Fads or bubbles?

Abstract

This paper tests between fads and bubbles using a switching regression to distinguish between competing models. Two main features of the bubbles model distinguish it from the fads model. First, the bubbles model implies that returns are drawn from regimes which differ in the way returns vary with deviations from fundamental prices. Second, the bubbles model implies that deviations from fundamental price will help predict regime switches. Using US data for 1926–89, we find evidence which is consistent with the fads model even when we allow for variation in expected dividend growth rates and expected discount rates. However, the restrictions which the fads model implies for a more general switching-regression specification are rejected. The rejections point in the direction of the bubbles model, although not all of the implications of the bubbles model are supported by the data.

We would like to thank the editors of the journal, James Hamilton and Baldev Raj, two anonymous referees, O. Blanchard and seminar participants at the Econometric Society, Canadian Econometric Study Group, SEDC, Bank of Canada, University of British Columbia, Carleton University and Simon Fraser University for helpful comments. Dr. Schaller thanks the Financial Research Foundation of Canada and the SSHRC for their financial support and the Operations Research Center at MIT for providing a pleasant environment in which to pursue this research. Any errors are our own. We are solely responsible for the views expressed here.