Fads or Bubbles?

Working Paper 97-2

56 Pages Posted: 8 Feb 1998

See all articles by Huntley Schaller

Huntley Schaller

Carleton University - Department of Economics

Simon van Norden

HEC Montreal - Department of Finance; CIRANO; University of Montreal - Center for Interuniversity Research in Econometrics

Date Written: January 1997

Abstract

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.

JEL Classification: G12

Suggested Citation

Schaller, Huntley and van Norden, Simon, Fads or Bubbles? (January 1997). Working Paper 97-2, Available at SSRN: https://ssrn.com/abstract=57941 or http://dx.doi.org/10.2139/ssrn.57941

Huntley Schaller (Contact Author)

Carleton University - Department of Economics ( email )

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Simon Van Norden

HEC Montreal - Department of Finance ( email )

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