How Efficient Markets Undervalue Stocks: CAPM and Ecmh Under Conditions of Uncertainty and Disagreement

Abstract

Taken together, the Efficient Capital Markets Hypothesis (ECMH) and the Capital Asset Pricing Model (CAPM) appear to predict that the market price of a security in an efficient market should reflect the best possible estimate of its fundamental value. Although this notion once exercised great influence among both finance theorists and legal scholars, closer inspection reveals it to be tautological: because the CAPM rests on an assumption that all investors make identical estimates of securities' future risks and returns, it naturally predicts that market prices reflect that consensus. More recent work in finance examines what happens to securities prices when investors hold disagreeing expectations for the future. This "heterogeneous expectations" literature offers to resolve a number of the mysteries that have plagued scholars who rely on the conventional ECMH/CAPM. In illustration, this paper presents a simple heterogeneous expectations pricing model premised on investor disagreement, risk aversion, and short sales restrictions. The model explains at least the following market puzzles: (1) why many investors don't diversify; (2) why target shareholders receive large premiums in corporate takeovers while bidding firms' share prices remain relatively unchanged; (3) why certain anomalous classes of securities, including neglected stocks, low P/E stocks, and low- beta stocks, offer superior risk-adjusted returns relative to the market; (4) why stock buyback programs and dividend payments support stock prices while stock issues depress market prices; and (5) how certain actively managed investment funds, Berkshire Hathaway chief among them, can consistently beat the market over long periods.

JEL Classification: G11, G12, G14