Fundamental Factors versus Herding in the 2000-2005 US Stock Market and Prediction

Abstract

We present a general methodology to incorporate fundamental economic factors to our previous theory of herding to describe bubbles and antibubbles. We start from the strong form of Rational Expectation and derive the general method to incorporate factors in addition to the log-periodic power law (LPPL) signature of herding developed in ours and others' works. These factors include interest rate, interest spread, historical volatility, implied volatility and exchange rates. Standard statistical AIC and Wilks tests allow us to compare the explanatory power of the different proposed factor models. We find that the historical volatility played the key role before August of 2002. Around October 2002, the interest rate dominated. In the first six months of 2003, the foreign exchange rate became the key factor. Since the end of 2003, all factors have played an increasingly large role. However, the most surprising result is that the best model is the second-order LPPL without any factor. We thus present a scenario for the future evolution of the US stock market based on the extrapolation of the fit of the second-order LPPL formula, which suggests that herding is still the dominating force and that the unraveling of the US stock market antibubble since 2000 is still qualitatively similar to (but quantitatively different from) the Japanese Nikkei case after 1990.