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An Evaluation of Recent Evidence on Stock Market Bubbles

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  • Robert P. Flood
  • Robert J. Hodrick
  • Paul Kaplan

Abstract

Several recent studies have attributed a large part of asset price volatility to self-fulfilling expectations. Such an explanation is unattractive to many since it allows allocations that need bear no particular relation to those implied by the economist's standard kit of market fundamentals. We examine the evidence presented in some of these studies and find (i) that all of the bubble evidence can equally well be interpreted as evidence of model misspecification and (ii) that a slight extension of standard econometric methods points very strongly toward model misspecification as the actual reason for the failure of simple models of market fundamentals to explain asset price volatility.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1971.

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Date of creation: Jul 1986
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Publication status: published as Robert P. Flood and Peter M. Garber, eds., Speculative Bubbles, Speculative Attacks and Policy Switching, M.I.T. Press, 1994, pp. 105-133.
Handle: RePEc:nbr:nberwo:1971

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References

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  1. Eichenbaum, Martin & Hansen, Lars Peter, 1990. "Estimating Models with Intertemporal Substitution Using Aggregate Time Series Data," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 53-69, January.
  2. Marsh, Terry A. & Merton, Robert C., 1984. "Dividend variability and variance bounds tests for the rationality of stock market prices," Working papers 1584-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  3. Flood, Robert P. & Garber, Peter M. & Scott, Louis O., 1984. "Multi-country tests for price level bubbles," Journal of Economic Dynamics and Control, Elsevier, vol. 8(3), pages 329-340, December.
  4. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
  5. Meese, Richard A, 1986. "Testing for Bubbles in Exchange Markets: A Case of Sparkling Rates?," Journal of Political Economy, University of Chicago Press, vol. 94(2), pages 345-73, April.
  6. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
  7. Grossman, Sanford J & Shiller, Robert J, 1981. "The Determinants of the Variability of Stock Market Prices," American Economic Review, American Economic Association, vol. 71(2), pages 222-27, May.
  8. Obstfeld, Maurice & Rogoff, Kenneth, 1983. "Speculative Hyperinflations in Maximizing Models: Can We Rule Them Out?," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 675-87, August.
  9. Scott, Louis O, 1985. "The Present Value Model of Stock Prices: Regression Tests and Monte Carlo Results," The Review of Economics and Statistics, MIT Press, vol. 67(4), pages 599-605, November.
  10. Tirole, Jean, 1985. "Asset Bubbles and Overlapping Generations," Econometrica, Econometric Society, vol. 53(6), pages 1499-1528, November.
  11. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
  12. Burmeister, Edwin & Wall, Kent D., 1982. "Kalman filtering estimation of unobserved rational expectations with an application to the German hyperinflation," Journal of Econometrics, Elsevier, vol. 20(2), pages 255-284, November.
  13. Mankiw, N Gregory & Romer, David & Shapiro, Matthew D, 1985. " An Unbiased Reexamination of Stock Market Volatility," Journal of Finance, American Finance Association, vol. 40(3), pages 677-87, July.
  14. Flood, Robert P & Hodrick, Robert J, 1986. " Asset Price Volatility, Bubbles, and Process Switching," Journal of Finance, American Finance Association, vol. 41(4), pages 831-42, September.
  15. Kleidon, Allan W, 1986. "Variance Bounds Tests and Stock Price Valuation Models," Journal of Political Economy, University of Chicago Press, vol. 94(5), pages 953-1001, October.
  16. Flood, Robert P & Garber, Peter M, 1980. "Market Fundamentals versus Price-Level Bubbles: The First Tests," Journal of Political Economy, University of Chicago Press, vol. 88(4), pages 745-70, August.
  17. Behzad T. Diba & Herschel I. Grossman, 1985. "The Impossibility of Rational Bubbles," NBER Working Papers 1615, National Bureau of Economic Research, Inc.
  18. Sargent, Thomas J & Wallace, Neil, 1973. "Rational Expectations and the Dynamics of Hyperinflation," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 14(2), pages 328-50, June.
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Citations

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Cited by:
  1. Refet Gurkaynak, 2005. "Econometric Tests of Asset Price Bubbles: Taking Stock," Finance 0504008, EconWPA.
  2. Qin Xiao & Randolph Gee Kwang Tan, 2006. "Signal Extraction with Kalman Filter: A Study of the Hong Kong Property Price Bubbles," Economic Growth centre Working Paper Series 0601, Nanyang Technolgical University, School of Humanities and Social Sciences, Economic Growth centre.
  3. Qin Xiao & Randolph Gee Kwang Tan, 2006. "Markov-switching Unit Root Test: A study of the Property Price Bubbles in Hong Kong and Seoul," Economic Growth centre Working Paper Series 0602, Nanyang Technolgical University, School of Humanities and Social Sciences, Economic Growth centre.
  4. Esteban Gómez & Sandra Rozo, 2007. "Beyond Bubbles: The role of asset prices in early-warning indicators," BORRADORES DE ECONOMIA 004245, BANCO DE LA REPÚBLICA.
  5. Robert P. Flood & Robert J. Hodrick, 1989. "Testable Implications of Indeterminacies in Models with Rational Expectations," NBER Working Papers 2903, National Bureau of Economic Research, Inc.
  6. Robert Flood, 1988. "Asset Prices and Time-Varying Risk," NBER Working Papers 2780, National Bureau of Economic Research, Inc.
  7. Kenneth A. Froot, 1990. "Short Rates and Expected Asset Returns," NBER Working Papers 3247, National Bureau of Economic Research, Inc.

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