Pitfalls in Testing for Explosive Bubbles in Asset Prices

Abstract

A number of studies (e.g., Robert J. Shiller, 1981; Olivier J. Blanchard and Mark Watson, 1982; Kenneth D. West, 1988) have argued that dividend and stock price data are not consistent with hypothesis, in which prices are given by present discounted values of expected dividends. These results have often been construed as evidence for existence of bubbles or fads. (Related arguments have been made with respect to gold, bonds, and foreign exchange). A major problem with such arguments (e.g., James Hamilton and Charles Whiteman, 1985) is that apparent evidence for bubbles can be reinterpreted in terms of market fundamentals that are unobserved by researcher. Behzad T. Diba and Herschel I. Grossman (1984, 1988b) and Hamilton and Whiteman (1985) have recommended alternative strategy of testing for rational bubbles by investigating stationarity properties of asset prices and observable fundamentals.1 In essence, argument for equities is that if stock prices are not more explosive than dividends then it can be concluded that rational bubbles are not present, since they would generate an explosive component to stock prices.2 Using unit-root tests, autocorrelation patterns, and cointegration tests to implement this procedure, Diba and Grossman (1988b p. 529) state that the analysis supports conclusion that stock prices do not contain explosive rational This paper shows that above battery of tests is in fact unable to detect an important class of rational bubbles. The point is demonstrated by constructing rational bubbles that appear to be stationary when unitroot tests are applied, even though they are explosive in relevant sense. Simulations show that, when such bubbles are present, stock prices will not appear to be more explosive than dividends on basis of these tests, even though bubbles are substantial in magnitude and volatility. The presence of rational bubbles in actual stock prices thus remains an open question.