Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment
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.
Research Area
Financial Markets
Keywords
bubbles, option prices, sentiment, valuation ratios, volatility
JEL Classification
G10, G12, G14
Research Data
Topic
Stability and Regulation
Saving and Borrowing
Consumption
Saving and Borrowing
Consumption
Relations
1
Publication Type
Working Paper
Link to Publication
Collections
- LIF-SAFE Working Papers [334]