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Investor Sentiment Aligned:
A Powerful Predictor of Stock Returns
Dashan Huang
Fuwei Jiang
Jun Tu
Guofu Zhou
Singapore Management University (Huang, Jiang, Tu)
Washington University in St. Louis (Zhou)
For the Q-Group Presentation
on April 7th, 2017 at Charleston, SC.
Sentiment and Stock Returns
Sentiment:
People
feel excessively optimistic or pessimistic
about a situation not justified by the facts at hand
Long history in finance: Keynes (1936)
Theoretically, sentiment can drive asset prices away
from their fundamental values due to limits of arbitrage
e.g., short-sell constraint, margin constraint, noise trader risk
Empirically, sentiment strongly predicts stocks that
are speculative, hard to arbitrage, or in the short legs
of long-short strategies
e.g., Baker and Wurgler (2006, 2007), Baker, Wurgler, and Yuan (2012,
JFE), Stambaugh, Yu, and Yuan (2012, JFE)
Why Sentiment Matter?: Some Macro Points
Money is scarce in recessions/downturns:
In
bad times, investors expect much higher
return to put money into stocks.
Shocks in supply/liquidity:
Loss of returns on the market
Loss of jobs
Risk appetite change:
Investors are unwilling to take risks in good times
Borrowing constraints:
ever
more stringent
Measurement of Sentiment
Sentiment is not directly observable
Baker and Wurgler (2006, JF) construct a sentiment index as
the first principal component (PC1) of the 6 sentiment proxies:
Closed-end fund discount rate, CEFD
Share turnover, TURN
Number of IPOs, NIPO
First-day returns of IPOs, RIPO
Dividend premium, PDND
Equity share in new issues, S
explains well the cross-sectional stock returns
influential: > 1111 google citations
Bottom Line:
the BW index cannot explain the
time variation of the aggregate stock market return.
What Do We Do?
This paper seeks to answer
Does sentiment forecast the aggregate stock market if it
is aligned in the right way?
What is the economic channel/driving force?
We find
sentiment strongly forecasts the aggregate stock market;
it outperforms greatly marcoeconomic predictors, at least in the
month-by-month horizon;
The value of predictability is of economic/practical significance;
The forecasting power of sentiment comes from the investor's
underreaction to cash flow information
Theoretical basis:
Econometrically, a method eliminating a common noise of the proxies
Economically, market trends and sentiment are related (e.g., De Long
et al. (1990, JPE), and Zhou and Zhu (2014, working paper)
Conclusions and Future Works
This paper finds
sentiment strongly forecasts the aggregate stock market if it is aligned
properly;
it outperforms greatly marcoeconomic predictors, at least in the
month-by-month horizon;
The value of predictability is of economic/practical significance;
The forecasting power of sentiment comes from the investor's
underreaction to cash flow information
Future Research:
More sentiment proxies:
Consumer sentiment
VIX
Returns on Art and Other Collectibles
Combined with technical analysis:
More theory in addition to Zhou and Zhu (2014), and more empirical work
along lines of Neely, et al (2014) and Han and Zhou (2013).