Check Yourself Before You Wreck Your Wealth: The Effects of the Business Cycle on Stock Market Efficiency

Abstract

The Efficient Markets Hypothesis (EMH) has been financial dogma since the 1970s. As a cornerstone of modern financial theory, the EMH influences many financial models and investment decisions. With varying levels of estimated efficiency, the EMH can be categorized into three forms: weak, semi-strong, and strong. Two defining characteristics of the EMH are that securities prices are accurate reflections of all available information, and above-average returns cannot be maintained without above-average risks. Essentially, this hypothesis maintains that investors cannot “beat the market.” I investigate the effects that the business cycle may have on efficiency in the U.S. stock market. The purpose of this research is to analyze market efficiency during expansions and contractions of the business cycle. Using historical monthly S&P 500 data returns as a benchmark, I examine monthly returns of a sample of mutual funds and ETFs. I compare these returns with the Capital Asset Pricing Model (CAPM) to determine the degree of efficiency throughout the business cycle.