Crash Prediction Using Fundamental Variables: Evidence from Mainland China

Abstract

This article investigates how fundamental crash prediction models perform in mainland China’s fast-growing equity markets. We apply three families of fundamental models, price-to-earnings ratio, cyclically adjusted price-to-earnings ratio, and bond-stock earnings yield differential, to the Shanghai and Shenzhen stock indices. Our statistical analysis supports the dominant view that Chinese equity markets behave different from U.S. markets. We find that fundamental models are significant predictors of equity market crashes in China despite these differences. Finally, we show how to use these crash prediction models to improve active portfolio management.