Abstract
We start this chapter with a deeper look at how crash prediction models such as the bond–stock earnings yield differential (BSEYD) work. Next, we explore the BSEYD’s ability to predict crashes through a case study of the market meltdowns in China, Iceland, and the US in the 2007–2009 period. Historically, when the BSEYD measure is too high, meaning that long bond interest rates are too high relative to the trailing earnings over price ratio, there usually is a crash of 10% or more within four to twelve months. The BSEYD model did in fact predict all the three crashes. Iceland had a drop of fully 95%, China fell by two–thirds and the US by 57%. The material in this chapter is based on Lleo and Ziemba (2012).
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