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

Abstract

We define a sentiment indicator based on option prices, valuation ratios, and interest rates. The indicator can be interpreted as a lower bound on the expected growth in fundamentals that a rational investor would have to perceive to be happy to hold the market. The bound was unusually high in the late 1990s, reflecting dividend growth expectations that in our view were unreasonably optimistic. Our approach exploits two key ingredients. First, we derive a new valuation ratio decomposition that is related to the Campbell–Shiller loglinearization but that resembles the Gordon growth model more closely and has certain other advantages. Second, we introduce a volatility index that provides a lower bound on the market's expected log return.

House price bubble detection in Ukraine

“…We then formulate a threshold, the breach of which identifies the presence of a bubble. A threshold of one to two standard deviations outside the time series (depending on the asset class and the historical volatility of prices) can be considered a proper one for bubble detection (Fleckenstein and Sheehan, 2008; Gao and Martin, 2021). In this paper, we use a threshold of one standard deviation outside the time series.…”

A Mathematical Model of Financial Bubbles: A Behavioral Approach

“…The repercussions for the tulip market were felt in short order; by early November 1636, tulip prices had fallen to one-seventh of their peak value [4]. This historical example of a bubble clearly shows the influence of human behavior on the price of an asset and the emergence of a bubble, which is a major and current topic of interest in behavioral finance [5][6][7][8].…”

Information Shocks in the U.S. and Asset Mispricing in Emerging Economies

“…In contrast, when using stock market indices directly, local bubbly peaks are eventually followed by even higher peaks, which prevents any benchmarking. High valuation ratios are sometimes cited as direct evidence of a bubble (see Gao and Martin (2021)). Robustness tests show that our empirical results remain valid to other equity mispricing definitions.…”