Causes of fragile stock market stability

Abstract

We develop a behavioral stock market model in which a market maker adjusts stock prices with respect to the orders of chartists, fundamentalists and sentiment traders. We analytically prove that the mere presence of sentiment traders, i.e. traders who optimistically buy stocks in rising markets and pessimistically sell stocks in falling markets, compromises the stability of stock markets. In particular, this means that instead of converging towards their fundamental value, stock prices either display endogenous oscillatory dynamics or converge towards nonfundamental fixed points - observations that challenge standard stability claims offered in the pertinent literature.