Some Anomalous Evidence Regarding
Market Efficiency

Michael C. Jensen
Harvard Business School
MJensen@hbs.edu

Abstract
The efficient market hypothesis has been widely tested and, with few exceptions, found consistent
with the data in a wide variety of markets: the New York and American Stock Exchanges, theAustralian, English, and German stock markets, various commodity futures markets, the Over-theCounter markets, the corporate and government bond markets, the option market, and the market
for seats on the New York Stock Exchange. Yet, in a manner remarkably similar to that describedby Thomas Kuhn in his book, The Structure of Scientific Revolutions, we seem to be entering astage where widely scattered and as yet incohesive evidence is arising which seems to beinconsistent with the theory. As better data become available (e.g., daily stock price data) and as
our econometric sophistication increases, we are beginning to find inconsistencies that our cruder
data and techniques missed in the past. It is evidence which we will not be able to ignore.
The purpose of this special issue of the Journal of Financial Economics is to bring together anumber of these scattered pieces of anomalous evidence regarding Market Efficiency. As Ball(1978) points out in his survey article: taken individually many scattered pieces of evidence on thereaction of stock prices to earnings announcements which are inconsistent with the theory don’tamount to much. Yet viewed as a whole, these pieces of evidence begin to stack up in a manner
which make a much stronger case for the necessity to carefully review both our acceptance of theefficient market theory and our methodological procedures.
Keywords: market efficiency, Efficient Market Theory, theory of ‘random walks’, rational
expectations theory, abnormal returns, asset pricing model.

Journal of Financial Economics, Vol. 6, Nos. 2/3 (1978) 95-101.

© M. C. Jensen 1978

This document is available on theSocial Science Research Network (SSRN) Electronic Library at:

http://papers.ssrn.com/ABSTRACT_ID=244159

Last modified: July 2002

Some Anomalous Evidence Regarding Market Efficiency
Michael C. Jensen
Harvard Business School
Mjensen@hbs.edu
Journal of Financial Economics, Vol. 6, Nos. 2/3 (1978) 95- 101.

1. Why a special issue on market efficiency?
I believe there is no other proposition in economics which has more solid
empirical evidence supporting it than the Efficient Market Hypothesis. That hypothesis
has been tested and, with very few exceptions, found consistent with the data in a wide
variety of markets: the New York and American Stock Exchanges, the Australian,English, and German stock markets, various commodity futures markets, the Over-theCounter markets, the corporate and government bond markets, the option market, and themarket for seats on the New York Stock Exchange. Yet, in a manner remarkably similar
to that described by Thomas Kuhn in his book, The Structure of Scientific Revolutions,
we seem to be entering a stage where widely scattered and as yet incohesive evidence isarising which seems to be inconsistent with the theory. As better data become available(e.g., daily stock price data) and as our econometric sophistication increases, we are
beginning to find inconsistencies that our cruder data and techniques missed in the past. It
is evidence which we will not be able to ignore.
The purpose of this special issue of the Journal of Financial Economics is to bring
together a number of these scattered pieces of anomalous evidence regarding MarketEfficiency. As Ball (1978) points out in his survey article: taken individually many
scattered pieces of evidence on the reaction of stock prices to earnings announcements
which are inconsistent with the theory don’t amount to much. Yet viewed as a whole,these pieces of evidence begin to stack up in a manner which make a much stronger caseJensen21978

for the necessity to carefully review both our acceptance of the efficient market theory
and our methodological procedures.
It is my hope that bringing the studies contained in this volume together in one
place will help to highlight and hasten the progress of what I believe is a coming minirevolution in the field. Focusing the attention of scholars throughout the world on these
disturbing pieces of evidence will, I hope, result in the resolution of the questions theyraise.
In most cases our tests of market efficiency are, of course, tests of a joint
hypothesis; market efficiency and, in the more recent tests, the two parameter equilibrium
model of asset price determination. The tests can fail either because one of the twohypotheses is false or because both parts of the joint hypothesis are false. The pieces ofevidence contained in this issue are particularly interesting in view of this jointness andthe recent criticisms of our asset pricing models.1 The eventual resolution of theseanomalies will result in more precise and more general theories of market efficiency andequilibrium models of the determination of asset prices under uncertainty.
2. The efficient market hypothesis
The Efficient Market Hypothesis is an important concept, and it has become
increasingly widely accepted since interest in it was reborn in the late 1950’s and early
1960’s under the rubric of the ‘theory of random walks’ in the finance literature and‘rational expectations theory’ in the mainstream economics literature.
Indeed, the Efficient Market Hypothesis progressed from the state of a curiosity
taken seriously by only a few scientists in the economics and finance communities, tothat of a dominant paradigm in finance and the basis of an emerging revolution in
macroeconomics (where the principle is still generally referred to as rational

1See Fama (1976, chs. 5 and 9) and Roll (1977) for more details of these criticisms. Fama (1976)
provides a detailed discussion of the nature of the joint hypothesis in tests of market efficiency.

