How Market Sentiment Drives Forecasts of Stock Returns

42 Pages Posted: 15 May 2020 Last revised: 14 Aug 2020

See all articles by Roman Frydman

Roman Frydman

New York University (NYU) - Department of Economics

Nicholas Mangee

Armstrong Atlantic State University

Josh R. Stillwagon

Babson College - Economics Division

Date Written: April 21, 2020

Abstract

We reveal a novel channel through which market participants’ sentiment influences how they forecast stock returns: their optimism (pessimism) affects the weights they assign to fundamentals. Our analysis yields four main findings. First, if good (bad) “news” about dividends and interest rates coincides with participants’ optimism (pessimism), the news about these fundamentals has a significant effect on participants’ forecasts of future returns and has the expected signs (positive for dividends and negative for interest rates). Second, in models without interactions, or when market sentiment is neutral or conflicts with news about dividends and/or interest rates, this news often does not have a significant effect on ex ante or ex post returns. Third, market sentiment is largely unrelated to the state of economic activity, indicating that it is driven by non-fundamental considerations. Moreover, market sentiment influences stock returns highly irregularly, in terms of both timing and magnitude. This finding supports recent theoretical approaches recognizing that economists and market participants alike face Knightian uncertainty about the correct model driving stock returns.

Keywords: stock-return forecasts, fundamentals, market sentiment, structural change, model ambiguity

JEL Classification: G12; G14; G41; C58

Suggested Citation

Frydman, Roman and Mangee, Nicholas and Stillwagon, Josh R., How Market Sentiment Drives Forecasts of Stock Returns (April 21, 2020). Institute for New Economic Thinking Working Paper Series No. 115
https://doi.org/10.36687/inetwp115 , Available at SSRN: https://ssrn.com/abstract=3601327

Roman Frydman (Contact Author)

New York University (NYU) - Department of Economics ( email )

19 West 4th Street
New York, NY 10012
United States

Nicholas Mangee

Armstrong Atlantic State University ( email )

11935 Abercorn Street
Savannah, GA 31419
United States

Josh R. Stillwagon

Babson College - Economics Division ( email )

Babson Park, MA 02457
United States

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