Over the several hundred during which organized asset trading has occurred, there have been several spectacular pricing bubbles (rapidly increasing asset prices that surpass supportable values for the underlying assets). Following these asset bubbles, there have been dramatic market reversals (rapidly plunging asset prices to levels well below supportable values for the underlying assets). Lastly in the cycle, there have been eventual recoveries, wherein asset prices roughly equate to supportable values for the underlying assets (Brunnermeier, 2001).
Supporters of the efficient markets hypothesis contend that such long-term volatility and major market reversals cannot occur. Their explanations for these events follow the line that, for reasons not known, all relevant information was not available to investors when such outcomes occurred. Thus, according to this line of reasoning, investors behaved rationally based on what was known at the time (Mishkin & White, 2002). Behavioral finance theory contends, however, that long-term volatility in asset pricing and the resulting market reversals are the products of irrational behavior on the part of investors, such as discounting available information that does not support their assessments (Shiller, 2000).
Neither supporters of the efficient markets hypothesis nor behavioral finance theorists deny that bubbles, crashes, and recoveries occur. The two camps, however, disagree as to the explanations for the occurrences of the phenomena and the behavior of investors during the life spans of such phenomena. This study investigated the validity of the opposing positions.
Asset pricing bubbles have been occurring since the Tulip Bulb Bubble that began in 1637 and ended in a major market reversal in 1937. Four major episodes of long-term volatility ending in major market reversals occurred in stock markets in the United States in the twentieth century (Dimson & Mussavian, 2000). Ot...