William T. Ziemba

Stock Market Crashes: Predictable and Unpredictable and What to do About Them

This book presents studies of stock market crashes big and small that occur from bubbles bursting or other reasons. By a bubble we mean that prices are rising just because they are rising and that prices exceed fundamental values. A bubble can be a large rise in prices followed by a steep fall. The focus is on determining if a bubble actually exists, on models to predict stock market declines in bubble-like markets and exit strategies from these bubble-like markets. We list historical great bubbles of various markets over hundreds of years.

The High Price–Earnings Stock Market Danger Approach of Campbell and Shiller versus the BSEYD Model

We show how to use Campbell and Shiller’s work on price-to-earnings (P/E) ratio and the predictability of long-term returns to create a crash prediction measure: the high P/E measure. Next, we present a statistical procedure to test the accuracy of crash prediction models. We use this procedure to test the accuracy of the bond–stock earnings yield differential (BSEYD) and high P/E models on a 51-year period on the US market, starting on January 1, 1962, and ending on December 31, 2014 (12,846 daily data points). At the end of the Chapter, we expand the analysis beyond the US market to look at the two main Chinese stock markets: Shanghai and Shenzhen. Material in this chapter is based on Lleo and Ziemba (2017) and Lleo and Ziemba (2016c).

Discovery of the Bond–Stock Earnings Yield Differential Model

We discuss the bond–stock earnings yield differential (BSEYD) model starting from when Ziemba first used it in Japan in 1988–89 in various countries. The model has called many but not all crashes. Those have high interest rates in the most liquid long-term bonds relative to the trailing earnings-to-price ratio (EP ratio). In general, when the model is in the danger zone, there will almost always be a crash. The model called the 2000 and 2002 US crashes. A long horizon study for the US, Canada, Japan, Germany, and UK shows that being in the stock market when the bond–stock signal is not in the danger zone and in cash when it is in the danger zone provides a final wealth about double buy and hold in these five countries during 1975–2000 or 1980–2000.

Effect of Fed Meetings and Small-Cap Dominance

In this chapter we discuss the generally positive effects on the US stock market of FED meetings and small cap stocks.Sixty-fourty pension fund fixed mix and presidential party effects are studied along with the effects on the stock market when congress is in session.Five strategies are presented and two simple presidential party strategies have over long periods produced higher returns than small or large cap stocks and about twenty times more final wealth than the highly recommended 60-40 stock-bond mix.

The Swiss Black Swan Unpegging Bad Scenario: The Losers and the Winners

Financial disasters to hedge funds, bank trading departments, and individual speculative traders and investors almost always occur because of non-diversification in all possible scenarios, being overbet and being hit by a bad scenario. Black swans, namely those scenarios that are unexpected and extreme, are the worst type of bad scenario. The Swiss National Bank decision on January 15, 2015 to abandon the 1.20 peg against the euro was a tremendous blow for Swiss exporters, Swiss and international investors, hedge funds, global macro funds and banks as well as the Swiss central bank. We discuss the causes of this policy change, the money losers and the few winners, and what it means for Switzerland, Europe and the rest of the world, what kinds of trades lost and how they have been prevented.