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

Jeremy J. Siegel

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: This research examines a detailed time series of future aggregate profit forecasts. It seeks to determine whether the path of equity prices in the twelve month period surrounding the October 1987 crash could be justified by changes in the fundamental determinants of stock prices, i.e., the present value of expected future corporate profits. It does not address what caused the shifts in expectations of future corporate profits, but whether there was a sufficiently large change in these forecasts to justify the movement of stock prices.

The paper concludes that the rise and subsequent fall of stock prices in 1987 cannot be explained by discounting the mean or "consensus" level of future profit forecasts with a constant equity risk premium. It is determined that the required equity risk premium must have changed over three percentage points over the period to reconcile the consensus valuations with the actual time series of stock prices.

Two explanations are offered to explain the deviation of actual stock prices from the consensus valuation. The first analyzes whether changes in the required equity risk premium was correlated with the cross-sectional dispersion of the forecasts of future corporate profits. The second explanation, using a Lintner model of heterogeneously informed investors with a constant equity risk premium, examines whether changes in an index of investor "sentiment" could explain stock prices in 1987.

The study finds that both the one-year ahead dispersion of profit forecasts and the indicators of investor sentiment are independently significant in explaining the deviation between the S&P 500 Index and the consensus valuations of corporate equity during this period. Therefore one cannot reject the hypothesis that the stock market behavior during 1987 was accompanied by changes in the perceived risk of the future stream of corporate profits or shifting sentiment between those investors adhering to the optimistic and pessimistic profit forecasts. Changes in consensus valuations alone cannot explain the movements in the market.

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