Forecasting Asset Price Booms

December 28, 2011

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While much of the work posted lately has been related to forecasting banking, currency, sovereign debt, and internal uprisings, the paper “Early Warning Indicators for Asset Price Booms” attempts to forecast stock and real estate booms over the next eight quarters.

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Abstract: The recent financial crisis has demonstrated in an impressive way that boom/bust cycles can have devastating effects on the real economy. This paper aims at contributing to the literature on early warning indicator exercises for asset price booms. Using a sample of 17 industrialized OECD countries and the euro area over the period 1969 Q1 – 2010 Q2, an asset price composite indicator incorporating developments in both stock and house price markets is constructed. The latter is then further developed in order to identify periods that can be characterized as asset price booms. The subsequent empirical analysis is based on a probit-type approach incorporating several monetary, financial and real variables. Following some statistical tests, credit aggregates, the investment-to-GDP ratio, the interest rate spread together with the house price growth gap and stock price developments appear to be useful indicators for the prediction of asset price booms up to two years ahead.

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During asset price booms the balance sheet positions of the financial and non-financial sectors improve and the value of collateral increases, permitting a further extension of the banking credit for investment which may reinforce the increase in asset prices. The opposite mechanism can sometimes be observed during asset price downward adjustments.

Credit growth forecasts booms, as well as busts. The difference is how long credit has been growing.

  • Grantham defines bubbles where prices exceed 2 standard deviations of a long term trend.
  • Hope tends to build slowly while fear often crystallizes swiftly. Prechter (1999)

Source : Early Warning Indicators for Asset Price Booms

 

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