much higher? For example, what is the predicted rate of return in a competitive market for an investor like Warren Buffett who sits on the corporate board, is close friend of the CEO, and has a voice in major corporate decisions? Much of Bulfett’s success may be attributed to his ability 1 reduce the information (and “agency”) costs that confront ordinary passive investors. Lower informa- tion costs could in tum be viewed as reducing on costs competitive market for like a close friend of the CEO, and has a investo Bullett’s perceived risks and required rates of return, thus making stocks more valuable to him than to ordinary investors, Heterogeneous Information and Beliefs. This brings us to another, closely related deficiency of efficient markets theory—one which stems from its mechanical” characterization of investors as homo- zencous, Wholly objective, information-processing machines. Investor sentiment and confidence play no role, and publicly available information is sumed to have the same implications for all In reality, of course, individual investors can differ greatly n their beliefs, and a single piece of informa- IBM's latest earnings report—may be interpreted quite differently by different investors, The assumption of homogeneous. investors was understandable at the time the theory was developed. For one thing, it allowed researchers to demonstrate to highly skeptical readers that stock prices do respond to information, and in rational s. But there were other grounds for using such a clearly unrealistic assumption, As the great Aus- trian economist F. A. Hayek argued in his 1945 classic, “The Use of Knowledge in Society, ket prices incorporate information that is not—and perhaps cannot—be fully known by any individual For this reason, markets are likely to be more rational in viewing information than the individual investors who comprise them. Indeed, that is the beauty of markets. But this does not mean markets are infallible (To paraphrase Churchill on democracy. it's not that markets are perfect in allocating resources; it’s just thatall other systems are so much worse. Forall their virtues, markets cannot fully overcome the inevi- table limits of individual knowledge—limits that under certain circumstances, can have pronounced effects on market behavior. To see how such li ight affect markets, consider that the trading decisions of individual investors are based not only on the individual's information about a given stock or commodity, but also on that individual's beliefs about the informa- tion on which other investors base their trading. And because an investor possessing a piece of informa- tion or holding a beliefabout the future cannot know with certainty the extent to which that information or belief is shared by others, he does not know the wal ” mar- nits 1 timer Hecnenic Revie $8 195), 319 Mh ul Vou Ms ScunERextent to which the information is already reflected, in prices One plausible way of interpreting episodes of high turnover and rapid price changes, such as the stock market crash of 1987, is that investors’ costs of becoming quickly informed about the motives for others’ trades can become extraordinarily high Under such conditions of extreme uncertainty, the “mechanistic” model of efficiency, with its assump- tions of zero information costs and homogeneous investors, clearly breaks down, In such case stors’ required rates of return can be seen as rising sharply in response to the sudden surge in price volatility, and the general uncertainty is re- solved only gradually over time (in part through the commentary of market analysts and others whose economic role efficient markets theory has largely ignored), A central question for finance theory, then, is whether events such as the crash of ‘87 are unam- higuous evidence of market irrationality. Are we forced to conclude, along with Keynes (and the new “behaviorialist” school of thought in finance), that the market is a game of musical chairs in which “animal spirits” regularly prevail over reason? Or can such episodes plausibly be described by Hayekian models in which rational individuals with different information confront extreme uncertainty? xpanding efficient markets theory to accom- modate information costs and differences among investors may help us decide this issue. For, in addition to the basic uncertainty that attends all business activity, differences among investors’ infor- mation and beliefs are an added source of uncer tainty and hence information costs; and, in cases where such costs are high, investors may expect to carn significantly higher returns. ABrief Digression on the Role of Security Ana- lysts. As mentioned above, efficient markets theory has virtually nothing to say about the economic role of security analysts and public commentary. The theory’s silence on security analysts has even led many academies to view them as redundant. What do stock analysts do? Besides talking to management on a regular basis, they pay close attention to economic events affecting the compa- nies they follow, and to the accompanying market reactions. They also talk to large investors about their reasons for buying or selling and so attempt to gauge “investor sentiment.” In so doing, analysts can be viewed as reducing