Fama, Business, College Term Papers.com


		Data Bases
		• Custom Term Papers • Free Term Papers • Free Research Papers • Free Essays • Free Book Reports • Plagiarism?

		Links
		• Top 100 Term Paper Sites • Top 25 Essay Sites • Top 50 Essay Sites • Search 97,000 Papers @ DirectEssays.com • Search 101,000 Papers @ ExampleEssays.com • Search 90,000 Papers @ MegaEssays.com

		Free Essays
		• Term Paper Sites • Chuck III's Free Essays • Free College Essays • TermPaperSites.com • My Term Papers • Get Free Essays • Essay World • Planet Papers

Search Lots of Essays

Back to Subjects - Business

Fama

Fama recent studies seem to suggest market inefficiency–specifically, long-term under reaction 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 under reaction 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 under reaction. 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 under reaction as the dominant phenomenon, while the random split predicted by market efficiency holds up rather well. Overreaction and Under reaction: 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. “Long-term return anomalies are sensitive to methodology.” I also classify the poor long-term post event 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 under reaction is about as frequent. The granddaddy of under reaction 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 under reaction produces positive post event abnormal returns for stock splits, stock tenders, and open market share repurchases. In these cases, the abnormal returns are attributed to under reaction to positive information. Finally, stock prices seem to under react to the negative information in dividend omissions and to the positive information when dividends are initiated. 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 under react 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 under reaction. 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. “The evidence for anomalies does not suggest that market efficiency should be abandoned.” 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 co-variation 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 under reaction 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. 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. Bibliography: recent studies seem to suggest market inefficiency–specifically, long-term under reaction 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 under reaction 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 under reaction. 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 under reaction as the dominant phenomenon, while the random split predicted by market efficiency holds up rather well. Overreaction and Under reaction: 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. “Long-term return anomalies are sensitive to methodology.” I also classify the poor long-term post event 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 under reaction is about as frequent. The granddaddy of under reaction 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 under reaction produces positive post event abnormal returns for stock splits, stock tenders, and open market share repurchases. In these cases, the abnormal returns are attributed to under reaction to positive information. Finally, stock prices seem to under react 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 under react 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 under reaction. 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. “The evidence for anomalies does not suggest that market efficiency should be abandoned.” 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 co-variation 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 under reaction 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.

Word Count: 1003