In studies of long-term stock return anomalies, overreaction to new information
is as common as underreaction, and postevent continuation is as frequent as
postevent reversal. This finding is consistent with market efficiency. Many of
the apparent anomalies disappear when a different model of normal returns or
different statistical method is used. Taken together, the studies of return
anomalies do not provide reason to reject market efficiency.
A growing body of literature reports anomalies in long-term share returns. These abnormal
returns are usually interpreted as evidence of market inefficiency because they seem to
indicate that the market overreacts or underreacts to new information.
Fama reviews this literature and finds a roughly even split between studies finding
overreaction and studies finding underreaction, which he argues is consistent with
efficiency. In an efficient market, the expected value of abnormal returns is zero.
Chance generates some apparent anomalies, evenly split between overreaction and
underreaction.
Fama also criticizes the studies because they rarely test an alternative
return-generating model to the efficiency model. He finds two studies that present
alternative models; both models predict short-term continuation in share returns and
long-term reversal in the returns. Fama reviews the results from these studies of return
anomalies. He finds a pattern consistent with that predicted by the two models in terms
of long-term return reversals and also returns to contrarian investment strategies,
seasoned equity offerings, new exchange listings, and acquiring firms in mergers. This
pattern is not the norm because studies of dividend initiations, dividend omissions,
stock splits, proxy contests, and spin-offs show the opposite pattern—long-term
return continuation.
One of the models predicts that the announcement effect of certain events will be of the
same sign as the subsequent abnormal long-term returns. Fama finds this pattern in
studies of seasoned equity offerings, dividend initiations, dividend omissions, share
repurchases, stock splits, and spin-offs. He does not find this pattern for new exchange
listings, proxy fights, initial public offerings, and acquiring firms in mergers. The
two models are good at predicting the effects of some events and not others, and there
is no explanation when they will work. A valid model should produce predictions that
capture the anomalous effects of events better than market efficiency could. The
existing models fail in this regard.
Fama discusses some of the technical problems of drawing inferences about long-term
returns. Studies of abnormal returns require a model of normal returns. With an increase
in the return horizon, errors from bad-model specification will grow at a faster rate
than the volatility of returns. Bad-model problems thus cause particularly severe
problems for long-term return studies.
Fama concludes with a discussion of individual anomaly studies. He shows that the
anomalies reported in these studies disappear or become marginal if different models of
normal returns are used or different statistical models are used to study the effects.
Taken together, the studies reporting anomalies in long-term returns do not provide a
reason to reject market efficiency.