DP13454 Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment
|Author(s):||Can Gao, Ian Martin|
|Publication Date:||January 2019|
|Keyword(s):||bubbles, Option prices, sentiment, valuation ratios, volatility|
|JEL(s):||G10, G12, G14|
|Programme Areas:||Financial Economics, Monetary Economics and Fluctuations|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=13454|
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.