What Factors Contribute to U.S. Stock Market Bubbles?

Abstract

This paper considers several important macroeconomic variables such as inflation, Federal funds rates and unemployment along with behavioral variables such as momentum trading to explain excessive U.S. equity returns during the post World War II era. The theoretical hypotheses propose three regimes of economic conditions that give rise to excessive equity prices. Periods of excessive returns most often are followed by periods of below average returns. However, occasionally, periods of excessive returns are followed by even higher excessive returns with subsequent crashes. Such higher excessive returns are commonly referred to as booms or bubbles. We formulate and test certain hypotheses that attribute excessive equity returns initially to economic fundamentals and subsequently to behavioral variables. We use a 3-state regime Markov switching methodology to capture the specific fundamental and behavioral factors that drive equity prices across business cycles.

Keywords: Bubbles, Excessive stock returns, Macroeconomic variables, Regimes, Business cycles

JEL Classification: G12