A Tale of Two Indexes: Predicting Equity Market Downturns in China

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Systemic Risk Centre Discussion Papers DP 82
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Predicting stock market crashes is a focus of interest for both researchers and practitioners. Several prediction models have been developed, mostly for use on mature financial markets. In this paper, we investigate whether traditional crash predictors, the price-to earnings ratio, the Cyclically Adjusted Price-to-Earnings ratio and the Bond-Stock Earnings Yield Differential model, predict crashes for the Shanghai Stock Exchange Composite Index and the Shenzhen Stock Exchange Composite Index. We also constructed active investment strategies based on these predictors. We found that these crash predictors have predictive power and the active strategies delivered lower risk and higher risk-adjusted return than a simple buy and hold investment.