Sentiment, Convergence of Opinion, and Market Crash

41 Pages Posted: 22 Oct 2010 Last revised: 22 Jun 2011

See all articles by Qingwei Wang

Qingwei Wang

Cardiff University - Cardiff Business School; ZEW – Leibniz Centre for European Economic Research

Date Written: May 1, 2010

Abstract

I introduce a novel proxy of investor sentiment and differences of opinion among trendchasing investors to forecast skewness in daily aggregate stock market returns. The new proxy is an easy-to-construct, real time measure available at different frequencies for more than a century. Empirically I find that negative skewness is most pronounced when investors have experienced high sentiment. The role of differences of opinion depends on the states of average investor sentiment: it positively forecasts market skewness in an optimistic state, but negatively forecasts it in a pessimistic state. Conceptually, I provide an explanation for the role of differences of opinion based on the theory of Abreu and Brunnermeier (2003). I argue that convergence of opinion in an optimistic state indicates that the price run-up is unlikely to be sustained since fewer investors can remain net buyers in the future. Therefore rational arbitrageurs coordinate their attack on the bubble, leading to a market crash. Vice versa, the convergence of opinion in a pessimistic state promotes coordinated purchases among rational arbitrageurs, leading to a strong recovery.

Keywords: investor sentiment, differences of opinion, technical trading, skewness, stock market crash

JEL Classification: G01, G12, G14

Suggested Citation

Wang, Qingwei, Sentiment, Convergence of Opinion, and Market Crash (May 1, 2010). Available at SSRN: https://ssrn.com/abstract=1695410 or http://dx.doi.org/10.2139/ssrn.1695410

Qingwei Wang (Contact Author)

Cardiff University - Cardiff Business School ( email )

Aberconway Building
Colum Drive
Cardiff, CF10 3EU
United Kingdom

ZEW – Leibniz Centre for European Economic Research ( email )

P.O. Box 10 34 43
L 7,1
D-68034 Mannheim, 68034
Germany

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