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.
Highlights
The distinguished economist and former chairman of the Federal Reserve Alan Greenspan does believe that security prices exhibit price bubbles
It is argued that fear is a potential mechanism underlying financial decisions and drives the countercyclical risk aversion
I construct an euphoria/fear index, which is based on an economic model of time varying risk aversion
Summary
The distinguished economist and former chairman of the Federal Reserve Alan Greenspan does believe that security prices exhibit price bubbles. A price bubble can be defined as an irrational strong price increase, followed by a remarkable crash in the price of the security. Greenspan argues that the price run-up is fueled by euphoria in the market. When euphoria turns into fear, security prices are going to crash. Such a bubble in stock prices would not be predictable ex ante but observable ex post. Price bubbles could exhibit the particular euphoria-fear pattern that Greenspan describes if bubbles build up endogenously when the market economy evolves.
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