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In several recent studies unit root methods have been used in detection of financial bubbles in asset prices. The basic idea is that fundamental changes in the autocorrelation structure of relevant time series imply the presence of a rational price bubble. We provide cross-country evidence for performance of unit-root-based early warning systems in ex-ante prediction of financial crises in 15 EU countries over the past three decades. We find especially high performance for time series that are explicitly related to debt, which issue signals a few years in advance of a crisis. Combining signals from multiple time series further improves the predictions. Our results suggest an early warning tool based on unit root methods provides a valuable accessory in financial stability supervision.

To promote the financial stability, there is a need for an early warning system to signal the formation of asset price misalignments. This research provides two novel methods to accomplish this task. Results in this research shows that the conventional unit root tests in modified forms can be used to construct early warning indicators for bubbles in financial markets. More precisely, the conventional augmented Dickey-Fuller unit root test is shown to provide a basis for two novel bubble indicators. These new indicators are tested via MC simulations to analyze their ability to signal emerging unit roots in time series and to compare their power with standard stability and unit root tests. Simulation results concerning these two new stability tests are promising: they seem to be more robust and to have more power in the presence of changing persistence than the standard stability and unit root tests. When these new tests are applied to real US stock market data starting from 1871, they are able to signal most of the consensus bubbles, defined as stock market booms for example by the IMF, and they also flash warning signals far ahead of a crash. Also encouraging are the results with these methods in practical applications using equity prices in the UK, Finland and China as the methods seem to be able to signal most of the consensus bubbles from the data. Finally, these early warning indicators are applied to data for several housing markets. In most of the cases the indicators seem to work relatively well, indicating bubbles before the periods which, according to the consensus literature, are seen as periods of sizeable upward or downward movements. The scope of application of these early warning indicators could be wide. They could be used eg to help determine the right timing for the start of a monetary tightening cycle or for an increase in countercyclical capital buffers.

This paper provides an early warning indicator for bubbles in financial markets. The indicator is based on traditional unit root tests, more precisely on the augmented Dickey-Fuller test and may be used in a repeated manner with rolling samples. The performance of the indicator is tested extensively via Monte Carlo simulations and comparisons of the results with the most powerful standard (stability) tests. The new indicator seems to be more robust and to have more power than the standard tests. In empirical application to US stock market data for 1871-2010, the new indicator signals most of the consensus bubbles and gives warning signals well ahead of the crash, in most cases as early as 12 months ahead. The indicator also signals most of the 'negative bubbles' before their turning points. The author would like to thank Matti Viren, Esa Jokivuolle, Jouko Vilmunen, Pentti Saikkonen, Heikki Kauppi and Ari Hyytinen for their comments at various stages of this work. I would also like to thank Nina Björklund and Tarja Yrjölä for research assistance.

The dividend yield ratio in the stock markets is, to an extent, comparable to the rent-price ratio in the housing market.Taking advantage of this definitional similarity, one can then use the traditional unit root test for log dividend yield in this case, the log rent-price ratio to test for the existence of real estate bubbles.Such unit root tests are conducted for Finland, USA, UK, Spain and Germany, and the simple test results strongly suggest the existence of bubbles in nearly all of these countries.In addition to this, we develop a continuous and monthly rent-price information-based method to track the periods when real estate prices diverge from their fundamental levels.This indicator seems to work quite well in most cases, indicating bubbles during periods which, according to the consensus literature, are seen as periods of sizable upward or downward shifts in house prices.

Tests for unit roots in log dividend yields, which are consistent with `rational bubbles' in stock prices, are conducted for the S&P500 and Finnish stock market indexes.In addition to the traditional unit root tests, we split the data into 10-year segments and use frequency domain analysis to test for the presence of unit roots in the dividend yield data.The results strongly suggest the existence of bubbles in both the US and Finnish markets.Finally we develop a novel dividend yield-based method to track periods when stock prices divert their fundamental levels. This indicator produces promising results, as it seems to have some forecasting ability concerning booms and busts in the stock markets.