Theory and Evidence: Can Stock Market Bubbles Be Predicted?

Jacob Theill

Student thesis: Master thesis


Bubbles in the stock markets are intriguing phenomena, which has not only had a big impact on economies around the world from time to time, but it has also been a driving force behind new theories, models and paradigm shifts in the science of economics. The purpose of this thesis is to review the different perspectives on stock bubbles in literature and determine if stock bubbles can be identified and controlled. In this review, theories and models from both macroeconomic and finance literature are discussed in relation to three specific bubble cases: The US stock bubble in the late 1920’s, the Japanese stock bubble from 1985-1990 and the Dot-com bubble in the late 1990’s. The review acknowledges that this analysis is complex due to the timing of the events and literature in relation to each other, but this also provides insight into how theories and models have evolved. Keynes (1936) provides a framework for understanding how stock bubbles affect the economy, as well as notable observations of how psychology affects stock markets. The Austrian (Mises, 1949; Hayek, 1933) and Schumpeterian (Schumpeter, 1939) schools of thought provide alternative explanations of why stock bubbles occur due to respectively malinvestment and periodic cycles/waves. Furthermore, the financial instability hypothesis (Minsky, 1986) argues that the capitalistic system is fragile by nature, and that this fragility must be minimized with the help of regulation and policy. Models based on rational expectations, such as the EMH and RBC theory are challenged by the existence of stock bubbles, and there are strong arguments for adjusting how decision making is modelled. The paper finds that fundamental ratios, such as the cyclically adjusted price-earnings (CAPE) ratio (Shiller & Campbell, 1998), the price-to-book (P/B) ratio and the dividend yield (D/P), are the best available tools for identifying stock market bubble situations (Keimling, 2016), which is defined as a persistent deviation of price from fundamental value of a stock index. Furthermore, the paper shows that stock bubbles can be controlled to some extent by both governments and central banks with regulations and monetary policies, and that policymakers have become more aware of stock bubbles and the credit cycle (Yellen, 2009), especially following the financial crisis that begun in 2008. Lastly, the thesis recommends further research on fundamental ratios for identification of stock bubbles around the world, due to identified gaps in the current available literature.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
Publication date2016
Number of pages75