Periodically Collapsing Bubbles in the South African Stock Market

This paper studies the existence and timing of bubbles in South Africa’s stock market. An empirical model of bubble formation is tested against three competing models of asset price returns that rule out the existence of bubbles. The model controls for nonlinearities inherent in asset price returns by allowing for the existence of multiple regimes. The regimes are all related to the size of the bubble and allows for a bubble to persist and survive over a significant period of time – as was observed with the housing market before the financial crisis in 2008/09. Two regimes are identified – a bubble survival regime and a bubble collapse regime. The bubble model fits the data better than the competing models and suggests that the formation and existence of periodically collapsing bubbles are a reality. The model identifies probabilities of survival and collapses that are directly related to the size of the bubble relative to the fundamental price of the stock market. The results show that stock market returns ought to decrease as the size of the bubble grows, which could burst the bubble and cause a collapse in the stock exchange – far below the correction required to return to equilibrium.