Booms, busts and behavioural heterogeneity in stock prices

We empirically evaluate a behavioural model with boundedly rational traders who disagree about the persistence of deviations from the fundamental stock price. Fundamentalist traders believe in mean-reversion, while chartists extrapolate trends. Agents gradually switch between the two rules, based upon their relative performance, leading to self-reinforcing regimes of mean-reversion and trend-following. For the fundamental price we use well-known models of Gordon (1962) and Campbell and Cochrane (1999). We estimate the two-type switching model using U.S. stock prices until 2012Q4 and find significant behavioural heterogeneity. Our model suggests that behavioural regime switching strongly amplifies booms and busts in stock prices.