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Fear and stock price bubbles
1Department of Finance, University of Luxembourg, Luxembourg, Luxembourg.
Plos One
|May 13, 2020
Summary
Stock market bubbles form during euphoria and burst from increasing fear, a pattern confirmed by a new euphoria/fear index. This index, based on time-varying risk aversion, predicts market crashes a year in advance.
Area of Science:
- Financial Economics
- Behavioral Finance
Background:
- Alan Greenspan's claim suggests stock market bubbles form during euphoria and burst due to fear.
- Empirical evidence shows increased risk aversion during crises, driven by fear.
- Fear is a key mechanism in financial decision-making, influencing countercyclical risk aversion.
Observation:
- A novel euphoria/fear index was constructed using an economic model of time-varying risk aversion.
- The index was applied to US industry returns from 1959 to 2014.
- Analysis focused on identifying patterns preceding stock market bubbles and crashes.
Findings:
- The study validates Greenspan's claim: price run-ups occur in euphoric periods, followed by fear-driven crashes.
- Euphoria transitions to fear approximately one year before an industry crash, even while the market remains bullish.
- Industries without subsequent crashes do not exhibit a distinct euphoria-fear pattern.
Implications:
- Findings support Greenspan's views on market bubbles, challenging accusations of him being a 'serial bubble blower'.
- The euphoria/fear index provides a potential tool for early detection of market instability.
- Understanding the role of fear in financial markets can improve risk management strategies.
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