Behavioral Finance

CHAPTER 14

Predictability of Stock Prices: Fama-French Leads the Way

The 1992 article by Eugene Fama and Kenneth French1 lit a torch to the broad acceptance of the capital asset pricing model (CAPM) and dealt a substantial blow to the widespread support for the efficient market hypothesis (EMH). Fama and French are strongly associated with the EMH and have been two of its staunchest defenders. It was certainly not their intention to cast doubt upon the EMH, but the conclusion that stocks with high book-to-market values perform better than stocks with lower book-to-market values created a near revolution in the way academic finance and professional money management looked upon the EMH.

The simplest random walk version of the EMH, the martingale property of risk-adjusted stock returns, implies that returns are unpredictable. The conclusion from Fama-French ran counter to that and strongly implied that there was, indeed, predictability that could be gleaned from past data. That argument posed a serious threat to the EMH unless it could be found that unknown risk factors were the cause of the predictability, in which case the predictability would resolve itself via the efficient market's routine pricing of risk. In this chapter, we review the Fama-French research and discuss the ramifications for the EMH.

TESTING THE CAPITAL ASSET PRICING MODEL

The Fama-French agenda was to test whether or not the beta of the CAPM was a significant predictor of stock price returns. Earlier research ...