A Rational Pricing Explanation for the Failure of the CAPM

ciency hypothesis by Fama (1970), Fama and French (1989) argue that stock market returns are predictable. There is also evidence of the predictability in the cross section of stock returns, which casts doubt on the widely accepted CAPM by Sharpe (1964) and Lintner (1965). In particular, Fama and French (1992, 1993) report that value stocks, stocks of high book-to-market value ratio, have much higher riskadjusted returns than growth stocks, stocks of low book-to-market value ratio. Also, Jegadeesh and Titman (1993) show that the momentum strategy of buying the past winners and selling the past losers is quite profitable. The advocates of the market efficiency hypothesis argue quite convincingly that many of these anomalies can be attributed to data snooping. For example, if we experiment with a large number of macro variables, it should not be a surprise that a few of them might be correlated with future stock market returns by chance. However, investors cannot profit from such an ex post relation if it does not persist in the future. Indeed, Bossaerts and Hillion (1999), among others, find that, although the variables uncovered by the early authors forecast stock returns in sample, their out-of-sample predictive power is negligible. Similarly, Schwert (2002), among others, finds that many trading strategies, which have been found to generate abnormal returns, were unprofitable in the past decade. Overall, Malkiel (2003) asserts that there is no reliable evidence of persistent stock return predictability and the U.S. equity market is remarkably efficient in the sense that abnormal returns disappear quickly after they are discovered. Some anomalies, however, cannot be easily discarded as data snooping. Jegadeesh and Titman (2001) and Schwert (2002) find that the momentum strategy remained highly profitable in the 1990s, one decade after it was published in academic jourA Rational Pricing Explanation for the Failure of the CAPM