Efficient Capital Markets: II 1583 expected inflation and interest rates suggests that the implied variation in xpected returns is a small part of the variance of returns-less than 3% for monthly returns. The recent tests suggest, however, that for long-horizon returns, predictable variation is a larger part of return variances Thus, following evidence(Rozeff (1984), Shiller(1984) that dividend yields (/P) forecast short-horizon stock returns, Fama and French(1988b)use D/P NYSE stocks for horizons from 1 month to 5 years. As shted portfolios of explains small fractions of monthly and quarterly return variances. frac tions of variance explained grow with the return horizon, however, and are E/Ratios, especially when past earnings(E)are averaged over 10-30 years, have reliable forecast power that also increases with the return horizon Unlike the long-horizon autocorrelations in Fama and French (1988a),the long-horizon forecast power of D /P and E/P is reliable for periods after 1940 Fama and French(1988b) argue that dividend yields track highly autocor related variation in expected stock returns that becomes a larger fraction of return variation for longer return horizons. The increasing fraction of the variance of long-horizon returns explained by D/P is thus due in large part to the slow mean reversion of expected returns. Examining the forecast power of variables like D/P and E /P over a range of return horizons nevertheless res striking perspective on the implications of slow-moving expected turns for the variation of returns B 2. Market Efficiency The predictability of stock returns from dividend yields (or E/P) is not in itself evidence for or against market efficiency. In an efficient market, the forecast power of D/P says that prices are high relative to dividends when discount rates and expected returns are low, and vice versa. On the other hand, in a world of irrational bubbles, low D /P signals irrationally high stock prices that will move predictably back toward fundamental values. To judge whether the forecast power of dividend yields is the result of rational variation in expected returns or irrational bubbles, other information must be used. As always, even with such information, the issue is ambiguou For example, Fama and French (1988b) show that low dividend yields imply low expected returns, but their regressions rarely forecast negative returns for the value. and equally weighted portfolios of NYSE stocks. In their data, return forecasts more than 2 standard errors below 0 are never observed. and more than 50%o of the forecasts are more than 2 standard errors above 0. Thus there is no evidence that low D/P signals bursting bubbles, that is, negative expected stock returns. a bubbles fan can argue, however, that because the unconditional means of stock returns are high, a bursting bubble may well imply low but not negative expected returns. Conversely, if here were evidence of negative expected returns, an efficient-markets type could argue that asset-pricing models do not say that rational expected returns are always positive