Is R-Squared a Measure of Market Inefficiency?

This paper provides a critical evaluation of a widely made argument that stock prices in markets with lower return R2 are more efficient. We show that in a standard rational expectations model, return R2 is independent of the amount of information incorporated into stock prices. Furthermore, an alternative model in which stock price fluctuations are driven by investor sentiment leads to an opposite prediction that lower return R2 is associated with stronger medium-term price momentum and long-term price reversal, two commonly believed signs of market inefficiency. By examining stock returns both in the U.S. and internationally, we found empirical evidence consistent with this contrasting prediction. Overall, our analysis casts doubt on the argument that low return R2 is a measure of market efficiency.