Critique of Asset Pricing Circularity

Abstract:     
This theoretical paper investigates the phenomenon of asset pricing models which specify explanatory variables that are not independent of the variable to be explained. Such logically circular asset pricing models reduce to either economically- meaningless tautologies and or scientifically-invalid market- generated autoregressions, a.k.a. market timing. These tautology and timing implications need to be made explicit. So-called firm "size" (market value of equity) and so-called "value" (book-to-market value ratio) are two of the best known variables that are circular in models that seek to explain total return. Circular models are based on intellectual speculation and not on fact. Theoretical, methodological, empirical and clinical arguments support this conclusion.

JEL Classification: G12, C14, C12

working papers series