A probit-based analysis of the deep stock market drawdowns

Abstract

PurposeThis study is motivated in part by the fact that the unfolding 2022 bear market, which has reached the −25% drawdown, has not been preceded by the inverted 10Y-3 m spread or an inverted near-term forward spread.Design/methodology/approachThe authors develop a three-factor probit model to predict/explain the deep stock market drawdowns, which the authors define as the drawdowns in excess of 20%.FindingsThe study results show that (1) the rising credit risk predicts a deep drawdown about a year in advance and (2) the monetary policy easing precedes an imminent drawdown below the 20% threshold.Originality/valueThis study three-factor probit model shows adaptability beyond the typical recessionary bear market and predicts/explains the liquidity-based selloffs, like the 2022 and possibly the 1987 deep drawdowns.