Tuesday, February 22, 2011


The below study contains several glaring problems. Of note, the "bubble clarification method". As if it were so easy. As stated below, the approach relies on the delta between "fundamental" and empirical levels of price growth rates, and that the empirical price is rising. The difficulty lies in determining what "fundamental" value is, using ONE OF THREE price models (ostensibly using the one that gives the best results in retrospect). Relying on the CAPM model and its silly measure of "beta" as volatility simply assumes historical returns on ASSETS will not be correlated to returns for INVESTORS, who have different (in the language of the paper) "information sets".

So the paper states to merely ride the bubble, properly identified, until it comes time to sell, at which point the paper (for obvious reasons as it is an academic exercise) is conspicuously silent.

Even Mr. Greenspan, who otherwise luxuriated in his reputation as Maestro of economic policy for the previous Millenia stated thusly:

"It is doubtful that bubbles, even if identified early, could be pre-empted short of the central bank inducing a substantial contraction in economic activity—the very outcome we would be seeking to avoid.”

Here is the abstract for the study, which can be found in full here.

We empirically analyze rational investors' optimal response to asset price bubbles.
We define bubbles as a sudden acceleration of price growth beyond the growth in
fundamental value given by an asset pricing model. Our new bubble detection
method requires only a limited time-series of historical returns.
We apply our method to US industries and find strong statistical and economic
support for the riding bubbles hypothesis: when an investor detects a bubble,
her optimal portfolio weight increases significantly.
A dynamic riding bubble strategy that uses only real-time information earns abnormal annual returns of 3% to 8%.

Central to our approach is a new bubble identification method. This method relies
on two main characteristics of asset price bubbles, described for example by Abreu and Brunnermeier (2003): (1) the growth rate of the price is higher than the growth rate of fundamental value and (2) the growth rate of the price experiences a sudden acceleration consistent with the features of the Minsky model described by Kindleberger (2000). An investor concludes that a bubble exists if both conditions are fulfilled. A bubble ends when the investor observed a crash during the previous six months or when a bubble is no longer detectable. The investor estimates the growth rate of fundamental value based on one of three different asset pricing models, the Capital Asset Pricing Model (CAPM), the Fama-French (1993) Three-Factor Model (3F-Model), and the Carhart (1997) Four-Factor Model (4F-Model). To detect a sudden acceleration, the investor conducts a structural change test as in Andrews (1993).

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