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.
Highlights
FrameworkIf one thinks from the perspective of an investor whose beliefs and risk preferences are consistent with (2) (or with the alternatives mentioned in footnote 1) and (3), the mNCC holds if this investor—whom we refer to as a representative investor—maximizes utility Etu(Wt+1), with relative risk aversion −Wu (W )/u (W ) (which need not be constant) at least one, and chooses to invest his or her wealth fully in the market
We define a sentiment indicator based on option prices, valuation ratios, and interest rates
Valuation ratios alone would make for an even simpler sentiment indicator. Are they enough? In theory, no: as we have argued, valuation ratios can be high for good reasons if interest rates are low or if risk premia are low, or both, and our measure embraces this fact by incorporating r f,t and LVIXt
Summary
If one thinks from the perspective of an investor whose beliefs and risk preferences are consistent with (2) (or with the alternatives mentioned in footnote 1) and (3), the mNCC holds if this investor—whom we refer to as a representative investor—maximizes utility Etu(Wt+1), with relative risk aversion −Wu (W )/u (W ) (which need not be constant) at least one, and chooses to invest his or her wealth fully in the market This setup allows for the possibility that other investors are irrational and/or face trading constraints; we emphasize, that our representative investor is assumed to be unconstrained, and, in particular, to be able to trade in option markets, so that he or she is marginal for option prices. The indicator is high, indicating the possible presence of a bubble, if there is a combination of high interest rates, a high market valuation ratio (i.e., low dividend yield), and high option prices
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