When Does Investor Sentiment Predict Stock Returns?

40 Pages Posted: 16 Mar 2010

See all articles by San-Lin Chung

San-Lin Chung

National Taiwan University - Department of Finance

Chi-Hsiou Daniel Hung

University of Glasgow - Adam Smith Business School

Chung-Ying Yeh

Tunghai University-Department of Finance

Date Written: March 14, 2010

Abstract

We examine the predictive effect of sentiment on the cross-section of stock returns across different economic states. The degree of mispricing and the subsequent price correction can be different between economic expansion and recession because of the limits of arbitrage and short sale constraints. The predictive ability of sentiment is asymmetric between different states of the economy. We implement a multivariate Markov-switching model to characterize the economic states. Conditional on the identified economic states, we use the lagged sentiment proxy to forecast the portfolio returns related to small stocks, non-earning stocks, growth stocks, and non-dividend-paying stocks. We find that only in the expansion state does sentiment performs both in-sample and out-of-sample predictive power on these categories of stocks. When an expansion state has high sentiment, these categories of stocks earn relatively low subsequent returns. The predictive ability of sentiment can not be attributed to time-variation in the market beta driven by investor sentiment.

Keywords: Investor Sentiment; Stock Returns; Return Predictability; Markov-Switching Vector Autoregressive Model; Bootstrap

JEL Classification: E32; G11; G12; G14

Suggested Citation

Chung, San-Lin and Hung, Chi-Hsiou Daniel and Yeh, Chung-Ying, When Does Investor Sentiment Predict Stock Returns? (March 14, 2010). Available at SSRN: https://ssrn.com/abstract=1570487 or http://dx.doi.org/10.2139/ssrn.1570487

San-Lin Chung

National Taiwan University - Department of Finance ( email )

Taipei, 106
Taiwan
886-2-33661084 (Phone)
886-2-23660764 (Fax)

HOME PAGE: http://www.fin.ntu.edu.tw/~slchung/

Chi-Hsiou Daniel Hung

University of Glasgow - Adam Smith Business School ( email )

Gilbert Scott Building
University of Glasgow
Glasgow, Scotland G12 8QQ
United Kingdom

Chung-Ying Yeh (Contact Author)

Tunghai University-Department of Finance ( email )

Taichung 407
Taiwan
Tel:886-4-2359-0121 ext.35819 (Phone)

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