Does Investor Sentiment Predict Overpriced or Underpriced Stock Markets?

Abstract

The research literature shows that investor sentiment is a contrarian predictor of aggregate stock market returns. However, we contend that investor sentiment only predicts aggregate stock market returns during high-sentiment states where overpricing is more prevalent than underpricing. Using a two-state predictive regression model, we find that the investor sentiment indexes of both Baker and Wurgler (2006) and Huang et al. (2014) are contrarian predictors of aggregate stock market returns at all horizons during high-sentiment states, which agrees with our hypothesis.