Bubble Detection and Sector Trading in Real Time

Abstract

We conduct a pseudo real-time analysis of the existence and severity of speculative bubbles in eleven US sectors over the period 1973-2015. Based on the real-time bubble signals, a trading strategy is constructed which switches funds between the market index and those industry sectors that exhibit bubble dynamics. Our strategy generates highest after-transaction-cost return and Sharpe ratio, and first-order stochastically dominates three other investments (including two alternative active strategies as well as the buy-and-hold investment in the market index). Subsample analysis and specification checks confirm the robustness of the reported findings.

Keywords: Speculative bubbles, price-earnings ratio, explosive dynamics, real-time trading, stochastic dominance

JEL Classification: C12, C22, G01, G11