Not necessarily. The fundamental value of a firm increases with uncertainty about average future profitability, and this uncertainty was unusually high in the late 1990s. We calibrate a stock valuation model that includes this uncertainty, and compute the level of uncertainty that is needed to match the observed Nasdaq valuations at their peak. This uncertainty seems plausible because it matches not only the high level but also the high volatility of Nasdaq stock prices. We also show that uncertainty about average profitability has the biggest effect on stock prices when the equity premium is low.

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The market dynamics of technology stocks in the late 1990s have stimulated a growing body of theory that analyzes the joint effects of short-sales constraints and heterogeneous beliefs on stock prices and trading volume. This paper examines several implications of these theories using a unique data sample from a market with stringent short-sales constraints and perfectly segmented dual-class shares. The identical rights of the dual-class shares allow us to control for stock fundamentals. We find that trading caused by investors’ speculative motives can help explain a significant fraction of the price difference between the dual-class shares.

A recursive test procedure is suggested that provides a mechanism for testing explosive behavior, date-stamping the origination and collapse of economic exuberance, and providing valid confidence intervals for explosive growth rates. The method involves the recursive implementation of a right-side unit root test and a sup test, both of which are easy to use in practical applications, and some new limit theory for mildly explosive processes. The test procedure is shown to have discriminatory power in detecting periodically collapsing bubbles, thereby overcoming a weakness in earlier applications of unit root tests for economic bubbles. An empirical application to Nasdaq stock price index in the 1990s provides confirmation of explosiveness and date-stamps the origination of financial exuberance to mid-1995, prior to the famous remark in December 1996 by Alan Greenspan about irrational exuberance in financial

This paper studies asset price bubbles in a continuous time model using the local martingale framework. Providing careful definitions of the asset’s market and fundamental price, we characterize all possible price bubbles in an incomplete market satisfying the ”no free lunch with vanishing risk” and ”no dominance” assumptions. We propose a new theory for bubble birth which involves a nontrivial modification of the classical framework. We show that the two leading models for bubbles as either charges or as strict local martingales, respectively, are equivalent. Finally, we investigate the pricing of derivative securities in the presence of asset price bubbles, and we show that: (i) European put options can have no bubbles, (ii) European call options and discounted forward prices can have bubbles, but the magnitude of their bubbles must equal the magnitude of the asset’s price bubble, (iii) with no dividends, American call prices must always equal an otherwise identical European call’s price, regardless of bubbles, (iv) European put-call parity in market prices must always hold, regardless of bubbles, and (v) futures price bubbles can exist and they are independent of bubbles in the underlying asset’s price. These results imply that in a market satisfying NFLVR and no dominance, in the presence of an asset price bubble, risk neutral valuation can not be used to match call option prices. We propose, but do not implement, some new tests for the existence of asset price bubbles using derivative securities.

We compare price-to-earnings ratios and dividend yields, which are indirect measures of sentiment, with the bullish sentiment index, which is a direct measure. We find that the sentiment index does better as a market-timing tool than do P/E ratios and dividend yields, but none is very reliable. We do not argue that market timing is impossible. Rather, we observe that stock prices reflect both sentiment and value, both of which are difficult to measure and neither of which is perfectly known in foresight. Successful market timing requires insights into future sentiment and value, insights beyond those that are reflected in widely available measures. JEL Classification: G11, G14 I. Market Timing in Regressions and Reality Value and sentiment are the two drivers of security prices in Shefrin and Statman’s (1994) behavioral capital asset pricing theory. Prices equal value in markets where only information traders trade and changes in value are the only driver of prices. However, noise traders join information traders in real-world markets and their sentiment, bullish or bearish, is the second driver of prices. Sentiment drives prices away from value. One implication of the two-driver framework is that stock prices are predictable if sentiment, bullish or bearish, fades over time on a predictable path. Market timers with reliable measures of sentiment can accumulate more than buyand-hold investors by switching from stocks to cash when sentiment is bullish and switching back to stocks when sentiment is bearish. But are there reliable measures of sentiment? And does sentiment fade on a predictable path?

ABSTRACT: The efficient markets hypothesis implies that, in the presence of rational investors, bubbles cannot develop. We analyze the trading behavior of a sophisticated investor, a London goldsmith bank, during the South Sea bubble in 1720. The bank believed the stock to be overvalued, yet found it profitable not to attack the bubble. Detailed examination of daily transactions in the London stock market shows that “riding the bubble ” was a highly profitable strategy. These findings lend support to recent theoretical work arguing that predictable investor sentiment may prevent rational investors from attacking a bubble.

Preliminary – Comments and suggestions are invited We develop a model of hedge fund returns, which reflect the contractual relationships between a hedge fund, its investors and its prime brokers. These relationships are modelled as short option positions held by the hedge fund, wherein the “funding option ” reflects the short option position with prime brokers and the “redemption option ” reflects the short option position with the investors. Given an alpha producing human capital, the hedge fund’s ability to deploy leverage to magnify its alpha is shown to be sharply constrained by the presence of these short options, which have a high probability of being exercised in “bad states ” of the world, either due to poor performance or due to macroeconomic developments that are performanceindependent. We show that the hedge funds typically have an optimal level of leverage that trades off rationally the ability to increase alpha with the risk of early exercise of short options, which may precipitate the liquidation of the fund. Optimal leverage is shown to differ across hedge funds reflecting their de-levering costs, Sharpe ratios, correlation of assets, secondary market liquidity of their assets, and the volatility of the assets. Using a minimum level of unencumbered cash level as a risk limit, we show how a hedge fund can optimally choose aggregate risk capital and then allocate its risk capital across different risk-taking units to maximize alpha in the presence of these short option positions. Implications of our analysis for hedge fund investors and policy makers are summarized. Our framework can be easily modified to study portfolio selection problem facing any fund, which has granted redemption rights to its investors (money market funds, long-only funds, etc). 1

This paper proposes an autoregressive regime-switching model of stock price dynamics in which the process creates pricing bubbles in one regime while error-correction prevails in the other. In the bubble regime the stock price depends negatively on inflation. In the error-correction regime it depends on the price-dividend-ratio. We find that the probability of regime-switch depends on exogenous inflation and lagged price. The model is consistent with Shleifer and Vishny’s theoretical noise trader and arbitrageur model and Modigliani’s inflation illusion phenomenon. The results emphasize the importance of inflation and the price-dividend-ratio when assessing investment risk.

We define CoVaR as the Value-at-Risk (VaR)offinancial institutions conditional on other institutions being under distress. The increase of CoVaR relative to VaR measures spillover risk among institutions. We estimate CoVaR using quantile regressions and document significant CoVaR increases among financial institutions. We identify six risk factors that allow institutions to offload tail risk, and show that such hedging reduces the wedge between CoVaR and VaR. We argue that financial institutions should report CoVaRs in addition to VaRs, and draw implications for risk management, regulation, and systemic risk. We define Co-Expected Shortfall as a sum of CoVaRs.