Booms, busts and behavioural heterogeneity in stock prices

The global financial crisis indicated the limitations of representative rational agent models for asset pricing solely based on economic fundamentals. We estimate a simple behavioural heterogeneous agents model with boundedly rational traders in which the fundamental value of the stock prices is publicly available, but beliefs about the persistence of deviations from the fundamental differ. Some agents (called fundamentalists) believe in mean-reversion of stock prices, while others (chartists) expect a continuation of the trend. Agents gradually switch between the two rules, based upon their relative forecasting performance, and due to positive expectations feedback this leads to self-reinforcing regimes of mean-reversion and trend-following. We estimate a two-type switching model using quarterly U.S. stock price data until 2012Q4. The estimation shows an improvement over representative agent models that is both statistically and economically significant. We also perform Monte Carlo simulations to evaluate the power of the specification tests. Finally, we combine our model with the consumption-habit asset pricing model of Campbell and Cochrane (1999) to assess the importance of behavioural heterogeneity next to time-varying risk premia. We estimate the two-type switching model on deviations from the consumption-habit benchmark and find significant behavioural heterogeneity. Overall, our model suggests that behavioural regime switching has significant and robust effects on asset prices and amplifies booms and busts, in particular, the dot-com bubble and the financial crisis in 2008