DEA-based firm strengths and market efficiency in U.S. and Japan

Efficient market theory suggests that economic fundamentals of public firms are strongly associated with stock returns in the capital markets. However, there is no universal metric of fundamental strength of a firm to verify market efficiency. In this chapter, we develop a Data Envelopment Analysis-based relative strength evaluation technique using publicly-available annual accounting data for a given group of firms (or market). Under an iterative configuration of the data as inputs and outputs, we search for the maximum attainable correlation between finn strength and stock returns. Such a maximum correlation, termed firm Strength-Based Efficiency (SEE) index for the market, measures the degree to which firm fundamentals play a role in stock returns in a particular economy. Computing SI3E is a difficult discrete optimization problem that is solved via a hybrid simulated annealing procedure. SEE index values appear to be similar for the overall (large cap) markets in the U.S. and .Japan, and past (observed) firm strengths have no explanatory power on future stock returns. Expectations on future strengths, computed using Book-to-Market, Earnings-Per-Share, Leverage, Asset Turnover, etc., are evident in stock returns up to 2 years in advance, but market risk has only a negligible effect in our relative framework.