Sentiment and Price Formation: Interactions and Regime Shifts
36 Pages Posted: 6 Mar 2008
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: Suggested Citation