Are Stock Markets Adaptive? Evidence from US, Hong Kong and India

Abstract

The study tests the adaptive market hypothesis for the US (Dow Jones and S&P 500), Hong Kong (Hang Seng) and Indian (BSE Sensex) stock markets by testing the 20 years of daily and the weekly data for the return predictability. The indices exhibit the time varying realized risk premia, and the time varying risk return characteristic (Sharpe ratio), indicating that risk preferences are adaptive to the changing market conditions. We also test the time varying return predictability by applying the Ljung - Box test and the Chow - Denning heteroscedasticity consistent variance ratio test to the fixed length moving sub-sample windows of 100, 200, 300 and 500 days and 25, 50 and 100 weeks. We find the evidence of the changing return predictability for all the indices and for all the sub-sample window sizes. Despite the significant correlation between the log returns of the indices, barring Dow Jones and S&P 500, for the weekly data, the periods of the return predictability of the indices do not coincide. For the daily data, the return predictability for the US and the Indian stock markets coincided during the sub-prime crisis of 2008. The heteroscedasticity consistent Chow - Denning statistic is a better measure for comparing the relative market efficiency between the stock markets. This statistic is robust to the sub-sample window size and data frequency i.e. weekly or daily data. This statistic indicates that the periods of return predictability are sparse and hence an active investment management could add value by implementing appropriate trading strategies in the periods of the return predictability. For the period considered, the relative efficiency of Indian stock market is comparable to that of the US stock market.