Fear and stock price bubbles

Abstract

I evaluate Alan Greenspan’s claim that stock price bubbles build up in periods of euphoria and tend to burst due to increasing fear. Indeed, there is evidence that e.g. during a crisis, triggered by increasing fear, both qualitative and quantitative measures of risk aversion increase substantially. It is argued that fear is a potential mechanism underlying financial decisions and drives the countercyclical risk aversion. Inspired by this evidence, I construct an euphoria/fear index, which is based on an economic model of time varying risk aversion. Based on US industry returns 1959–2014, my findings suggest that (1) Greenspan is correct in that the price run-up initially occurs in periods of euphoria followed by a crash due to increasing fear; (2) on average already roughly a year before an industry is crashing, euphoria is turning into fear, while the market is still bullish; (3) there is no particular euphoria-fear-pattern for price-runs in industries that do not subsequently crash. I interpret the evidence in favor of Greenspan, who was labeled “Mr. Bubble” by the New York Times, and who was accused to be a serial bubble blower.