investor uncertainty about the information and trading motives of other investors, For example, analysts’ earnings forecasts func- tion as estimates of the information about near-term profitability that has already been built into current prices. The existence of such forecasts enables investors to compare their own private forec: against what amounts to a public consensus. And by reducing one source of investors’ uncertainty- namely, about why others are trading—securities analysts reduce information costs and raise the market value of publicly traded companies. Media commentary on markets can be viewed as playing a similar role. Failure to Consider ‘Transactions Costs. Be- sides assuming zero information costs and homoge- neous investors, early versions of efficient markets theory also assumed that the markets themselves are costless to operate. But if stock markets are large- scale, high-tumover institutions whose primary pur pose is to minimize the transactions costs associated with helping firms raise capital, they have not succeeded in eliminating such cos Having said this, it is not clear what role transactions costs play in setting stock prices. In a published in 1978, Michael Jensen argued that ient market can only be expected to adjust prices within limits defined by the cost of trading,”! According to this view, for example, if transactions re 1%, an abnormal return toa trading strategy of up to 1% would be considered within the bounds of efficiency. It could not be exploited for profit net of cost his view makes sense to traders, but it has several shortcomings from a broader economic perspective. First, there must exist some level of transactions costs at which we are unwilling to call a market “efficient.” If transactions costs were ex- tremely large, there would be few opportunities to profit from price errors, net of costs, Nevertheles makes little sense to describe a market with ex- tremely large costs of trading and thus extremely large price errors as “efficient.” Second, although transactions costs of x% may be consistent with price errors of £x%, they are not consistent with price biases of that size. Since most 21, MG Jensen, “Some Anomalous Evidence Regarding Market Eicency Journat of Fouanctal Beonomis6 IS), 9.8. 12 JOURNAL OF APPLIED CORPORATE FINANCEDifferences among investors intern ad hence information cost acertaint “event studies” and related efficiency tests study av- erage returns, the pricing errors due to transactions costs should net to zero overa broad sample of trades and thus transactions costs are not obviously relevant, to interpreting the results of the studies. ‘Third, because transactions costs vary across investors, defining efficiency in terms of transactions costs can produce as many definitions as there are investors, Whose transactions costs are to be used in judging the market to be efficient? A possible solu- tion might be to define efficiency in terms of the lowest-cost trader. But, because some spe: institutional investors face transactions costs as low as one tenth of one percent, this approach can degenerate into ignoring transactions costs entirely Thus, the role of transactions costs in the theory of market efficiency remains largely unresolved Market Microstructure Effects. A closely-re- lated issue is the effect of the actual market mecha- nism on transacted prices, known in the literature as market “microstructure” effects. Researchers typi- cally assume that trades could be executed at the closing prices recorded in data files such as CRSP’s. These price estimates, however, have a margin of error that is as large as their quoted spreads, which run about 3% forthe average NYSE-AMEX stock (and average close to 6% for NYSE-AMEX stocks with prices less than $5). To compound the problem, cannot always execute at quoted spreads ause of illiquidity. Such market microstructure effects can be quite large relative to the size of the short-term abnormal returns reported by many event studies. Consider the “tum of the year” or “January” effect—the widely-recognized tendency of stocks (particularly low-price stocks) to produce large returns in the first trading days of the calendar year. A 1989 study by Donald Keim demonstrates that this effect can be explained largely by a pronounced (if unex- plained) tendency of stocks to trade near the bid at the end of the year and then move toward the ask at the beginning.” Similar microstructure effects may well also be exaggerating the size of the short-term price rever- the seasonal patterns in daily or weekly returns, pained beets sre un added source of J. ins caves where such costs are high, wwicostly higher retuens, and even the abnormal longer-term returns reported in the anomalies literature. Such effects are espe- cially likely to influence the findings of research on low-price stocks. In 1985, for example, Werner DeBondt and Richard Thaler published a study re- porting very large gains from a contrarian strategy of buying stocks immediately after large percentage declines and holding them for five years.” In a study published this past year, however, two of my Roch- ester colleagues and I discovered that DeBondt and Thaler's results were distorted by some very large percentage gains on some very low-priced