What Is an Asset Price Bubble? An Operational Definition

Abstract

This paper reviews and analyses the current definitions of bubbles in asset prices. It makes the case that one cannot identify a bubble immediately, but one has to wait a sufficient amount of time to determine whether the previous prices can be justified by subsequent cash flows. The paper proposes an operational definition of a bubble as any time the realised asset return over given future period is more than two standard deviations from its expected return. Using this framework, the paper shows how the great crash of 1929 and 1987—both periods generally characterised as bubbles—prove not to be bubbles but the low point in stock prices in 1932 is a ‘negative bubble.’ The paper then extends this analysis to the internet stocks and concludes that it is virtually certain that it is a bubble.

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