Jensen31978expectations). In the literature of finance, accounting, and the economics of uncertainty,
the Efficient Market Hypothesis is accepted as a fact of life, and a scholar who purports
to model behavior in a manner which violates it faces a difficult task of justification.
The Efficient Market Hypothesis is in essence an extension of the zero profit
competitive equilibrium condition from the certainty world of classical price theory to thedynamic behavior of prices in speculative markets under conditions of uncertainty. The
proposition has been stated in many ways, but I believe the simplest and most general
way to express it is the following:
A market is efficient with respect to information set θ t if it is impossible to makeeconomic profits by trading on the basis of information set θ t .
By economic profits, we mean the risk adjusted returns net of all costs. Application of thezero profit condition to speculative markets under the assumption of zero storage costs2
and zero transactions costs gives us the result that asset prices (after adjustment forrequired returns) will behave as a martingale3 with respect to the information set θ t .
Several versions of the Efficient Market Hypothesis have been widely discussed
and tested in the literature. The differences revolve primarily around the definition of theinformation set θ t used in those tests. The three broad categories of hypotheses whichhave developed are:(1) The Weak Form of the Efficient Market Hypothesis, in which the information set θ tis taken to be solely the information contained in the past price history of the market
as of time t.

2For markets such as the stock, bond and commodity futures markets zero storage costs are a goodapproximation to reality. In these cases it is the certificates or sometimes only the record of ownershipwhich is being ‘stored’.
3()()

That is E P t + 1 θ t = P t 1 + ρ t , where ρ t is the required return on the asset for period t andE( P t +1 θ t ) is the expected end of period price conditional on knowledge of the information set θ t .

Jensen41978(2) The Semi-Strong Form of the Efficient Market Hypothesis, in which θ t mistaken tobe all information that is publicly available at time t. (This includes, of course, thepast history of prices so the weak form is just a restricted version of this.)(3) The Strong Form of the Efficient Market Hypothesis, in which θ t is taken to be all
information known to anyone at time t.
Version 3, the Strong Form of the Efficient Market Hypothesis, is an extremeform which few people have ever treated as anything other than a logical completion of
the set of possible hypotheses. Although there is evidence inconsistent with the Strong
Form of the Efficient Market Hypothesis, if there is anything surprising about it, it is thefact that such inconsistent evidence is so scarce.
Version 2, the Semi-strong Form of the Efficient Market Hypothesis, represents
the accepted paradigm and is what is generally meant by unqualified references in theliterature to the ‘Efficient Market Hypothesis.’ Of course, the precise meaning of‘publicly available’ must be defined to give the hypothesis content. In specific tests thatdefinition is usually made clear, but exactly where those boundaries are in a general sense
is something that will profitably receive more attention in the future.
3. The contents of the issue
In his survey paper ‘Anomalies in Relationships Between Securities’ Yields andYield-Surrogates’, Ball (1978) examines the evidence contained in 20 previous studies ofstock price reaction to earnings announcements. He finds that the post-announcement risk
adjusted abnormal returns are systematically non-zero in the period following earnings
announcements in a fashion inconsistent with market efficiency. Ball argues that the nonzero abnormal returns are due to inadequacies in the two parameter asset pricing model
used in the studies to adjust for risk differentials and not to inefficiencies in the pricing ofshares. He provides methodological suggestions for reducing the estimation bias due toinadequacies in the asset pricing model.