stocks, One stock earned 3500% after trading at $1/16 (which is half of $1/8, the minimum increment in which NYSE stocks are typically quoted). We also found that adjustments of $1/8 in the prices of their “loser stocks would have reduced the five-year returns of this contrarian strategy by 2500 basis points.” Like transactions costs, microstructure or trad- ing-mechanism effects present the researcher with a dilemma. Trading mechanisms certainly are_not costless to operate, and thus the prices at which trades are transacted are likely to be affected in systematic ways by institutional arrangements. Thi seems particularly likely for small-capitalization and low-price stocks, and for stocks and stock exchanges with low turnover. But, unlike transactions costs, it seems unreasonable to interpret price behavior caused by the trading mechanism as evidence of market inefficiency, because recorded prices are not those at which the simulated trading strategies could have been executed at the close of trading. Yet taking this view to its limit leads here, as in the case of transactions costs, to the perverse out- come that the probability ofa market's being judged efficient increases with the size of bid/ask spreads. Thus, as with transactions costs, the precise role of market microstructure effects in the theoryof market efficiency is not apparent. Problems in Testing “Efficiency” as a Model of Stock Markets As noted earlier, investors’ ability to exploit public information for gain can be tested only by taterns, Hidhask Spreads and Fsimated Securty Journal of 22, DIK Keim, Trading| Resume: The Case of Common Stocks at Calendar Turning Point Finanetal Beonomtes 25 (1989), 758 325, Delon and Thaler 985), cited eae. 2, Ass mone general indlcaton of skewed returns, we found tha althougt the mechan turns of winner” andlewer” stocks hifered by only 5 the avers 13, retuens dled by 57, Soe R Hal, SP. Kethan and J. Shanken, “Problems in Measuring Polio Performance: An Application to Contrarian Investment Sta een Jornal of Panes Economies 38 1995), pp. 79-107, VOLUMES NUMBER 1 #- SPRING 1995comparing the returns earned when trading on public information against the returns otherwise expected from passive investing, In many empirical tests of market efficiency, the Capital Asset Pricing Model has been used to estimate such expected fetus, But, as also mentioned, the CAPM has come under attack from empirical studies showing at best weak correlations between actual stock market returns and those predicted by the CAPM. And because tests of market efficiency are thus “joint tests” of both the CAPM’s success in measuring expectations and the market's ability to incorporate new information in prices, flaws in the CAPM raise doubts about the reliability of the existing empirical research—both the work that appears to contradict market efficiency as well as that which supports it Changes in Riskless Rates and Risk Premiums. ‘The CAPM states that «a stock’s expected return is equal to the riskless rate (in practice, the interest rates, on Treasury notes or bonds) plus a risk premium obtained by multiplying the stock’s beta times the market equity risk premium (the amount a stock of average risk is expected to earn above the riskless rate), Expressed as an equation: ECR) = RF + B (Rm - Rf). Unfortunately, the model is completely silenton a number of important issues of practical as well as theoretical import, For example, what riskless rates, market risk premiums, and individual betas would be consistent with an efficient market? And how are such measures expected to change overtime, fat all? (Most empirical tests of market efficiency simply assume that riskless rates, market risk premiums, o1 betas are constant.) The second question is potentially troubling because the more we allow both interest rates and the market risk premium to vary over time, the less ability we have to answer a question such as: Are stock prices in general too volatile? In 1981, for example, Robert Shiller published a study conclud- ing that the historical variance of stock prices over the 108-year period from 1871 to 1979 was much too, large to be justified by the variance of corporate dividends.* Using the CAPM, however, it’s impos- sible to say whether Shiller is right. Because of its assumption of constant riskless rates and market risk premiums, the CAPM provides no means of judging the “correct” amount of variance in the market index. Shiller's test, for example, assumes in the tradition of the CAPM that the market-wide expected return i: constant in nominal terms over the entire sample period 1871-1979 in order to place bounds on the price variance allowable in an efficient: market Under this assumption, the probability of rejecting market efficiency seems almost 100%!" But consider what happens when we relax this assumption. Consider the S&P 500 as the value of a claim on perpetuity of expected earnings produced by the 500 companies comprising the index. If the real riskless rate is assumed (0 be zero (close to its historical average), then an increase in the risk premium from 6% to 8% will reduce the value of the S&P 500 by 25%. Do we see too few or too many such. percentage declines in the S&P 5007 It seems quite plausible that market risk premiums