This Time It’s Different

Abstract

Using insights from Hyman Minsky’s Financial Instability Hypothesis (FIH), we develop a theoretical framework for how speculative bubbles may materialize in securities markets. Our model and empirical analysis show that agents place undue emphasis on recent experience of risk and returns when developing future expectations. We use the aggregate investor allocation to equities (aggregate total market capitalization of equities divided by the price of all real liabilities outstanding), Tobin’s Q (the aggregate market price of equities divided by the replacement cost of nonfinancial firms’ assets), Shiller Total Return Cyclically Adjusted Price to Earnings Ratio (TR CAPE), and Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE) as proxy variables for bubbles. We find statistically significant, negative relationships between all four of these proxy variables and two dependent variables, Subsequent Ten-Year Annualized Cumulative Equity Market Returns (Nominal and Real), and also Subsequent 10-year Average Losses, thereby providing evidence against the Efficient Market Hypothesis and suggesting the possibility of speculative bubbles.