Asymmetric Fads and Inefficient Plunges: Evaluating the Adaptive versus Efficient Market Hypotheses

We propose the concept of inefficient plunges to characterize asymmetric deviations of market price from the efficient price with the aim of examining the efficient market hypothesis. To gauge market inefficiency, we present an asymmetric Fads model, which allows for both inefficient plunges in the transitory component and a switching variance in the permanent component by embedding a Markov-switching process in an unobserved components model. Applying the model to the S&P 500 and the FTSE 350 reveals that inefficient plunges are deep, steep, and transient. This finding suggests that market inefficiency is a regime-dependent and asymmetric phenomenon, meaning that although the U.S. and U.K. stock markets are efficient during normal times, they are considerably below efficient prices during crises. Overall, the asymmetric Fads model proposed in this study supports the adaptive market hypothesis and casts doubt on the efficient market hypothesis.