Working Paper: CEPR ID: DP13454
Authors: Ian Martin; Can Gao
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.
Keywords: volatility; valuation ratios; bubbles; sentiment; option prices
JEL Codes: G10; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high sentiment indicator (E32) | perceived overvaluation of the market (D46) |
| high sentiment indicator (E32) | market activity (G10) |
| high sentiment indicator (E32) | financial stress indicators (G51) |
| high valuation ratios (G32) | low expected returns (G12) |
| high valuation ratios (G32) | high expected dividend growth (G35) |
| high valuation ratios (G32) | overstated conclusions about future returns (G17) |
| lower bound on expected log returns (C51) | understanding market behavior (G41) |