Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment
67 Pages Posted: 24 Mar 2021 Last revised: 21 Dec 2023
There are 2 versions of this paper
Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment
Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment
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: Suggested Citation