could change dramatically in response to sudden changes in investors’ perceptions of political risk and economic uncertainty. But the answer to this question depends on how frequently the risk premium can be expected to change by as much as 2%, (And, although the CAPM is silent on this issue, researchers are now attempting to find ways to address it.) ‘Trends in Real Rates and Market Risk Premi- ums. Moreover, there is nothing in the CAPM that would rule out serial correlation in changes in either the riskless rate orthe market risk premium.” In fact, the investment opportunity set facing companies and investors seems likely to exhibit positive serial correlation—that is, « tendency for increases to be followed by further increases—due to bursts of in- vention, among other factors. A gradual aging of the population seems likely to induce positive depen- dence in interest rates (as a growing number of retirees seeks to live off income from investment and a shrinking workforce operates those investments), In contrast, the market risk premium seems particularly likely to have elements of negative dependence, Consider, for example, how tisk pre- miums would change if the level of general eco- nomic uncertainty perceived by investors varies over time, but tends eventually to return to “normal” Increases in perceived risk will cause the levels. Siler CIN), cea caer This ist cise of eine am excessive and iced faith i the CAPA uundesnine what apps. ny view te tae mone reasenable bein he H nurker pricing rationality 4 27 For sine informal evidence ofa tarp decline ja musket ek premiums ile Stock Prices Rflet Fundamental JOURNAL OF APPLIED CORPORATE FINANCEWorking along changes in the supply of risky assets by corporati investors required returns and market risk premiums, negative serial correlation index to fall (even given the same level of expected corporate profits) in order to give investors a tempo- rarily higher expected return over the period of increased uncertainty. And, if the uncertainties that trigger sharp price declines are resolved over time, the index then tends to rise.?* Working along with such cycles in economic uncertainty and investor confidence, changes in the supply of risky assets (due to the creation of new assets and the obsolescence of old) by corporations would reinforce this pattern of negative serial corre- lation in investors’ required returns and market risk premiums, For example, suppose expectations of increased political and economic stability are asso- ciated with rising stock prices and P/E ratios (as has happened since the recent U.S. House and Senate elections) in response to declines in both interest rates and the general market risk premium, For U.S, corporations, this means a reduction in their cost of capital; and, in response to the lower cost of capital, they can be expected to expand the supply of new risky investments over the next few years, As the aggregate supply of risky assets increases, investors required rates of return will tend to rise back toward normal levels over time, ratios to fall. Given the above assumptions, then (all of which seem fairly plausible), an efficient market would be expected to exhibit serial dependence in both real interest rates and market risk premiums. The point of these conjectures is to illustrate that the cyclical patterns (or “mean reversion”) in stock returns are not necessarily evidence of the market irrationality asserted by Shiller and the so-called behavioralists, Such negative dependence is equally consistent with rational responses by (1) investors to changes in general political and economic conditions and (2) corporations to the resulting changes in investor demand (as reflected in interest rates and risk premiums) for stocks.”” ©: sing prices and P/E ind investor confidence, the pattern of ns would Changes in Betas. Finally, consider the relation between beta and market efficiency. Finance theory says nothing about how betas vary both among companies and over time. It thus offers no guidance as 10 what betas and what pattems of changes in observed betas are consistent with efficiency The current theory fails to account, for example, for the fact that betas can be expected to change in fairly predictable ways in response to changes in stock price levels. To illustrate, if we assume that a company has a given level of overall risk (a fixed ‘asset beta”), the beta of the company’s stock (its equity beta) will rise along with increases in its degree of financial leverage (or debt-to-equity ratio) When expressed in market value terms, moreover, a company’s debt-to-equity ratio will increase not only when it issues more debt, but also when its stock price Falls. Loosely speaking, this means that when a company’s stock price drops sharply, inves tors’ perception of the stock's risk and hence its required return actually increases, Conversely, when the stock price rises significantly, its perceived risk and required return fall. Such systematic changes in betas in response to large stock price changes could account for a number of the “anomalies” noted earlier. For ex- ample, the longer-term “mean reversion” of stock returns—the tendency of high stock returns to be followed by low ones, and vice versa—discovered by Gene