Intrinsic bubbles and regime-switching

Froot and Obstfeld (1991) allow for an intrinsic bubble in stock prices, using approximately a century of annual data for the US, in an attempt to model the widely documented deviations from the prices predicted by present values or fundamentals, However they assume that the log of real dividends follows a constant random walk with drift over the whole period. We show that this assumption is invalid, and that a Markov-switching model is a more appropriate representation of dividends. We then generalise the formulation of stock prices (including the intrinsic bubble) to allow for this, and show that regime-switching provides a better explanation for stock prices than the bubble. We show that when allowance is made both for the bubble and for regime-switching in the dividend process, the incremental explanatory contribution of the bubble is low. (C) 1998 Elsevier Science B.V. All rights reserved.