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Stock market bubbles, inflation and investment risk

  • Kaliva, Kasimir
  • Koskinen, Lasse
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    This paper proposes an autoregressive regime-switching model of stock price dynamics in which the process creates pricing bubbles in one regime while error-correction prevails in the other. In the bubble regime the stock price depends negatively on inflation. In the error-correction regime it depends on the price-dividend ratio. We find that the probability of regime-switch depends on exogenous inflation and lagged price. The model is consistent with Shleifer and Vishny's theoretical noise trader and arbitrageur model and Modigliani's inflation illusion phenomenon. The results emphasize the importance of inflation and the price-dividend ratio when assessing investment risk.

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    File URL: http://www.sciencedirect.com/science/article/B6W4W-4NCJCYH-1/1/8cf56410228b1402c98f38dae503e1fd
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    Article provided by Elsevier in its journal International Review of Financial Analysis.

    Volume (Year): 17 (2008)
    Issue (Month): 3 (June)
    Pages: 592-603

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    Handle: RePEc:eee:finana:v:17:y:2008:i:3:p:592-603
    Contact details of provider: Web page: http://www.elsevier.com/locate/inca/620166

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    1. Markus K. Brunnermeier & Stefan Nagel, 2004. "Hedge Funds and the Technology Bubble," Journal of Finance, American Finance Association, vol. 59(5), pages 2013-2040, October.
    2. Smith, Vernon L & Suchanek, Gerry L & Williams, Arlington W, 1988. "Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets," Econometrica, Econometric Society, vol. 56(5), pages 1119-51, September.
    3. West, Kenneth D, 1988. "Dividend Innovations and Stock Price Volatility," Econometrica, Econometric Society, vol. 56(1), pages 37-61, January.
    4. Dilip Abreu & Markus K. Brunnermeier, 2002. "Bubbles and crashes," LSE Research Online Documents on Economics 24905, London School of Economics and Political Science, LSE Library.
    5. Andrei Shleifer & Robert W. Vishny, 1995. "The Limits of Arbitrage," NBER Working Papers 5167, National Bureau of Economic Research, Inc.
    6. Robert J. Shiller, 1997. "Why Do People Dislike Inflation?," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 13-70 National Bureau of Economic Research, Inc.
    7. Maheu, John M & McCurdy, Thomas H, 2000. "Identifying Bull and Bear Markets in Stock Returns," Journal of Business & Economic Statistics, American Statistical Association, vol. 18(1), pages 100-112, January.
    8. Hess, Martin K., 2003. "What drives Markov regime-switching behavior of stock markets? The Swiss case," International Review of Financial Analysis, Elsevier, vol. 12(5), pages 527-543.
    9. Robert B. Barsky & J. Bradford De Long, 1989. "Bull and Bear Markets in the Twentieth Century," NBER Working Papers 3171, National Bureau of Economic Research, Inc.
    10. Neil Shephard & Anders Rahbek, 2002. "Autoregressive conditional root model," Economics Series Working Papers 2002-W07, University of Oxford, Department of Economics.
    11. Andrew J. Filardo, 1993. "Business cycle phases and their transitional dynamics," Research Working Paper 93-14, Federal Reserve Bank of Kansas City.
    12. Manuel S. Santos & Michael Woodford, 1997. "Rational Asset Pricing Bubbles," Econometrica, Econometric Society, vol. 65(1), pages 19-58, January.
    13. Steven A. Sharpe, 2002. "Reexamining Stock Valuation and Inflation: The Implications Of Analysts' Earnings Forecasts," The Review of Economics and Statistics, MIT Press, vol. 84(4), pages 632-648, November.
    14. Donald W.K. Andrews & Werner Ploberger, 1992. "Optimal Tests When a Nuisance Parameter Is Present Only Under the Alternative," Cowles Foundation Discussion Papers 1015, Cowles Foundation for Research in Economics, Yale University.
    15. Black, Fischer, 1986. " Noise," Journal of Finance, American Finance Association, vol. 41(3), pages 529-43, July.
    16. Ritter, Jay R. & Warr, Richard S., 2002. "The Decline of Inflation and the Bull Market of 1982–1999," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(01), pages 29-61, March.
    17. McMillan, David G., 2004. "Nonlinear predictability of short-run deviations in UK stock market returns," Economics Letters, Elsevier, vol. 84(2), pages 149-154, August.
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