Stock Market Crash Of 2008: An Empirical Study Of The Deviation Of Share Prices From Company Fundamentals

Taisei Kaizoji and Michiko Miyano
Graduate School of Arts and Sciences,
International Christian University

Abstract

The aim of this study is to investigate quantitatively whether share prices deviated from company fundamentals in the stock market crash of 2008. For this purpose, we use a large database containing the balance sheets and share prices of 7,796 worldwide companies for the period 2004 through 2013. We develop a panel regression model using three financial indicators–dividends per share, cash flow per share, and book value per share–as explanatory variables for share price. We then estimate individual company fundamentals for each year by removing the time fixed effects from the two-way fixed effects model, which we identified as the best of the panel regression models. One merit of our model is that we are able to extract unobservable factors of company fundamentals by using the individual fixed effects.

Based on these results, we analyze the market anomaly quantitatively using the divergence rate–the rate of the deviation of share price from a company’s fundamentals. We find that share prices on average were overvalued in the period from 2005 to 2007, and were undervalued significantly in 2008, when the global financial crisis occurred. Share prices were equivalent to the fundamentals on average in the subsequent period. Our empirical results clearly demonstrate that the worldwide stock market fluctuated excessively in the time period before and just after the global financial crisis of 2008.

Stock Market Crash Of 2008: An Empirical Study Of The Deviation Of Share Prices From Company Fundamentals – Introduction

The stock market crash of 2008 is one of the largest stock market crashes in the history of capitalist economies. During the period from 2004 through 2013, the Dow Jones Industrial Average hit a high of 14,164.43 on October 9, 2007. For the eight trading days between October 1 and October 10, 2008, the DJIA fell continuously from 10,831.07 to 8,451.19, a 22.11 percent decline. The DJA hit a bottom of 6,594.44 on March 5, 2009. In less than 18 months, the index had declined more than 50 percent. The crisis was not limited to the US market. Markets worldwide were simultaneously in free fall. Figure 1 shows the mean of the logarithmic share price for 7,796 worldwide companies in the period 2004 through 2013. This value hit 1.71 in 2007, and in 2008 hit a bottom of 1.26. The mean share price declined by 36 percent in one year.

The liquidity crunch in U.S. and European short-term money markets began with an incident in August 2007 involving the complete evaporation of liquidity of three hedge funds invested in U.S. asset-backed securities (ABS) affiliated with BNP Paribas, one of the largest banks in France. U.S. and European financial institutions that provided liquidity support for the redemption of asset backed commercial paper (ABCP) were obliged to raise funds. Consequently, liquidity pressures in funding markets rose, spurring a liquidity crisis in short-term money markets. Amid this abrupt tightening of global financial markets, which triggered Lehman Brothers, a large investment bank, to file for bankruptcy in September 2008, investors in large numbers rapidly withdrew their funds from the stock markets, causing severe global disruptions.

In an efficient market (Fama 1970), stock price volatility is linked to changes in company fundamentals. To explore this notion, numerous attempts have been made by scholars to determine whether stock price volatility systematically exceeds levels which could be justified by changes in fundamentals. (See Shiller 1981, LeRoy and Porter 1981, Mehra and Prescott 1985, De Bondt and Thaler 1985, Fama and French 1992, Jegadeesh and Titman 1993, etc.) The issue remains controversial.

Stock Market Crash

This paper examines the question of whether the stock market crash of 2008 was an efficient response to financial shocks that was in line with fundamentals or was caused by investor panic. In order to produce estimates of the fundamentals required for our study, we construct a panel regression model using three financial indicators dividends per share, cash flow per share, and book value per share as explanatory variables for share price. These financial indicators are the representative variables commonly used to evaluate a firm’s business performance. We perform the panel analysis using a large database gleaned from the balance sheets of 7,796 of the world’s largest listed companies over a 10-year period (2004-2013). The two-way fixed effects model was selected as the best panel regression model for our work, based on standard tests for panel regression models.

The two-way fixed effects model has two fixed effects: the individual fixed effects that account for an individual company’s heterogeneity, including such factors as the company’s diversity of corporate governance and the quality of its employees; and the time fixed effects that indicate variables that fluctuate over time but are fixed across companies. The time fixed effects reflect various shocks, including financial shocks.

We define fundamentals as the theoretical value that omits the time fixed effects from our estimated regression model. One advantage of our model is that it can capture unobservable factors explaining company fundamentals. We investigated the distributions of the divergence rate, which is defined as the logarithmic difference between the share price and the fundamentals, and found that share prices deviated substantially from company fundamentals in the period 2006 to 2008. The distributions of the divergence rate deviated in the positive direction in the boom period from 2006 through 2007, but shifted significantly from the positive side to the negative side in 2008. It is clear that share prices (on average) were overvalued against the fundamentals during the boom period from 2006 to 2007, while in 2008 they were significantly below the fundamentals. In addition, the distributions of the divergence rate were negatively skewed and leptokurtic as compared to the distributions in other periods. It is notable that the negative skewness and leptokurtosis of the distributions of the divergence rate is indicative of the danger of a bubble. We conclude that the bubble of 2006 and 2007, and the subsequent crash of 2008, cannot be linked to changes in company fundamentals, but rather was likely caused by factors such as the psychological panic of investors.

This paper is organized as follows: Section 2 describes the data used in this study; Section 3 discusses the panel data regression model for company fundamentals; Section 4 examines the divergence rate, that is, the deviation of share prices from the fundamentals; Section 5 gives concluding remarks.

Stock Market Crash

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