Identifying irrational exuberance in the Indian markets

Abstract

Bubbles are a characteristic feature of a market-based capitalist economy which imposesignificant costs when they eventually burst as was witnessed in the recent economic crisis.While there are many who vehemently argue that bubbles cannot be identified in advance,there is considerable evidence that asset markets are mean-reverting in nature. This implies that when real asset prices / valuation ratios are significantly above their historical means,they can provide an early warning signal of the presence or the formation of a bubble. This information can be valuable to policy makers who can take appropriate policy action to nip itin its bud before it becomes catastrophic.This paper aims to determine whether valuation ratios in the Indian stock market like priceearnings and dividend yield are helpful in predicting future returns and whether there exists statistical measures beyond which we can conclude, with a reasonable degree of certainty, thepresence of bubbles.