Speculative Bubbles in Mature Stock Markets: Evidence for Their Existence and Their Linkages

Economists have long conjectured that movements in stock prices may involve speculative bubbles. A speculative bubble is usually defined as the difference between the market value of a security and its fundamental value. Although there are several important theoretical issues surrounding the topic of asset bubbles, their existence is inherently an empirical issue that has not been settled. This paper proposes a new methodology for testing for the existence of rational bubbles. Unlike previous authors, we treat both the dividend and the bubble process as part of the state vector. The new methodology is applied to the four mature markets of the U.S., Japan, England and Germany to test whether a bubble was present during the period of January 1951 to December 1998. This paper also examines whether there are linkages between these national bubbles. We find evidence that U.S. bubbles cause bubbles in the other three markets but we find no evidence for reverse causality. Current Draft: February 2002. This paper was presented at the European Financial Management Association Meetings, Lugano, Switzerland, June 27-30, 2001 and also at the Western Economic Association Meetings, San Francisco, July 5-8, 2001. We are thankful to two discussants and several colleagues for their useful comments.