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A Counterfactual Valuation of the Stock Index as a Predictor of Crashes

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  • Tom Roberts

Abstract

Stock market fundamentals would not seem to meaningfully predict returns over a shorter-term horizon—instead, I shift focus to severe downside risk (i.e., crashes). I use the cointegrating relationship between the log S&P Composite Index and log earnings over 1871 to 2015, combined with smoothed earnings, to first construct a counterfactual valuation benchmark. The price-versus-benchmark residual shows an improved, and economically meaningful, logit estimation of the likelihood of a crash over alternatives such as the dividend yield and price momentum. Rolling out-of-sample estimates highlight the challenges in this task. Nevertheless, the overall results support the common popular belief that a higher stock market valuation in relation to fundamentals entails a higher risk of a crash.

Suggested Citation

  • Tom Roberts, 2017. "A Counterfactual Valuation of the Stock Index as a Predictor of Crashes," Staff Working Papers 17-38, Bank of Canada.
    • Handle: RePEc:bca:bocawp:17-38
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    More about this item

    Keywords

    Asset Pricing; Financial stability;

    JEL classification:

    • C50 - Mathematical and Quantitative Methods - - Econometric Modeling - - - General
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G0 - Financial Economics - - General
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G19 - Financial Economics - - General Financial Markets - - - Other

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