Investor sentiment and the economic policy uncertainty premium

Abstract

Motivated by recent studies documenting an equity premium associated with economic policy uncertainty (EPU), we test the hypothesis that the EPU premium is stronger (weaker) following periods of low (high) investor sentiment. We estimate stock sensitivity to an economic policy uncertainty (EPU) index and show that stocks in the Australian equities market in the highest uncertainty beta quintile underperform stocks in the lowest quintile, similar to U.S. stocks. However, we find that this negative uncertainty premium remains significant only following periods of low investor sentiment as it disappears following periods of high sentiment. Our results complement the U.S. evidence in that uncertainty averse investors are willing to pay high prices for stocks with positive uncertainty beta and require extra compensation to hold stocks with the negative beta, but only in low sentiment periods. These results are consistent with strong (weak) intertemporal hedging demand for positive EPU beta stocks in low (high) sentiment periods. It is also consistent with limited (full) participation of pessimistic investors and investors with a high aversion to uncertainty in low (high) sentiment periods. Our results suggest that betting against EPU as a trading strategy would be relatively more profitable when executed during low sentiment periods.