Introduction

The proposition that securities markets are efficient forms the basis for most research in financial economics. A voluminous literature has developed supporting this hypothesis. Jensen (1978) calls it the best established empirical fact in economics. Indeed, apparent anomalies such as the discounts on closed end mutual funds and the success of trading rules based on earnings announcements are treated as indications of the failures of models specifying equilibrium returns, rather than as evidence against the hypothesis of market efficiency. Recently the Efficient Markets Hypothesis and the notions connected with it have provided the basis for a great deal of research in macro–economics. This research has typically assumed that asset prices are in some sense rationally related to economic realities.

Despite the widespread allegiance to the notion of market efficiency a number of authors have suggested that certain asset prices are not rationally related to economic realities. Modigliani and Cohn (1979) suggest that the stock market is very substantially undervalued because of inflation illusion. A similar claim regarding bond prices is put forward in Summers (1983). Brainard, Shoven and Weiss (1980) found that the then low level of the stock market could not be rationally related to economic realities. Shiller (1979 and 1981a) concludes that both bond and stock prices are far more volatile than can be justified on the basis of real economic events.