An Evaluation of Recent Evidence on Stock Market Bubbles
Robert P. Flood, Robert J. Hodrick, Paul Kaplan
NBER Working Paper No. 1971
Several recent studies have attributed a large part of asset price volatility to self-fulfilling expectations. Such an explanation is unattractive to many since it allows allocations that need bear no particular relation to those implied by the economist's standard kit of
market fundamentals. We examine the evidence presented in some of these
studies and find (i) that all of the bubble evidence can equally well be
interpreted as evidence of model misspecification and (ii) that a slight extension of standard econometric methods points very strongly toward model misspecification as the actual reason for the failure of simple models of market fundamentals to explain asset price volatility.
Published: Robert P. Flood and Peter M. Garber, eds., Speculative Bubbles, Speculative Attacks and Policy Switching, M.I.T. Press, 1994, pp. 105-133.