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: 24 Nov 2017
Date Written: November 23, 2017
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 shed some 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. Analyzing the US market as of September 2017, our empirical methodology predicts very negatively-skewed distributions with substantial crash risk and low expected rates of returns.
Keywords: return predictability, valuation ratios, skewness
JEL Classification: G12, G17, C22
Suggested Citation: Suggested Citation