50 Pages Posted: 10 Apr 2017 Last revised: 14 Sep 2017
Date Written: September 11, 2017
Recent evidence shows that investor sentiment is a contrarian predictor of stock returns with speculative stocks earning lower (higher) future returns than safe stocks following high (low) sentiment states. We extend this argument by conditioning expected stock returns on sentiment dynamics and show that the mispricing of speculative and safe stocks worsens with sentiment continuations but is corrected with sentiment transitions, supporting the view that the mispricing of these stocks is sentiment-driven. We show that the unconditional contrarian return predictability of sentiment, at least in the short-run, is due to the returns of stocks in sentiment transitions. Results show that ex post, sentiment is a momentum predictor if subsequent sentiment continues; and a contrarian predictor if subsequent sentiment transitions. We show that the MAX effect can either be positive or negative contingent on sentiment dynamics. The absence of a negative MAX effect following Low sentiment states suggested by prior studies is due to the completely offsetting negative MAX effect when sentiment continues in a Low state and the positive MAX effects when sentiment transitions from a High to a Low state.
Keywords: Sentiment dynamics, Hard to value stocks, Max effect
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation
Cheema, Muhammad A. and Nartea, Gilbert V., Investor Sentiment Dynamics and the Cross-section of Stock Returns (September 11, 2017). Available at SSRN: https://ssrn.com/abstract=2949772