Predictability of Asset Returns and the E¢ cient Market Hypothesis

This paper is concerned with empirical and theoretical basis of the E¢ cient Market Hypothesis (EMH). The paper begins with an overview of the statistical properties of asset returns at di¤erent frequencies (daily, weekly and monthly), and considers the evidence on return predictability, risk aversion and market e¢ ciency. The paper then focuses on the theoretical foundation of the EMH, and show that market e¢ ciency could co-exit with heterogeneous beliefs and individual irrationality so long as individual errors are cross sectionally weakly dependent in the sense de…ned by Chudik, Pesaran, and Tosetti (2010). But at times of market euphoria or gloom these individual errors are likely to become cross sectionally strongly dependent and the collective outcome could display signi…cant departures from market e¢ ciency. Market e¢ ciency could be the norm, but it is likely to be punctuated with episodes of bubbles and crashes. The paper also considers if market ine¢ ciencies (assuming that they exist) can be exploited for pro…t. Keywords: Market E¢ ciency, Predictability, Heterogeneity of Expectations, Forecast averaging, Equity Premium Puzzle JEL classi…cations: G12, G14 I am grateful to Elisa Tosetti for valuable help with the preparation of this paper, and to Alex Chudik, Bill Janeway, Ron Smith, Ansgar Walther, and Aman Ullah for helpful comments. Part of this paper is based on my presentation at the CFS symposium "Market E¢ ciency Today" held in Frankfurt/Main on October 6, 2005 in honor of Eugene F. Fama.