Abstract
This study evaluates the performance of stock market indices after times of extreme opinions. The underlying conjecture is that extreme opinions are associated to overreactions in the perception of wealth. The analysis covers 34 countries from 1988 through 2013. In a novel approach, views regarding economic performance are approximated using content in the global economic press. Consistent with the overreaction conjecture, stock market indices are shown to under-perform following extreme optimistic views and over-perform after pessimistic views. A long-short contrarian portfolio earns 11% annually over the next five years. This persistent and predictable difference in returns cannot be explained by risk considerations and cannot be replicated using alternative strategies based on past returns or past economic growth.
Highlights
In November 2009, the weekly magazine The Economist ran a cover in which the title “Brazil takes off” was accompanied by a statue of Christ the Redeemer ascending like a rocket from Rio de Janeiro's Corcovado mountain
The results presented above are consistent with the proposed conjecture of excessive responses associated to extreme opinions
Despite the difference in terms of return predictability, it must be noted that there is a strong association between the return of the long short portfolio strategy based on extreme opinions and the return of the long short portfolio strategy based on economic growth
Summary
In November 2009, the weekly magazine The Economist ran a cover in which the title “Brazil takes off” was accompanied by a statue of Christ the Redeemer ascending like a rocket from Rio de Janeiro's Corcovado mountain. The reported findings show that empirical studies that focus on subjective states can advance the understanding of economic dynamics This is a natural outcome once it is recognized that economic processes emerge as the result of the co-evolution of structural and subjective elements. 11 See for example models of categorical thinking (Mullainathan 2002), trend chasing (Hong and Stein 1999) and predictor selection dynamics (Brock and Hommes 1998) These analyses focus on firm level returns and use historic information on asset prices, financial statements and market activity.. More closely related to the current study, some contributions focus on the dynamic relationship of aggregate proxies for investor sentiment and stock returns.13 In these contributions, the proxies are based on consumer confidence surveys and financial markets’ outcomes.
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