Investor sentiment—the propensity of individuals to trade on noise and emotions rather than facts—represents investors’ beliefs about future cash flows that the prevailing fundamentals cannot explain. Such activity can lead to mispricing. Eventually, any mispricing would be expected to be corrected when the fundamentals are revealed, making investor sentiment a contrarian predictor of stock market returns.
Examples of times when investor sentiment ran high are the 1968-69 electronics bubble, the biotech bubble of the early 1980s, and the dot-com bubble of the late 1990s. Sentiment fell sharply, however, after the 1961 crash of growth stocks, in the mid-1970s with the oil embargo, and in the crash of 2008.
Over roughly the last decade, researchers have explored investor sentiment’s impact on markets. Malcolm Baker and Jeffrey Wurgler have even constructed an investor sentiment index based on six metrics: trading volume as measured by NYSE turnover; the dividend premium (the difference between the average market-to-book ratio of dividend-payers and non-payers); the closed-end fund discount; number of IPOs; first-day returns on IPOs; and the equity share in new issues. (Data available at Wurgler’s New York University webpage.)
Does investor sentiment (the psychology of crowds) affect stock prices, leading to mispricings? The argument against the belief that investor sentiment affects stock prices is that any effects caused by sentiment should, in theory, be eliminated by rational traders seeking to exploit the profit opportunities created by mispricings. However, if there are limits to arbitrage, rational traders cannot fully exploit such opportunities—and sentiment effects become more likely.
The question then is, does investor sentiment predict overpriced or underpriced stock markets? Let’s review the evidence.
Baker, Wurgler and Yu Yuan, authors of the study, “Global, Local, and Contagious Investor Sentiment,” which appeared in the May 2012 issue of Journal of Financial Economics, investigated the effect of investor sentiment’s global and local components on major stock markets, both at the country average level and as they affect the time series of the cross section of stock returns.
They also studied whether sentiment spreads across markets. The study covered the period 1980 through 2005 and six stock markets: Canada, France, Germany, Japan, the United Kingdom and the United States. As previously mentioned, they compiled the first global sentiment index.
Following is a summary of their findings:
- Investor sentiment plays a significant role in international market volatility and generates return predictability of a form consistent with the correction of investor overreaction.
- Total sentiment, particularly the global component of total sentiment, is a contrarian predictor of country-level market returns—high investor sentiment predicts low future returns and vice versa. Results are similar for value-weighted and equal-weighted market returns and for non-U.S. markets.
- The economic significance of the effect is nontrivial. A one-standard-deviation increase in a country’s total investor sentiment index is associated with 3.5% per year lower value-weighted market returns and 4.3% per year lower equal-weighted returns.
- Global sentiment is the main driver of country-level results. A one-standard-deviation increase in the global sentiment index is associated with 5.4% per year lower value-weighted market returns and 5.6% per year lower equal-weighted market returns.
- Broad waves of sentiment have greater effects on hard-to-arbitrage (due to greater costs and greater risks) and hard-to-value (small-cap, high return volatility, growth and distressed) stocks. These stocks will exhibit high “sentiment beta.”
- After sorting stocks across years according to whether the level of their total sentiment index is positive or negative, top-volatility-decile stocks earn 16.1% per year lower returns when the year starts in a high-sentiment state—consistent with a correction of sentiment-driven overpricing. High-sentiment periods also portend 1% per month lower returns on the smallest capitalization portfolio, another economically large effect. The effect of sentiment is much smaller on low-volatility stocks or large stocks, as they are relatively easy to arbitrage and value.
- Not only does local and global sentiment predict the cross section of a country’s returns, but investor sentiment also is contagious. For instance, U.S. sentiment affects returns for countries linked with the United States by significant capital flows. This conclusion doesn’t depend on including the United States in the sample.
The authors concluded: “Global sentiment is a statistically and economically significant contrarian predictor of market returns. Both global and local components of sentiment help to predict the time series of the cross-section; namely, they predict the returns on high sentiment-beta portfolios such as those including high volatility stocks or stocks of small, distressed, and growth companies.”