Swedroe: Sentiment A Negative Predictor?

March 22, 2019

Many studies in behavioral finance suggest that speculative market sentiment can lead prices to diverge from their fundamental values.

For example, in their study “Investor Sentiment and the Cross-Section of Stock Returns,” published in the August 2006 issue of The Journal of Finance, authors Malcolm Baker and Jeffrey Wurgler developed a measure of investor sentiment that has become widely used to explain asset prices by aggregating information from six stock market-based proxies. However, there is little research on corporate managers’ sentiment.

Like investors, corporate managers are not immune from behavioral biases. As a result, they can be overly optimistic or pessimistic relative to fundamentals, leading to irrational market outcomes. And investors may simply follow managers’ sentiment in financial disclosures, even though this sentiment may not represent the underlying fundamentals of the firm.

The result is that high manager sentiment may lead to speculative market overvaluation. When the true economic fundamentals are revealed to the market gradually, the misvaluation diminishes and stock prices reverse, yielding low future stock returns.        

Recent Research

Fuwei Jiang, Joshua Lee, Xiumin Martin and Guofu Zhou contribute to the literature with their September 2017 study “Manager Sentiment and Stock Returns.”

The authors constructed a monthly corporate manager sentiment index based on the aggregated textual tone (the difference between the number of positive and negative words in the disclosures scaled by the total word count) of corporate financial disclosures in 10-Ks, 10-Qs and corporate conference call transcripts from 2003 to 2014. They then investigated the asset pricing implications of corporate manager sentiment, focusing on its predictability for future U.S. stock market returns.

Following is a summary of their findings:

  • Corporate managers as a whole tend to be overly optimistic when the economy and the market peak—the manager sentiment index is a contrarian indicator.
  • Periods with high manager sentiment are accompanied by high aggregate investment growth in the short run up to three quarters, but low subsequent aggregate investment growth in the long run up to two years, indicating that high manager sentiment captures managers’ overly optimistic beliefs about future returns to investment, which leads to overinvestment.
  • Higher manager sentiment precedes lower aggregate earnings surprises.
  • Manager sentiment negatively predicts cross-sectional stock returns, particularly for firms with high growth opportunities, high financial constraint, low dividend payout, high leverage, high financial distress, low profitability, high unexpected earnings, low price, high turnover, high beta, high idiosyncratic volatility, young age and small market cap. These are often companies whose stocks are costly to arbitrage—limits to arbitrage allow mispricings to persist. The results are statistically significant at the 1% confidence level out to six months, and statistically significant at the 5% confidence level out to 36 months.
  • Comparing their sentiment indicator with 14 other macroeconomic indicators, the predictive power of the sentiment indicator is greater and remains largely unchanged after controlling for them.
  • Their sentiment indicator is superior to five other investor sentiment signals (including the Conference Board’s and the University of Michigan’s consumer sentiment surveys, and the aforementioned Baker and Wurgler sentiment index).

Noting that their results are robust to a variety of alternative measures of manager sentiment, the authors concluded that there is “strong evidence that manager sentiment negatively predicts subsequent aggregate earnings surprises in the next year.” They added that their findings are consistent with the research findings from the field of behavioral finance, which has found that sentiment tends to capture mispricing rather than fundamental information.


The above findings demonstrate that the corporate managers’ sentiment is a negative predictor of future stock returns. Your takeaway should be that you should ignore management sentiment found in financial (and media) disclosures, especially if the sentiment happens to agree with your preconceived views, because that will lead to confirmation bias, overconfidence and overinvestment. Keep this in mind the next time you hear an optimistic outlook while watching CNBC or reading Barron’s.

If the above isn’t sufficient to keep you from “irrational exuberance,” perhaps the following advice from legendary investor Warren Buffett will. In his 2004 Berkshire Hathaway shareholder letter, he offered this advice: “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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