Identification of speculative bubbles using state-space models with Markov-switching

Al-Anaswah Nael, Wilfling Bernd

Abstract
In this paper we use a state-space model with Markov-switching to detect speculative bubbles in stock-price data. To this end we express a present-value stock-price model in state-space form which we estimate using the Kalman filter. This procedure enables us to estimate a two-regime Markov-switching specification of the unobservable bubble process. The respective Markov-regimes represent two distinct phases in the bubble process, namely one in which the bubble survives and one in which it collapses. We ultimately identify bursting stock-price bubbles by statistically separating both Markov-regimes from each other. In an empirical analysis we apply our methodology to a plethora of artificial and real-world data sets. Our study has two major findings. First, we find significant Markov-switching structures in real-world stock-price bubbles. Second, in the stock markets considered our identification procedure correctly detects most speculative periods which have been classified as such by economic historians.

Keywords
Stock market dynamics; detection of speculative bubbles; present-value models; state-space models with Markov-switching