Three new perspectives for testing stock market efficiency

Tests of market efficiency investigate whether the: a) cross-section of stock returns, b) time-series of stock returns and c) stock price volatility, are different from that implied by an equilibrium model governing stock returns. In this regard, my dissertation contains three essays exploring each of these methodologies from new perspectives. My first essay uses a competitive equilibrium model that links stock returns to the firm's operating risk and efficiency. The model implies that, ceteris paribus, an increase in operating risk decreases the firm's efficiency and increases expected stock returns. The empirical results strongly support the model's predictions and much of the book-to-market effect is subsumed by the operating efficiency measure. The second essay focuses on the time series patterns of returns. It investigates the efficacy of simple and common technical trading strategies. The results show that the success of trading strategies declines sharply with an increase in firm size, supporting the hypothesis that technical analysis is most appropriate for smaller stocks. Technical strategies applied to smaller stocks earn excess average monthly returns of 1.7 %, even after adjusting for aggregate risk factors such as market, size, book-to-market, momentum, and liquidity. The results are robust when adjusted for time varying expected returns, transactions costs, and nonsynchronous trading. In contrast, when applied to large stocks, such strategies do not earn excess returns over a buy and hold strategy, implying that pricing is effcient only for large stocks. The third essay re-examines the excess "volatility puzzle". Earlier evidence rejected the EMH by showing that stock prices are too volatile to be determined by expected discounted value of cash dividends. This essay tests a rational expectations present value model which implies that volatility of equilibrium stock price is the volatility of stock prices under the standard present value relation plus the variance of the firm's cash holdings.