Up the Stairs, Down the Elevator: Valuation Ratios and Shape Predictability in the Distribution of Stock Returns
45 Pages Posted: 19 Dec 2016 Last revised: 3 Jul 2018
Date Written: June 28, 2018
While a large literature on return predictability has shown a link between valuation levels and expected rates of returns, we document a link between valuation levels and the shape of the distribution of cumulative (for example, over 12 and 24 months) total returns. Return distributions become more asymmetric and negatively skewed when valuation levels are high. In contrast, they are roughly symmetric when valuation levels are low. These results turn out to be very robust to alternative (a) measures of valuation levels, (b) model specifications and (c) equity markets, shed light on how equity prices regress back to their means conditional on valuation levels and have important practical implications for risk measurement and asset management. Conceptually, our empirical results support asset pricing models that have asymmetric responses to shocks, such as stochastic bubbles, liquidity spirals or models with time-varying risk aversion.
Keywords: return predictability, valuation ratios, skewness
JEL Classification: G12, G17, C22
Suggested Citation: Suggested Citation