Business sentiment and the cross-section of global equity returns

Abstract

This study is the first to examine the relationship between business sentiment and future equity returns in the cross-section of countries. We demonstrate that high-sentiment markets outperform low-sentiment markets. A spread portfolio buying (selling) the quintile of countries with the highest (lowest) managerial sentiment yields a monthly return of 0.51% and is robust to many control variables. We link the observed phenomenon with the sentiment-chasing mechanism. In line with these behavioral roots, the effect is stronger in hard-to-value markets with elevated limits to arbitrage and in markets based in countries with collectivistic national cultures. Also, the overpricing is temporary: it is eventually reversed, erasing the initial profits. Finally, we demonstrate that practical implementation of the documented effect by international investors may be challenging.