Fama and Ken French could be explained largely by systematic shifts in beta after price changes, as could the ability of low P/E and low market-to- book stocks to outperform market averages.” Seasonal Patterns in Betas. To take another example, betas could well exhibit seasonals, ‘There is. no reason in principle why securities’ relative risks, or even aggregate risk, cannot vary with, say, the day-of-the-week. Consider a firm that routinel makes its major announcements—earnings, divi dends, investments, acquisitions—on ‘Thursdays, 28 this poin fas been made by FF Fama, Panndarons of Finance Basic Hows, New Vork), p12 Keele, On the Cmntarian tavestnent Strate Jortatof Busines OS), 147-165. EF, Pavan RR. French, -Pemaanent an Temporary Compents Sxk Pace Jornal of Puta Eciasny 964 1988), 24(n275 sn Ball and SP Kotha, “Nonotationary Expats! Retr: Inplics tionstorSeralComrelann ia Returns, Apparent Price Reversalsand Testoo¥ Market EMhiecy fornia of Pencil Boonies 25 989). 5174, 20. The suppl esky investnent onsets proxlaced by comport investi decisions is typically assumed by the CAPM te Fie god thus unafected By ‘hinges in prices and vaher financial variables, Burs without ny “suppily-sik {heory abet how corponations respond changesin eal rte a spe itiditicultiosee how wecoukl he surprised by enyobserved sequence market tur or use the sequence (jue ay nuke t Be efcent onic. This isa detclency sot aly vf the CAPM. ut of all or aels in noxbern Hace 15 iy including the DCF present value mode, the option pricing axalel, and ent market theory tell Fach of these financial maids concemed ‘cluisely th investor demand! for ane! hence dhe price erin set 19 relation to ether assets with ven pres, Indeed. wok are tha He esa insider the supp of ene spore the east effete tt miler Financial economic theo 0 tlk! Kesha (1949) provide evidence that endenout sk variation explains mel ofthe serial correlation observed in Fastin French (1568), felted sae i the evidence of apparent price reversils in De on nl Ther [985,957 Boal Chan 1988) sn Balla! Rekha 1989) repo ta the ee Ietas ofthe ment extarme Toning” socks can be expected t nerease Decne of the estreme increase in ther market debtcapty ration, Conversely, the extreme winning” stocks are likly to ae equity eta decreases da o exten leverage rections VOLUME # NUMER Ta SPRING 1995pethaps because it schedules board meetings on that day. Thursday returns then will exhibit higher variance and, possibly. covariance. To the extent this is so, what appear to be seasonal patterns of superior returns may turn out to be normal ones when adjusted for the associated temporary. in- creases in tisk. IS “BEHAVIORAL” FINANCE THE ANSWER? Given such limitations in the concept of market efficiency and the existing empirical tests of the theory, a group of finance scholars known as behavioralists has suggested that it is time to aban- don the premise of collectively rational investors on which the theory Behavioralists argue that stock price “corrections” and cycles reflect system atic biases in how investors use information, Inves- tors are said to place too much weight on current information, focusing myopically on short-term earn- ings, for example, while ignoring companies long- run propects, And stock prices accordingly are viewed as highly unreliable guides 10 corporate resource allocation and other important decisions, But, is behavioral finance the answer to the limita- tions of efficient markets theory? I don’t think so. First of all, the profit opportu- nities created by such alleged investor myopia seem grossly inconsistent with competitive markets. They are much to karge to be credible, thus casting doubt onthe research methods, Moreover, the failure of the vast majority of professional money managers (in- cluding contrarians as well as earnings momentum types) to outperform market averages with any degree of consistency should reinforce our skepti- cism about such claims Second, behavioral finance hi own, The extensive evidence of post-carnings-an- nouncement drift cited earlier means that investors place too little weight, not too much, on recent camings information, Showing that at theory has anomalies is one thing: replacing it with an anomaly- free theory is another Finally, behavioralists have also criticized the objectivity and openness of the research process over the 1960s and 70s, arguing that the process was slow to accept dissenting views. Benjamin Friedman for example, comments nomuilies of its 16 11 is no coincidence that the research [in support of efficient markets theory)...bas emerged almost entirely from the nation's business schools, From the perspective of the private-interest orientation of these instilutions, this identification # both understand able and appropriate. While Friedman is correct that the idea of efficiency arose in business schools, his further implication that the schools’ “private-interest orientation” influenced the research findings represents not just distortion, but in fact « complete inversion of the incentives of both researchers and teachers, In my experience, businessmen and MBA students have been more receptive to the message that there is gold in the streets than to the lesson that fiercely competitive financial markets climinate