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Discussion Paper Details

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Title: Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment

Author(s): Can Gao and Ian Martin

Publication Date: January 2019

Keyword(s): bubbles, Option prices, sentiment, valuation ratios and volatility

Programme Area(s): Financial Economics and Monetary Economics and Fluctuations

Abstract: We define a sentiment indicator that exploits two contrasting views of return predictability, and study its properties. The indicator, which is based on option prices, valuation ratios and interest rates, was unusually high during the late 1990s, reflecting dividend growth expectations that in our view were unreasonably optimistic. We interpret it as helping to reveal irrational beliefs about fundamentals. We show that our measure is a leading indicator of detrended volume, and of various other measures associated with financial fragility. We also make two methodological contributions. First, we derive a new valuation-ratio decomposition that is related to the Campbell and Shiller (1988) loglinearization, but which resembles the traditional Gordon growth model more closely and has certain other advantages for our purposes. Second, we introduce a volatility index that provides a lower bound on the market's expected log return.

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Bibliographic Reference

Gao, C and Martin, I. 2019. 'Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=13454