Sentiment, Habit and the Value Premium

Abstract

This paper extends the Campbell and Cochrane (1999) habit model with market sentiment as an additional state variable in both the drifts of consumption and dividend growths. The additional state variable results in different behaviour of the consumption and dividend growths and explains the causes of historical crises to either consumption or sentiment shocks. The model offers a behavioural explanation of the value premium puzzle in the context of habit models through a constructed price-dividend hyperplane. A Monte Carlo simulation of the models show a value premium relative to the original model due to agents' conservatism on value stocks earnings stream in a negative sentiment environment.

Keywords: Asset Pricing, Habit utility models, Market sentiment, Value premium

JEL Classification: G12, G17, G40, G41