Belief-based Equity Market Sentiment

Abstract

We form a belief-based equity market sentiment index, BBS, from investors' survey-based expectations of future aggregate stock returns. BBS spans 54 years, accommodates belief heterogeneity across different investor types, and accounts for variation in the participation of these investors in the market. We show both theoretically and empirically that high BBS is linked to low future market returns and to the subsequent relative underperformance of more arbitrage-constrained stocks. Based on theories of diagnostic expectations, we derive an irrational-beliefs index from BBS, that allows us to link return predictability to investors' judgment mistakes more directly. Compared to prior empirical literature, where a clear micro-foundation for investor sentiment is missing, our results point to the representativeness heuristic as a source of sentiment and a driver of return predictability.

Keywords: Expectations, sentiment, beliefs, representativeness heuristic, overextrapolation, cross-section, asset pricing

JEL Classification: G40, G41, G11, G12