Sentiment and the CAPM

Abstract

The security market line (SML) accords with the capital asset pricing model (CAPM) by taking on an upward slope in pessimistic sentiment periods, but is downward sloping during optimistic periods. We hypothesize that this finding obtains because periods of optimism attract equity investment by unsophisticated, overconfident, traders in risky opportunities (high beta stocks), while such traders stay along the sidelines during pessimistic periods. Thus, high beta stocks become overpriced in optimistic periods, but during pessimistic periods, noise trading is reduced, so that traditional beta pricing prevails. Unconditional on sentiment, these effects offset each other. While rational explanations cannot completely be ruled out, analyses using earnings expectations, fund flows, the probability of informed trading, and order imbalances do provide evidence that noise traders are more bullish about high beta stocks when sentiment is optimistic, while investor behavior appears to accord more closely with rationality during pessimistic periods, supporting our hypothesis.