Working Paper: NBER ID: w1779
Authors: Behzad T. Diba; Herschel I. Grossman
Abstract: This paper reports empirical tests for the existence of rational bubbles in stock prices. The analysis focuses on a familiar model that defines market fundamentals to be the expected present value of dividends, discounted at a constantrate, and defines a rational bubble to be a self-confirming divergence of stock prices from market fundamentals in response to extraneous variables. The tests are based on the theoretical result that, if rational bubbles exist, time series obtained by differencing real stock prices do not have stationary means. Analysis of the data in both the time domain and the frequency domain suggests that the time series of aggregate real stock prices is nonstationary in levels but stationary in first differences. Applications of the time domain tests to simulated nonstationary time series that would be implied by rational bubbles indicates that the tests have power to detect relevant nonstationarity when it is present. Furthermore, application of the time-domain and frequency-domain tests to the time series of aggregate real dividends also indicates nonstationarity in levels but stationarity in first differences -- suggesting that market fundamentals can account for the stationarity properties of real stock prices. These findings imply that rational bubbles do not exist in stock prices. Accordingly,any evidence that stock price fluctuations do not accord with market fundamentals (asspecified above) is attributable to misspecification of market fundamentals.
Keywords: Rational Bubbles; Stock Prices; Market Fundamentals; Time Series Analysis
JEL Codes: G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| rational bubbles do not exist (E32) | fluctuations in stock prices can be explained by market fundamentals (E32) |
| nonstationarity in levels of stock prices and dividends (C22) | rational bubbles do not exist (E32) |
| time series properties of stock prices align with those of dividends (G35) | rational bubbles do not exist (E32) |
| Dickey-Fuller tests and autocorrelation analysis (C22) | explore the relationship between stock prices and market fundamentals (G10) |
| rational bubbles (E32) | higher order nonstationarity in stock prices (C69) |