The originaltheoretical arguments put forward in favor of effi-cient markets were based on the notion of stabiliz-ing speculation in the form of arbitrage (Friedman,1953). Simply put, arbitrage is “the simultaneouspurchase and sale of the same, or essentially similar,security in two different markets for advantageouslydifferent prices” (Sharpe and Alexander, 1990). Intheory, a perfectly hedged trading position of thissort could be executed at no cost (as the short-saleproceeds are used to finance the long position).Vigilant traders on the look-out for just such arbi-trage opportunities would ensure that no one couldconsistently “beat the market”—the hallmark ofefficient markets theory.The academics’ logical case for efficient marketsboils down to a pair of simple rhetorical questions:Why would utility-maximizing traders leave unex-ploited any profitable opportunities (after adjustingproperly for risk)? And if no risk-adjusted “freelunches” exist, how could market prices be predict-able enough to make money? For several decades,empirical evidence piled up both for and againstmarket efficiency. As of the early 1990s, neitherside could claim total vindication. As the 1990sprogressed, however, the weight of the evidenceseemed to tip toward those who claimed asset priceswere, at least to some extent, predictable (Campbell,Lo, and MacKinlay, 1997, Chaps. 2 and 7).The academic asset-pricing literature today isdominated by attempts to explain why and to whatextent the price movements of financial assets arepredictable. One potential explanation of stock-return predictability is that markets are efficient(“no free lunch”) but expected returns are time-varying, perhaps being linked to the business cycle.For example, expected returns may be highest wheneconomic risks are perceived to be high, such as ator near the bottom of a business cycle. Conversely,expected returns may be lowest when economicrisks are perceived to be low, at or near a business-cycle peak. Thus, the simple random-walk modelof stock returns may be false, but a relevant notionof market efficiency survives because high returnsare earned only by taking large amounts of risk. Adifferent type of explanation of return predictabilityrejects market efficiency and focuses on marketimperfections of various sorts, such as incompletestock-market participation by households, signifi canttransactions costs, changes in investor sentiment,or limited wealth and liquidity resources to conductarbitrage (as in the current article).