Chapter 8
Anomalies
I can calculate the motion of heavenly bodies but not the madness of people.
—Isaac Newton
If, as presented in Chapter 4, stock prices are basically a rational forecast of the present value of expected future dividends, then why do observed stock prices vary so much? In two influential papers, Robert Shiller (1981, 1984) argued that stock prices do not reflect values based solely on fundamentals. Had they, then the variability in stock prices would be roughly accounted for by the variability in the underlying fundamentals incorporated in earnings and dividends. Yet, stock prices often exhibit excessive volatility in the absence of news reflected in fundamentals (for example, the crash of October 1987). See Summers 1981 and Cutler et al. (1989) for more on this topic.
As we shall see further on, the documentation of significant departures in prices from fundamentals (so-called anomalies) and the attempt to attribute these departures to cognitive biases, limitations to arbitrage, and boundedly rational behavior has generated a large and diverse literature in behavioral finance. (For an excellent survey, see Barberis and Thaler 2003.) The seeds to this literature can be traced to tests of the CAPM, whose failure as a predictive model spawned the controversial literature on anomalies.
The CAPM that was developed in Chapter 5 posits a relationship between asset returns and the return to the market portfolio in an equilibrium setting in which supply and demand determine ...
