Equity Risk Premia, Corporate Profit Forecasts, and Investor Sentiment around the Stock Crash of October 1987

This paper confirms that changes in consensus corporate profit forecasts and interest rates were completely unable to explain the rise and subsequent collapse of stock prices during 1987. The equity risk premium would have had to fall and then rise by about 4 percentage points to explain the behavior of stock prices around the crash on the basis of standard valuation models. Such shifts did not occur during the 1990-91 stock market cycle. There was, however, an unusually wide divergence of future profit forecasts before the crash, a phenomenon that may have left the market vulnerable to shifting investing sentiment.