The Dynamics of Value Across Global Equity Markets: The Risk Contagion

27 Pages Posted: 3 Apr 2015 Last revised: 7 Apr 2015

See all articles by Jan Novotny

Jan Novotny

City University London - Faculty of Finance; Charles University in Prague - CERGE-EI (Center for Economic Research and Graduate Education - Economics Institute)

Mayank Gupta

Cass Business School City University London; University of Verona - Department of Economics; University of Padua - Department of Economics and Management

Date Written: April 2, 2015

Abstract

The ratio between the share price and current earnings per share, the PE ratio, is widely considered to be an effective gauge of under/overvaluation of a corporation’s stock. Arguably, a more reliable indicator, the Cyclically-Adjusted Price Earning ratio or CAPE, can be obtained by replacing current earnings with a measure of permanent earnings i.e. the profits that a corporation is able to earn, on average, over the medium to long run. In this study, we aim to understand the cross-sectional aspects of the dynamics of the valuation metrics across global stock markets including both developed and emerging markets. We use a time varying DCC model to exploit the dynamics in correlations, by introducing the notion of value spread between CAPE and the respective Market Index from 2002 to 2014 for 34 countries. We find periods, notably around the 2008 financial crisis, when the value spread shows large degree of variation and thus provide a statistically significant signal for the asset allocation. The signal can be utilized for better asset allocation as it allows one to interpret the common movements in the stock market for under/overvaluation trends. These estimates clearly indicate periods of misvaluation in our sample. Furthermore, our simulations suggest that the model would have been able to provide early warning signs of misvaluation in real time on a global scale and formation of asset bubbles.

Keywords: CAPE, Portfolio Diversification, Price-Earning Ratio, Value Portfolio, Asset Mispricing, Spillover Risk

JEL Classification: C58, G11, G15, G17

Suggested Citation

Novotny, Jan and Gupta, Mayank, The Dynamics of Value Across Global Equity Markets: The Risk Contagion (April 2, 2015). Available at SSRN: https://ssrn.com/abstract=2589026 or http://dx.doi.org/10.2139/ssrn.2589026

Jan Novotny

City University London - Faculty of Finance ( email )

London, EC2Y 8HB
Great Britain

Charles University in Prague - CERGE-EI (Center for Economic Research and Graduate Education - Economics Institute) ( email )

P.O. Box 882
7 Politickych veznu
Prague 1, 111 21
Czech Republic

Mayank Gupta (Contact Author)

Cass Business School City University London ( email )

London, EC2Y 8HB
Great Britain
07466616332 (Phone)

HOME PAGE: http://www.cass.city.ac.uk

University of Verona - Department of Economics ( email )

Via dell'Artigliere, 8
Verona, 37129
Italy

University of Padua - Department of Economics and Management ( email )

Via Del Santo 23
Padova, 35122
Italy

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