Does the Stock Market Rationally Reflect Fundamental Values

This paper examines the power of statistical tests commonly used to evaluate the efficiency of speculative markets. It shows that these tests have very low power. Market valuations can differ substantially and persistently from the rational expectation of the present value of cash flows without leaving statistically discernible traces in the pattern of ex-post returns. This observation implies that speculation is unlikely to ensure rational valuations, since similar problems of identification plague both financial economists and would be speculators. THE PROPOSITION THAT securities markets are efficient forms the basis for most research in financial economics. A voluminous literature has developed supporting this hypothesis. Jensen [10] calls it the best established empirical fact in economics.1 Indeed, apparent anomalies such as the discounts on closed end mutual funds and the success of trading rules based on earnings announcements are treated as indications of the failures of models specifying equilibrium returns, rather than as evidence against the hypothesis of market efficiency.2 Recently the Efficient Markets Hypothesis and the notions connected with it have provided the basis for a great deal of research in macroeconomics. This research has typically assumed that asset prices are in some sense rationally related to economic realities. Despite the widespread allegiance to the notion of market efficiency, a number of authors have suggested that certain asset prices are not rationally related to economic realities. Modigliani and Cohn [14] suggest that the stock market is very substantially undervalued because of inflation illusion. A similar claim regarding bond prices is put forward in Summers [20]. Brainard, Shoven and Weiss [4] find that the currently low level of the stock market could not be rationally related to economic realities. Shiller [16, 17] concludes that both bond and stock prices are far more volatile than can be justified on the basis of real economic events. Arrow [2] has suggested that psychological models of "irrational decision making" of the type suggested by Tversky and Kahneman [22] can help to explain behavior in speculative markets. These types of claims are frequently