Market Efficiency

I love it when people place creative names on otherwise boring academic papers (Katz is one of the best).

Case Closed by Haugen

Great review by Empirical Finance here.  The problem is that every quant with a FactSet subscription knows what factors outperform.  If you pull up a symbol of a highly rated multi-factor stock (say, CORE, AEA, etc) you see all the same holders – AQR, Rentec, DFA, LSV, etc.  So, what is the edge here?  Before it was unique acess to data, but now?  Hmmph.

This article provides conclusive evidence that the U.S. stock market is highly inefficient. Our results, spanning a 45 year period, indicate dramatic, consistent, and negative payoffs to measures of risk, positive payoffs to measures of current profitability, positive payoffs to measures of cheapness, positive payoffs to momentum in stock return, and negative payoffs to recent stock performance. Our comprehensive expected return factor model successfully predicts future return, out of sample, in each of the forty-five years covered by our study save one. Stunningly, the ten percent of stocks with highest expected return, in aggregate, are low risk and highly profitable, with positive trends in profitability. They are cheap relative to current earnings, cash flow, sales, and dividends. They have relatively large market capitalization and positive price momentum over the previous year. The ten percent with lowest expected return (decile 1) have exactly the opposite profile, and we find a smooth transition in the profiles as we go from 1 through 10. We split the whole 45-year time period into five sub-periods, and find that the relative profiles hold over all periods. Undeniably, the highest expected return stocks are, collectively, highly attractive; the lowest expected return stocks are very scary – results fatal to the efficient market hypothesis. While this evidence is consistent with risk loving in the cross-section, we also present strong evidence consistent with risk aversion in the market aggregate’s longitudinal behavior. These behaviors cannot simultaneously exist in an efficient market.