The Importance of Fear: Investor Sentiment and Stock Market Returns

34 Pages Posted: 19 Mar 2016 Last revised: 24 Nov 2016

See all articles by Lee A. Smales

Lee A. Smales

University of Western Australia

Date Written: March 18, 2016

Abstract

The presence of investor sentiment pushes asset prices away from the equilibrium level justified by underlying fundamentals. While sentiment is not directly observable, identifying appropriate proxies and, quantifying the impact of sentiment on asset prices is an important topic. Asset prices that do not appropriately reflect fundamental values may result in inefficient allocation of capital – impacting portfolio allocation decisions and the cost of capital. Utilising a number of sentiment proxies, over the period 1990-2015, we demonstrate a strong relationship between investor sentiment and stock returns that is consistent with theoretical explanations of sentiment. We determine that VIX is the preferred measure of sentiment in terms of improving model fit and adding explanatory power. Causality tests suggest that investor fear (VIX) drives returns across firm-size and value, and also across industry. We also illustrate that firms that are more subjective to value, or face limits to arbitrage, such as small-cap stocks, or those in the business equipment (technology) or telecoms industry, are most responsive to changes investor sentiment. Finally, we demonstrate that sentiment has a greater influence on market returns during recession, when sentiment is at its lowest ebb, and this is particularly true for those stocks most susceptible to speculative demand.

Keywords: Investor sentiment, Financial markets, VIX, Stock markets

JEL Classification: G02, G1, G10

Suggested Citation

Smales, Lee A., The Importance of Fear: Investor Sentiment and Stock Market Returns (March 18, 2016). Applied Economics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2749518 or http://dx.doi.org/10.2139/ssrn.2749518

Lee A. Smales (Contact Author)

University of Western Australia ( email )

UWA Business School
35 Stirling Highway
Perth, Western Australia 6009
Australia

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