Market Rationality
In the prior sections we discussed the speed with which information is incorporated in »hare price. We referred to this as "informational efficiency." A number of authors are also concerned with whether prices accurately reflect investors' expectations about the present \alue of future cash flows. We will refer to this hypothesis as market rationality to distinguish it from informational efficiency, while recognizing that some authors use the word efficiency" to apply to both ideas. If markets exhibit rationality, there should be no systematic differences between share prices and the value of the security based on the present value of the cash flow to security nolders. Much of the evidence on informational efficiency bears on market rationality. For example, if prices can be shown to respond to noneconomic variables such as stock splits, ihis would be powerful evidence against market rationality.
The existence of excess return as a function of firm characteristics and time patterns in security returns provides evidence against market rationality. Examples of these relation-hips include the size effect, the market/book effect, the January effect, and the day of the week effect. For informational inefficiency it is necessary to show that a profitable trading trategy (including trading costs) can be constructed to exploit the anomaly. However, the mere presence of a persistent anomaly calls into question market rationality.
The major direct evidence on stock market rationality involves volatility tests, stock market crashes, and tests of market overreaction. Each will be discussed in turn.
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