Are Emerging Market Investors Overly Pessimistic in Extreme Risk-off Periods?

Motivated by Campbell and Shiller [2001], we ask if future returns and loss probabilities are predictable when markets trade at extremely low, depressed levels. In this paper we present empirical evidence that a predictable "undershooting phenomenon" exists in emerging markets. Depressed valuation ratios are a statistically significant predictor at the 99% level of confidence for future returns in most emerging markets. Overly anxious emerging market investors seem to overreact in periods of extreme stress and fear in financial markets.