DP14235 Market Efficiency in the Age of Big Data

Author(s): Ian Martin, Stefan Nagel
Publication Date: December 2019
Keyword(s): Big Data, Machine Learning, Market Efficiency
JEL(s): C11, C12, C58, G10, G12, G14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14235

Modern investors face a high-dimensional prediction problem: thousands of observable variables are potentially relevant for forecasting. We reassess the conventional wisdom on market efficiency in light of this fact. In our model economy, which resembles a typical machine learning setting, N assets have cash flows that are a linear function of J firm characteristics, but with uncertain coefficients. Risk-neutral Bayesian investors impose shrinkage (ridge regression) or sparsity (Lasso) when they estimate the J coefficients of the model and use them to price assets. When J is comparable in size to N, returns appear cross-sectionally predictable using firm characteristics to an econometrician who analyzes data from the economy ex post. A factor zoo emerges even without p-hacking and data-mining. Standard in-sample tests of market efficiency reject the no-predictability null with high probability, despite the fact that investors optimally use the information available to them in real time. In contrast, out-of-sample tests retain their economic meaning.