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We define a sentiment indicator that exploits two contrasting views of return predictability, and study its properties. The indicator, which is based on option prices, valuation ratios and interest rates, was unusually high during the late 1990s, reflecting dividend growth expectations that in our view were unreasonably optimistic. We interpret it as helping to reveal irrational beliefs about fundamentals. We show that our measure is a leading indicator of detrended volume, and of various other measures associated with financial fragility. We also make two methodological contributions. First, we derive a new valuation-ratio decomposition that is related to the Campbell and Shiller (1988) loglinearization, but which resembles the traditional Gordon growth model more closely and has certain other advantages for our purposes. Second, we introduce a volatility index that provides a lower bound on the market's expected log return.
Low probability events are overweighted in the pricing of out-of the-money index puts and single stock calls. We find that this behavioral bias is strongly time-varying, linked to equity market sentiment, and higher moments of the risk-neutral density. An implied volatility (IV) sentiment measure that is jointly derived from index and single stock options explains investors' overweight of tail events the best. Our findings also suggest that IV-sentiment predicts equity markets reversals better than overweight of small probabilities itself. When employed in a trading strategy, IV-sentiment delivers economically significant results, which are more consistent than the ones produced by the market sentiment factor. The joint use of information from the single stock and index option markets seems to explain the forecasting power of IV-sentiment. Out-of-sample tests on reversal prediction show that our IV-sentiment measure adds value over and above traditional factors in the equity risk premium literature, especially as an equity-buying signal. This reversals prediction seems to improve time-series and cross-sectional momentum strategies.