Do factor models explain stock returns when prices behave explosively? Evidence from China

Abstract

We test the Fama-French five-factor model when stock prices exhibit explosive (or bubble) behavior. Using the Backward Sup Augmented Dickey-Fuller (BSADF) statistic, we identify the bubble period for China's A-share stock market from September 2014 to June 2015. The model explains cross-sectional stock returns during the bubble period, but the explanatory power of the five-factor model declines as prices change from the random walk period to the bubble period. Furthermore, the marginal pricing ability of the five factors also decreases substantially in the bubble period. The speculative investor behavior may explain the declined explanatory power of the model during the bubble.