Re: Evidence Against the Market Bubble Story

Date: Wed Jun 14 2000 - 12:04:20 MDT

Robin writes:
> I once here cited analysis by Robert Shiller that suggested
> the current stock market was in a bubble. However, I just came
> across relevant analysis by J. Bradford Delong, who I have other
> reasons for respecting. He finds that long term fluctuations
> are probably rational, while short term ones can be irrational.

I found a web page for Brad DeLong, at He's got
some fascinating essays there. He writes a new article every week and
you can subscribe to them. Sounds like he'd be a great guy to have as
your econ prof.

> "Why Does the Stock Market Fluctuate?"
> Robert B. Barsky, J. Bradford De Long
> Quarterly Journal of Economics,
> Vol. 108, No. 2. (May, 1993), pp. 291-311.

I couldn't access this, but I found a 1990 essay on his web site at This one made
much the same point, that stock prices are rational over the longer term
(10 years), assuming that investors extrapolate recent dividend rates
into the future and determine prices based on expected dividend flows.

He shows a graph (his figure 4) of actual stock prices over the last
century, compared to what his model predicts, and they are in very close
agreement visually.

However upon closer study, I noticed some things which made me more
skeptical. His model often lags the actual stock price movements.
This is especially noticeable in the 1929 crash. The actual market peaked
in 1929. But his predicted prices continue to climb and peak in 1931.

It is easy to see why, given his model. He predicts stock prices based
on recent years' dividends. In 1929, dividends were still showing a
pattern of growth in recent years. It wasn't until the early 30s that
declines in dividends causes his predicted prices to fall.

But actually you can argue that the drop in dividends in 1930 and
onward was caused in part by the stock market crash. Obviously all
these effects are interrelated and it is hard to single one out, but
the crash surely played a contributory role in the economic slowdown.
As prices fell, people were wiped out, loans went bad, and there were
widespread spending reductions.

It seems, therefore, that the stock market crash led to dividend
reductions, which then caused his model to predict a stock market crash.
But that's not a good prediction because the causative condition only
occured after the supposed effect.

Does his more recent paper extend this analysis?

Also, whenever I read these kinds of papers I want to see whether the
analysis works when extrapolated forward. DeLong had results up through
the late 1980s. The last decade has been remarkable in its stock market
performance. Would his model successfully predict price movements in
the 1990s? My guess is that it would predict a strong bull market, as
the continued economic expansion has presumably produced dividend growth.
However I doubt that it would predict the degree of increase the market
has actually seen, with P/E ratios much higher than historical averages.


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