Stock Market Prices Do Not Follow Random Walks : Evidence from a Simple Specification Test

SINCE KEYNES' (1936) NOW FAMOUS PRONOUNCEMENT that most investors' decisions "can only be taken as a result of animal spirits-of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of benefits multiplied by quantitative probabilities," a great deal of research has been devoted to examining the efficiency of stock market price formation . In Fama's (1970) survey, the vast majority of those studies were unable to reject the "efficient markets" hypothesis for common stocks . Although several seemingly anomalous departures from market efficiency have been well documented, I many financial economists would agree with Jensen's (1978a) belief that "there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Markets Hypothesis ." Although a precise formulation of an empirically refutable efficient markets hypothesis must obviously be model-specific, historically the majority of such tests have focused on the forecastability of common stock returns . Within this paradigm, which has been broadly categorized as the "random walk" theory of stock prices, few studies have been able to reject the random walk model statistically. However, several recent papers have uncovered empirical evidence which suggests that stock returns contain predictable components. For example, Keim and Stambaugh (1986) find statistically significant predictability in stock prices by using forecasts based on certain predetermined variables . In addition, Fama and French (1988) show that