The Impact of U.S. Individual and Institutional Investor Sentiment on Foreign Stock Markets

Abstract

This study examines the degree to which U.S. individual and institutional investor sentiments are propagated abroad. Previous studies construe investor sentiments as fully irrational; we find contrary evidence that individual and institutional investor sentiments are driven by both rational and irrational factors, with distinct effects on domestic and international stock market returns. The generalized impulse response functions from VAR model estimations show that U.S. institutional investor sentiments have varying degrees of impact on the equity markets of the U.K., Mexico, and Brazil, and no effect on Chile. Specifically, the individual investor sentiment effect is statistically significant only for the U.K market. Not surprisingly, the two classes of investor sentiments have a strong significant effect on the U.S. stock market returns. The response of the U.S. to individual investor sentiments is relatively more erratic, while the response to institutional investor sentiments is smoother. This difference in pattern becomes more visible when we consider the response of the foreign stock markets. We find significant effects of rational sentiments of institutional investors on the U.S., the U.K., Mexico, and Brazil. However, there is an insignificant effect of the irrational sentiments on the same set of countries. A direct implication of our empirical evidence is that it is important for international asset pricing models to consider the role of rational sentiments of institutional and individual investors on developed and emerging markets.