Formal Identification of Sentiment Effects in Asset Markets

51 Pages Posted: 22 Feb 2012

See all articles by Peter G. Dunne

Peter G. Dunne

Central Bank of Ireland

John Forker

Queen's University Management School

Ronan Powell

University College Dublin (UCD) - Michael Smurfit Graduate School of Business

Andrey Zholos

Queen's University Management School

Date Written: February 22, 2012

Abstract

It is generally accepted that excessive exuberance or gloom in investor sentiment contributes to booms and crashes in asset prices but, because of its complex interaction with other aspects of the valuation process, these effects are not easy to identify with statistical confidence and this limits the scope for crafting an adequate and early policy response. To fill this gap, we develop an ex ante valuation approach that assigns different measures of sentiment to separate roles in the valuation equation. One measure of sentiment is assigned to capture risk aversion effects, while a broader-based investor sentiment index is assigned to capture changes in the perceived prospects for long-term earnings growth. The ratio of equity valuation when sentiment variables are included in the valuation exercise to the valuation when they are excluded is an obvious indicator of sentiment effects but this is difficult to assess statistically. We show that the ratio of average squared ‘implied’ long-run earnings growth ‘with’ and ‘without’ sentiment produces a sentiment indicator that can be assessed with statistical significance. Out-of-sample testing using the Dow 30 index shows that sentiment effects can often be confidently identified as widespread, significant and large. We find that the growth ratio is more prescient as an early warning indicator of mis-valuations. Being able to draw attention to such statistically verifiable arbitrage opportunities in a timely fashion offers macro-prudential policy makers a more targeted policy response than making alterations to poorly focused policy instruments, such as interest rates.

Keywords: bubbles, fundamental valuation, sentiment, early warning indicators

JEL Classification: E32, E44, E58, E66, G10, G12, G14

Suggested Citation

Dunne, Peter G. and Forker, John and Powell, Ronan G. and Zholos, Andrey, Formal Identification of Sentiment Effects in Asset Markets (February 22, 2012). Available at SSRN: https://ssrn.com/abstract=2009192 or http://dx.doi.org/10.2139/ssrn.2009192

Peter G. Dunne (Contact Author)

Central Bank of Ireland ( email )

P.O. Box 559
Dame Street
Dublin, 2
Ireland

John Forker

Queen's University Management School ( email )

25 University Square
Belfast, Northern Ireland BT7 1NN
Northern Ireland

Ronan G. Powell

University College Dublin (UCD) - Michael Smurfit Graduate School of Business ( email )

Blackrock, Co. Dublin
Ireland

Andrey Zholos

Queen's University Management School ( email )

25 University Square
Belfast, Northern Ireland BT7 1NN
Northern Ireland

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