Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment

67 Pages Posted: 24 Mar 2021 Last revised: 21 Dec 2023

See all articles by Ian Martin

Ian Martin

London School of Economics & Political Science (LSE) - Department of Finance

Can Gao

Swiss Finance Institute; University of St.Gallen; Swisss Institute for Banking and Finance

Multiple version iconThere are 2 versions of this paper

Date Written: January 1, 2021

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.

Keywords: bubbles, Option prices, sentiment, valuation ratios, volatility

JEL Classification: G10, G12, G14

Suggested Citation

Martin, Ian W. R. and Gao, Can, Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment (January 1, 2021). Available at SSRN: https://ssrn.com/abstract=3810730 or http://dx.doi.org/10.2139/ssrn.3810730

Ian W. R. Martin

London School of Economics & Political Science (LSE) - Department of Finance ( email )

United Kingdom

HOME PAGE: http://personal.lse.ac.uk/martiniw/

Can Gao (Contact Author)

Swiss Finance Institute ( email )

Switzerland

HOME PAGE: http://https://www.sfi.ch/en/people/can-gao

University of St.Gallen ( email )

Unterer Graben 21
St. Gallen, 9000
Switzerland

Swisss Institute for Banking and Finance ( email )

Rosenbergstrasse 52
St. Gallen, CH-9000
Switzerland

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