On the Inception of Rational Bubbles in Stock Prices

Abstract

This paper analyzes the theoretical possibility of rationalbubbles in stock prices in a model in which stockholders haveinfinite planning horizons and in which free disposal of equityrules out the existence of negative rational bubbles. Theanalysis shows that in this framework if a positive rationalbubble exists, then it started on the first date of trading ofthe stock. Thus, the existence of a rational bubble at any datewould imply that the stock has been overvalued relative to marketfundamentals since the first date of trading and that prior tothe first date of trading potential stockholders who anticipatedthe initial pricing of the stock expected that the stock would beovervalued relative to market fundamentals. The analysis alsoshows that any rational bubble will eventually burst and will notrestart. Thus, even if a positive rational bubble exists,stockholders know that after a random, but almost surely finite,date the stock price will conform to market fundamentals forever.