Equity Risk Premia, Corporate Profit Forecasts, and Investor Sentiment Around the Stock Crash of October 1987

Economists have produced no identifiable event which could justify, on fundamental grounds, the stock market crash of October, 1987. This research confirms that changes in consensus corporate profit forecasts and interest rates were completely unable to explain the decline in stock prices that took place at that time. It is shown that the equity risk premium would have to have increased by about four percentage points between October and November 1987 to explain the stock decline on the basis of these fundamental variables. Several possible explanations for the rise in the risk premium are explored. Another hypothesis is advanced that suggests that shifts in investor sentiment, perhaps induced by noise traders, was a factor in the stock decline. Analysis of historical data shows that investor sentiment, as well as profit forecasts and interest rates, are significantly associated with stock returns. On the basis of historical data analyzed for periods excluding the months around the crash, one can state that changing investor sentiment and profit forecasts can account for between 30 and 45% of the October, 1987 stock market decline. In contrast, changes in profit forecasts and interest rates alone would have, in fact, predicted a rise in stock prices. Hence it appears that a significant component of stock returns are driven by yet unexplained changes in investor sentiment unrelated to market fundamentals.