Composite survey sentiment as a predictor of future market returns: Evidence for German equity indices

Abstract

In this paper, I construct a novel composite sentiment indicator which captures the irrational beliefs of a general population in Germany. This indicator is used to demonstrate that sentiment of a general public is responsible for temporary overreaction of the aggregate German stock market, but also its narrower segments embodied in four important equity indices from the DAX family. My results show that population-wide beliefs work as a contrarian predictor of future returns of German equity indices for horizons of six to twelve months. In addition, the out-of-sample framework is developed to underline the degree of improvement achieved by combining several survey-based measures into one composite sentiment indicator. The results reveal that the composite indicator exhibits a more accurate forecasting performance than the popular sentiment measure, consumer confidence.