Speculative bubbles and tests of the contagion mechanism in financial markets

This dissertation extends previous research on bubbles by investigating whether changes in the financial asset prices of the S&P500 reflect changes in fundamentals. We propose that if this is not the case the volatility is due to a bubble. Hence, this is the general hypothesis from which several testable hypotheses are developed. A key issue in bubble research is the definition of fundamentals. In this work we assume that, in the long-run, operating revenues are the only source from which any payments can be made, including dividend payments. Therefore, if expectations are formulated correctly, on average, there has to be a relationship between changes in prices and changes in corporate revenues. Thus, we use different accounting variables as proxies for fundamentals. In addition, since the literature points to contagion of opinion as one of the causes for the creation of bubbles, we also examine the contemporaneous relationship between prices and several proxies for herding behavior. OLS, panel data analysis, and quantile regression are used to analyze the contemporaneous relationship between prices and fundamentals or contagion proxies; while cointegration (reconciled to be used with panel data) and the Bonferroni inequality are used to investigate the long-run equilibrium between prices and fundamentals. The results indicate that, overall, company earnings are not explanatory of prices. These findings hold both in the short-run and in the long-run equilibrium scenarios. In addition, we find that investors do not reward an increase of the debt in the capital structure of corporations. In reference to our contagion variables, changes in money flow, volume, and volatility are found explanatory of changes in prices. Nevertheless, the effect of these variables is not homogeneous across price changes. Specifically, Money Flow is significant across all quantiles except for the 30% lowest price changes, Volume is explanatory of the 35% highest price changes, while volatility is explanatory across all the distribution of price changes. An interesting observation is that the three independent variables become increasingly explanatory as we move up to higher quantiles. Taken together our findings are supportive of the bubble and contagion hypotheses.