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Forecasting the Collapse of Speculative Bubbles: An Empirical Investigation of the S&P 500 Composite Index

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Author Info

  • Chris Brooks

    ()
    (ICMA Centre, University of Reading)

  • Apostolos Katsaris

    ()
    (ICMA Centre, University of Reading)

Abstract

In this paper we test for the presence of periodically partially collapsing, positive and negative, speculative bubbles in the S&P 500 Composite Index for the period 1888-2001. We extend existing regime-switching models of speculative behaviour by including abnormal volume as an indicator of the probable time of the bubble collapse. Abnormal volume is included as both a classifying variable that helps predict the probability of the bubble surviving, and as a factor of risk in the surviving state equation. Increased volume is considered a signal that market beliefs concerning the future of the bubble are changing. We show that abnormal volume is a significant predictor and classifier of returns. Furthermore, we examine the financial usefulness of the augmented model by studying the risk-adjusted profits of a trading rule formed using inferences from it. Use of the augmented model trading rule leads to higher risk adjusted returns than those obtained from employing existing models or a buy and hold strategy.

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Bibliographic Info

Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2002-04.

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Length: 42 pages
Date of creation: Mar 2002
Date of revision:
Publication status: Published in Journal of Business 78:5, 2005, 2003-2036
Handle: RePEc:rdg:icmadp:icma-dp2002-04

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Web page: http://www.henley.reading.ac.uk/
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Related research

Keywords: Stock market bubbles; fundamental values; dividends; regime switching; speculative bubble tests;

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References

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  1. 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.
  2. Van Norden, S. & Schaller, H., 1996. "Speculative Behaviour, Regime-Switching and Stock Market Crashes," Working Papers 96-13, Bank of Canada.
  3. Campbell, John Y & Shiller, Robert J, 1987. "Cointegration and Tests of Present Value Models," Journal of Political Economy, University of Chicago Press, vol. 95(5), pages 1062-88, October.
  4. White, Eugene N, 1990. "The Stock Market Boom and Crash of 1929 Revisited," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 67-83, Spring.
  5. Weil, Philippe, 1990. "On the Possibility of Price Decreasing Bubbles," Econometrica, Econometric Society, vol. 58(6), pages 1467-74, November.
  6. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
  7. van Norden Simon & Vigfusson Robert, 1998. "Avoiding the Pitfalls: Can Regime-Switching Tests Reliably Detect Bubbles?," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 3(1), pages 1-24, April.
  8. West, Kenneth D, 1987. "A Specification Test for Speculative Bubbles," The Quarterly Journal of Economics, MIT Press, vol. 102(3), pages 553-80, August.
  9. Hall, Stephen G & Psaradakis, Zacharias & Sola, Martin, 1999. "Detecting Periodically Collapsing Bubbles: A Markov-Switching Unit Root Test," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 14(2), pages 143-54, March-Apr.
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