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Market tolerance: Valuation and the distance to crash

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  • Lee, Hyeonmin

Abstract

Valuation measures such as the Shiller CAPE reliably forecast long-horizon equity returns but offer little guidance on short-horizon crash risk. This paper proposes Market Tolerance — the minimum additional basis points of monetary policy tightening the market can absorb before the predicted next-month crash probability exceeds a given threshold. Using U.S. monthly data from 1986 to 2024, we fit a spline-logit model of crash risk as a function of lagged CAPE and FOMC event-window rate changes, and translate the fitted probabilities into monthly Market Tolerance values. Tolerance falls sharply with CAPE and reaches zero in high-valuation regimes: at a 15% crash-probability threshold, the median tolerance in the top CAPE quintile is 0 bp. More than half of those months already breach the threshold before any additional tightening arrives, indicating that elevated valuation itself — not heightened sensitivity to rate changes — drives the fragility. The qualitative pattern remains across alternative thresholds, sample subperiods, valuation measures, and selected crisis exclusions, although its strength varies across regimes.

Suggested Citation

  • Lee, Hyeonmin, 2026. "Market tolerance: Valuation and the distance to crash," Finance Research Letters, Elsevier, vol. 106(C).
    • Handle: RePEc:eee:finlet:v:106:y:2026:i:c:s1544612326007683
    DOI: 10.1016/j.frl.2026.110240
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