Fads or Bubbles?

This paper tests between fads and bubbles using a new empirical strategy (based on switching-regression econometrics) for distinguishing between competing asset-pricing models. By extending the Blanchard and Watson (1982) model, we show how stochastic bubbles can lead to regime-switching in stock market returns. By incorporating state-dependent heteroscedasticity into the Cutler, Poterba, and Summers (1991) fads model, we show that it can also lead to regime-switching. Two main features of the bubbles model distinguish it from the fads model. First, the bubbles model implies that returns are drawn from two distinct regimes. Second, the bubbles model implies that deviations from fundamental price will help predict regime switches. Using U.S. data for 1926-89, we find evidence that is consistent with the fads model even when we allow for variation in expected dividend growth rates and expected discount rates. However, the restrictions that the fads model implies for a more general switching model are rejected. The rejections point in the direction of the bubbles model, although not all the implications of the bubbles model are supported by the data.