Sentiment and Price Formation: Interactions and Regime Shifts

36 Pages Posted: 6 Mar 2008

See all articles by Nektaria Karakatsani

Nektaria Karakatsani

University of Warwick - Warwick Business School

Mark Salmon

University of Cambridge - Faculty of Economics and Politics

Date Written: March 4, 2008


The time-series relationship between investor sentiment and market returns, in particular the direction and size of the effects, remains ambiguous, being assessed under the restrictive assumption of linearity. This paper reveals the presence of four, intuitive, regimes in price and sentiment formation in the US stock market at the monthly level over the period 1965-2003, even after controlling for various economic and financial factors. An optimistic state of high returns (occurrence probability: 44%) alternates with a pessimistic state of low returns (35%), while two infrequent, highly volatile states capture temporal irregularities: episodes of extreme negative returns and strong pessimism (13%) and a reversal phase of intense optimism (8%). Five main findings arise: i) In the high return (low return) state, only individual (institutional) sentiment is influential, being a contrarian (momentum) signal for the subsequent return and responding positively (negatively) but weakly to its lagged value. In the former case, the impact of sentiment is consistent with correction of a previous mispricing, possibly induced by individuals, while in the latter, it indicates institutions' correct predictive ability. ii) The impact of institutional sentiment is substantial but constrained in the pessimistic state, while the effect of individual sentiment is moderate but augmented substantially at irregular times. iii) Individuals interpret institutional optimism as a positive signal, whereas institutions perceive individuals' optimism as a contrarian indicator. iv) Total arbitrage cost exerts a positive impact on both subsequent returns and institutional optimism. v) Interest rates' reductions amplify investors' optimism at irregular times, most evidently during the market reversal phase.

Keywords: Investor sentiment, Asset pricing, Regime-switching, Noise trading

JEL Classification: G12, G14

Suggested Citation

Karakatsani, Nektaria and Salmon, Mark Howard, Sentiment and Price Formation: Interactions and Regime Shifts (March 4, 2008). Available at SSRN: or

Nektaria Karakatsani (Contact Author)

University of Warwick - Warwick Business School ( email )

Gibbet Hill Rd
Coventry, CV4 7AL
Great Britain

Mark Howard Salmon

University of Cambridge - Faculty of Economics and Politics ( email )

Austin Robinson Building
Sidgwick Avenue
Cambridge, CB3 9DD
United Kingdom

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