Abstract
The purpose of this research is to identify (i) whether there is a significant speculative bubble in the U.S. stock market as of late 2014, (ii) how large the bubble is relative to past bubbles dating back to 1951, and (iii) why current monetary policy may be causing the bubble. In contrast to traditional microeconomic indicators used to examine stock bubbles, we make use of nominal GDP only. Moreover, we explain why that this variable should be closely related to the stock price index. This thesis asserts that nominal GDP is a weak attractor for stock price (measured by the S&P 500 index). However, because of the high inflation period during the 1970s, which interrupted the close relation between stock prices and nominal GDP, the price level is added to the regression in a new and interesting manner. Using Engle-Granger cointegration methods, we found a surprisingly strong and complicated long run relation between nominal GDP, inflation, and stock prices. According to our empirical results, we found strong evidence of a bubble in the US stock market, whose size has already expanded to roughly 1/3 to 1/2 the size of the dotcom bubble of 2000, and is roughly the same size as the stock bubble in 2007. These results accord well with analysis made by the Office of Financial Research of the US government. Both CUSUM and CUSUMSQ tests verify that the associated error correction model is stable for quarterly data over the entire period 1951- 2014.
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