Jensen51978

Watts (1978) in his paper ‘Systematic ‘Abnormal’ Returns After Quarterly
Earnings Announcements’ finds statistically significant abnormal returns even after
taking all the steps suggested by Ball. He then goes on to provide the first explicit test todetermine whether those abnormal returns emanate from market inefficiency or fromdeficiencies in the asset pricing model. He concludes that the abnormal returns are due tomarket inefficiencies and not asset pricing model deficiencies. However, theinefficiencies occurred only in the period 1962-1965, and not in the period 1965-1968.
Furthermore, after allowance for transactions costs, only a broker could have earned
economic profits in the 1962-1965 period.
Thompson (1978) in his study of ‘The Information Content of Discounts andPremiums on Closed-End Fund Shares’ finds that a relatively simple trading rule (basedon discounts for closed-end funds) earned statistically significant abnormal returns ofabout 4%, per year over the period 1940-1971. In addition, the results are quite uniform
throughout the period. Thompson is unable to distinguish, on the basis of the evidence,
whether the abnormal returns are due to market inefficiencies or inadequacies of the twoparameter asset pricing model. He argues that the abnormal returns are likely to be due toinadequacies of the asset pricing model and not to market inefficiency since the data on
the closed end fund discounts was widely available over the entire period and extensively
discussed in the professional press.
Galai (1978) in his paper ‘Empirical Tests of Boundary Conditions for CBOE
Options’ tests (1) whether the prices of stocks on the NYSE and the prices of theirrespective call options on the Chicago Board Options Exchange behave as a single
synchronized market, and (2) whether profits could have been made through a trading
rule on call options on the CBOE and their respective stocks on the NYSE. He finds thatthe two markets do not behave as a single synchronized market. In addition, he finds that
positive profits (ignoring risk differentials) could have been made from the trading rule(which is based on violations of the lower boundary condition of the option price).

Jensen

61978

However, the average profit is small relative to the dispersion of the outcomes, and it
appears that most of this would be wiped out by transactions costs for non-members ofthe exchange.
Chiras and Manaster (1978) in their study of ‘The Information Content of OptionPrices and a Test of Market Efficiency use the Black-Scholes-Merton option pricing
model and actual option prices to calculate implied variances of future stock returns.
These variances prove to be better predictors of future stock return variances than thoseobtained from historical stock price data. In addition, a trading strategy that utilizes theinformation content of the implied variances yields abnormally high returns, and thereturns appear to be high enough to allow profits even for non-members of the exchange.
Chiras and Manaster conclude that in the period covered by their data, June 1973 to April
1975, the prices of options on the Chicago Board Options Exchange provided theopportunity to earn economic profits and, therefore, that the CBOE market wasinefficient.
In his paper ‘The Market Valuation of Cash Dividends: A Case to Consider’,Long (1978) examines the history of the relative prices of two classes of stock of theCitizens Utilities Company. The two classes are virtually identical in all respects except
for dividend payout: one pays only stock dividends and the other pays only cashdividends. The stock dividends are not taxable as ordinary income under a 1955 IRS
ruling and a grandfather clause in the 1969 Tax Reform Act. Thus, this company provides
a unique laboratory-type experiment in which we can observe the effects on market
prices of cash dividend policies. The evidence indicates that the market prices assets insuch a way that it places a slight premium on cash dividends over capital gains. Thus, thecase provides strong evidence which is inconsistent with the famous dividend irrelevanceproposition of Modigliani and Miller (1961). In addition, for all practical purposes, most
holders of the cash dividend-paying shares of Citizens Utilities could realize an almost
perfectly correlated but higher after-tax return by holding the non-cash dividend-paying

Jensen71978

shares. That is, the price difference between the two classes of shares goes in the opposite
direction to that predicted by straightforward consideration of tax effects. This implies
that either (1) the market is inefficient, or (2) the two parameter asset pricing model isdeficient in that it does not take account of an apparently significant demand for cash
dividends (in spite of a lower after-tax total return to recipients of such dividends). At thistime we know of no rational motivation for such a demand for cash dividends. Because,
however, of the wide publicity accorded the Citizens Utility situation in the financialpress in the past and the widely supporting evidence for market efficiency, Long (likeBall and Thompson in their studies) concludes that the explanation for the phenomenon
lies in the inadequacy of the two parameter valuation model.4
In his two-part study on ‘Split [and Dividend] Information, Stock Returns andMarket Efficiency’, Charest (1978a; 1978b) examines a variety of methodological issues
associated with the techniques of estimating abnormal returns. He applies thesetechniques to the proposals, approvals, and realizations of stock splits and to theannouncement of cash dividend changes in common stocks on the NYSE over the period
1947-1967. The evidence from the stock split study shows some indication of non-zeroabnormal returns, but they are sensitive to the precise estimation techniques used and theparticular time intervals covered. Charest concludes that the evidence on market priceadjustment to stock splits is generally consistent with market efficiency.
Charest’s findings with respect to the market price reaction to changes in cash
dividend are, however, quite different from the stock split results. His evidence reveals
significant abnormal returns in the months following dividend changes. Furthermore,unlike the split results, the abnormalities are not sensitive to the particular estimation
procedure used. On average the prices of stocks on the NYSE under-react to the4Tax effects can be quite complex. Further analysis of these effects, such as that by Miller and Scholes
in their paper ‘Dividends and Taxes’ (1978, pp. 333-364), may well be important to a complete
understanding of Long’s results.