the easy opportunities for gain, Many critics of the literature on market effi ciency have suggested that it took too long to recognize anomalies, Consider this recent statement by Richard Thaler in his introduction to a collection of behavioralist studies in finance: The financial world as described in Eugene Fama’s 1970 efficient markets survey was one that bad no urgent need for people. Markets were effi- cienl, prices were unpredictable, and financial economists did not know how to spell’ the word anomaly. This statement, perhaps precisely because it is made from the secure vantage of hindsight, i strongly at odds with my own view of how the research evolved. In our 1968 paper cited at the beginning, Phil Brown and I mentioned anomalous evidence of post-earnings-announcement “drift” in prices. Since this was the second “event study” ever conducted (in the first, FEJR found no signs of anomalies) and was published just three years after the first time the words “efficient market” appeared in print, it seems that the efficient markets literature was not slow in introducing anomalous evidence. Moreover, the word “anomaly” was introduced to the financial economics literature in a paper 1 published in 1978 that surveyed a number of puz- dling findings related to earnings and dividends.** While that survey encountered some resistance and‘nts of the “GOs and Ys have helped transform the practice took two years to get published, other anomalies were uncovered in the meantime. Recognizing the pattern, Michael Jensen quickly put together an issue of the Journal of Financial Economics de- voted entirely to studies of anomalies that was published in the same year Overall, then, critics of the literature’s respon- siveness 0 anomalous results seem to have over- stated their ease. In retrospect, [am surprised by how quickly the literature embraced the idea of anoma- lies in the late 70s. We had much more difficulty convincing people that markets were efficient decade earlier, CONCLUDING OBSERVATIONS Are stock markets efficient? Yes and no. On the one hand, the research provides insights into stock price behavior that were previously unimaginable. On the other hand, as research has come to show, the theory of efficient markets is, like all theories, an imperfect and limited way of viewing stock markets. The issue will be impossible to solve conclusively while there are so many binding limitations to the asset pricing models that underlie empirical tests of market efficiency Our models of asset pricing began with the CAPM and thus have an accumulated history of only 30 years. With such a limited tradition in asset pricing, we could hardly expect to have a strong basis for concluding that security prices do (or do not) immediately restore equilibrium in response to new information, particularly in the presence of extreme uncertainty, Bearing such constraints in mind, I believe that much of the evidence on stock price behavior does not and cannot reliably address the factual issue of “efficiency” at this point in time. Our models of price equilibrium and our data are not yet up to the task. y that empirical research cannot be informative under these circumstances, We have learned a great deal from the “anomaly chasing” of the last decade, and there are enough puzzles and clues to work on for some time. Nevertheless, I do not believe that we can reliably learn much about whether (or to what extent) markets are efficient from these results, Do we have a better theory? I think not. But, as researchers comb through the evidence and seek more realistic ways of modelling stock price behavior, we are bound to improve the theory over time. Have we learned much from the theory of stock market efficiency? | think so, And I think this is a better question, The economic theory of competitive markets now seems unlikely to be dislodged from its central role in stock market research, for several reasons. First, stock markets must rank highly among markets on a priori likelihood of being competitive: there are no entry barriers; there are many buyers and sellers, who by and large appear to be greedy and enterprising people; and transaction costs are relatively low, Second, as outlined above, the inevi- tability of binding limitations in both our models of efficiency and in the available data provides a credible alternative explanation for the range of anomalies that have been documented over the last, decade. Third, | personally went through the trans- formation from the pre-EMH view of securities markets, and [am still impressed by how well prices respond to information, relative to what we expected thirty years ago. 53. R. Ball “Anomalies in Relationships Hetwoen Secures Vildh and Yel Sunogates”founnal of Financial ommies 6, (97), 108-126, 1 onrwed the ‘wor “anomaly” Irom Thomas Kuhn’ famrs book, The Sinctoe of Stent Revelations University of Chicas Press 1970), whit inteaduced the tenn othe * RAY BALL is Wesray Professor of Accountingat the University of Rochester's Simon School of Business, 17 Philosophy of sckence and scenic method. Kuhn's book, 1 might note, was pubblshed in dhe same years Faas review of the EMH iterature, and only eight Years before the Word appeased i the Financ economies hers VOLUMES NUMBER I # SPRING 1995