A Tale of Two Indexes: Predicting Equity Market Downturns in China

Abstract

Equity correction and crash prediction models were predominantly developed in mature financial markets. Do these models work in developing markets? This paper investigates the application of three families of fundamental models, the Price-to-Earnings ratio, Cyclically Adjusted Price-to-Earnings ratio, and Bond-Stock Earnings Yield Differential model, to mainland China's Shanghai and Shenzhen stock exchanges. We identify differences in market behavior and find that these models are significant predictors. We also show that these models can contribute to active management strategies that outperform a buy-and-hold investment, highlighting their real-world relevance.

Keywords: stock market corrections and crashes, Shanghai Stock Exchange, Shenzhen Stock Exchange, Bond-Stock Earnings Yield Differential (BSEYD), Price-to-Earnings ratio, Cyclically-Adjusted Price Earnings ratio (CAPE).

JEL Classification: G14, G15, G12, G10