Jensen81978

announcement of dividend changes—particularly decreases. That is, it takes aconsiderable period of time after the announcement for the full impact of the dividendchange to be impounded in stock prices. Again, the evidence is inconsistent with the joint
hypothesis that the market is efficient in the Semi-strong Form sense and that asset pricedetermination is adequately described by the two parameter model. Charest is unable todetermine the exact cause of the abnormal returns.
4. Conclusions?
It would be presumptuous as well as foolhardy for me to attempt to reconcile themany issues raised by the studies contained in this Symposium. The studies viewed
individually are interesting, stimulating, and puzzling. Unlike much of the ‘inefficiency
literature’ of the past, each and every one of these studies is a carefully done scientificpiece. Each of the authors displays in varying degrees a commonly held allegiance to theEfficient Market Hypothesis—witness the general reluctance to reject the notion ofmarket efficiency.
Viewed as a whole, however, the studies provide a powerful stimulus and serve tohighlight the fact that there are inadequacies in our current state of knowledge. My
reaction to this is one of excitement and enthusiasm. I have little doubt that in the next
several years we will document further anomalies and begin to sort out and understandtheir causes. The result will not be abandonment of the ‘efficiency’ concept, nor of asset
pricing models. Five years from now, however, we will as a profession have a muchbetter understanding of these concepts than we now possess, and we will have a much
more fundamental understanding of the world around us. I intend to do my best to seethat the Journal of Financial Economics continues to play a positive role in this process.

Jensen

91978

References

Ball, Ray. 1978. "Anomalies in Relationships Between Securities' Yields and Yieldsurrogates." Journal of Financial Economics 6, no. 2/3: pp 103-126.
Charest, Guy. 1978a. "Dividend Information, Stock Returns and Market Efficiency-II."
Journal of Financial Economics 6, no. 2/3: pp 297-330.
Charest, Guy. 1978b. "Split Information, Stock Returns and Market Efficiency-I."
Journal of Financial Economics 6, no. 2/3: pp 265-296.
Chiras, Donald P. and Steven Manaster. 1978. "The Information Content of Option Prices
and a Test of Market Efficiency." Journal of Financial Economics 6, no. 2/3: pp213-234.
Fama, Eugene F. 1976. Foundations of Finance. New York: Basic Books.
Galai, Dan. 1978. "Empirical Tests of Boundary Conditions for CBOE Options." Journalof Financial Economics 6, no. 2/3: pp 187-211.
Kuhn, Thomas S. 1970. The Structure of Scientific Revolutions. Chicago, IL: Universityof Chicago Press.
Long, John B., Jr. 1978. "The Market Valuation of Cash Dividends: A Case to Consider."Journal of Financial Economics 6, no. 2/3: pp 235-264.
Miller, Merton H. and Franco Modigliani. 1961. "Dividend Policy, Growth and theValuation of Shares." Journal of Business 34: October, pp 411-433.
Miller, Merton H. and Myron Scholes. 1978. "Dividends and Taxes." Journal ofFinancial Economics 6, no. 4: pp 333-364.
Roll, Richard. 1977. "A Critique of the Asset Pricing Theory's Tests; Part I: On Past andPotential Testability of the Theory." Journal of Financial Economics 4: pp 129176.
Thompson, Rex. 1978. "The Information Content of Discounts and Premiums on Closedend Fund Shares." Journal of Financial Economics 6, no. 2/3: pp 151-186.
Watts, Ross L. 1978. "Systematic 'Abnormal' Returns After Quarterly Earnings
Announcements." Journal of Financial Economics 6, no. 2/3: pp 127-150.