Investor Sentiment, Disagreement, and the Breadth–Return Relationship

Abstract

We study the cross-sectional breadth–return relation by assuming that investors subject to market sentiment hold a biased belief in the aggregate. With a dynamic multiasset model, we predict that the breadth–return relationship can be either positive or negative depending on the relative strength of two offsetting forces—disagreement and sentiment. We find evidence consistent with our predictions. The breadth–return relationship is positive when the sentiment effect is small. However, the relationship becomes negative when (i) the time-series variation of market-wide sentiment is high and (ii) the cross-sectional dispersion of firm-specific exposure to market-wide sentiment variation is large. Our unified framework reconciles a few seemingly inconsistent empirical studies in this literature and explains puzzling cross-sectional return patterns observed during the Internet bubble and the subprime crisis periods. This paper was accepted by Brad Barber, finance.