Sentiment Periods Research Articles

Certainty of uncertainty for asset pricing

Uncertainty is known to be crucial in asset pricing, yet evidence from a comprehensive analysis of various uncertainty measures remains sparse. By machine learning, we construct a novel economic uncertainty index derived from a heterogeneous range of uncertainty measures and investigate its predictability of stock returns. Our composite uncertainty index exhibits robust in- and out-of-sample predictability of stock market returns over the one- to 12-month horizon. The predictive power stems from the volatility-orthogonal components of individual uncertainty measures and becomes more pronounced during high uncertainty and high sentiment periods. The predictability of our economic uncertainty index aligns with theoretical frameworks linking uncertainty to future investment, cash flows, and market expectations.

Timing sentiment with style: Evidence from mutual funds

This study analyzes four distinct types of mutual fund sentiment timing skills using a multifactor framework. Our results indicate a diminished significance of market sentiment timing, in contrast to the results of prior studies. Additionally, we reveal that size and value sentiment timing can substantially enhance fund performance. Managers strategically reduce their exposure to small stocks using size sentiment timing and increase exposure to value stocks through value sentiment timing during high sentiment periods. We find no evidence that mutual fund managers engage in momentum sentiment timing.

Factor returns and FOMC announcements: The role of sentiment

We examine the dynamics of long-short factor returns on FOMC announcement days and the role of sentiment. We find that factor returns are negative on FOMC announcement days. Moreover, on these days returns are significantly lower following low sentiment periods. Hence, investor sentiment is a key driver of factor returns on FOMC days and this effect emanates mainly from the short portfolio leg of each factor.

State-dependent intertemporal risk-return tradeoff: Further evidence

We suggest that the intertemporal risk-return tradeoff is not necessarily positive but rather state dependent. We further explore the state dependent risk-return relation by examining how the positive risk-return relation is distorted in response to various market conditions, including extreme price changes, differing levels of investor sentiment, the introduction of stock options, and throughout business cycles. The tendency for uninformed investors to be optimistic (pessimistic) in response to good (bad) market news cause overpricing (underpricing), and the resulting trade activity of arbitrageurs that distorts the positive risk-return tradeoff, is documented consistently across these environments. We find that the attenuation (reinforcement) of the positive risk-return relation under investors’ optimistic (pessimistic) expectations is stronger in high (low) sentiment periods, in the presence of extreme returns, in the period after stock options became available, and during expansionary periods. We argue that the asymmetric intertemporal risk-return relation is a consequence of rational arbitrageurs’ trading to exploit mispricing through the selling of overpriced stocks conditional on good news and buying underpriced stocks conditional on bad news.

Manager sentiment and conditional conservatism

AbstractThis study examines the effect of manager sentiment on conditional conservatism. Manager sentiment refers to widely held beliefs of financial managers about their firms’ future economic prospects that are not justified by available economic fundamentals. Manager sentiment is likely to affect conditional conservative reporting because the decision to recognize unrealized economic losses in a timely manner flows from financial managers’ beliefs about their firms’ future cash flow prospects. We predict and find that manager sentiment is negatively associated with conditional conservatism, indicating that firms report less conservatively during periods of high manager sentiment (over‐optimism) and more conservatively during periods of low manager sentiment (over‐pessimism). Moreover, the effects of manager sentiment on conditional conservatism remain strongly negative after controlling for manager overconfidence. We further find that asset write‐offs are lower during high sentiment periods but higher in subsequent periods. Importantly, the manager sentiment effect on conservatism is incremental, and the opposite in sign, to the effect of investor sentiment, which has not been demonstrated in prior literature.

Geographic links and predictable returns

AbstractUsing establishment‐level data of U.S. public firms, we construct a novel measure of geographic linkage between firms. We show that the returns of geography‐linked firms have strong predictive power for focal firm returns and fundamentals. This effect is distinct from other cross‐firm return predictability and is not easily attributable to risk‐based explanations. It is more pronounced for focal firms that receive lower investor attention, are more costly to arbitrage, and during high sentiment periods. The cross‐firm information spillovers and return predictability are also stronger for geographic peers with economic linkages and with positive information. Our results are broadly consistent with sluggish price adjustment to nuanced geographic information.

Effect of sectoral holdings on the flow-performance sensitivity of mutual funds

We find that the flow-performance sensitivity (FPS) of mutual funds depends on the composition of their sectoral holdings. We use the Morningstar classification of fund holdings into the following three Super Sectors: Defensive, Sensitive, and Cyclical. On average, the FPS decreases as the fraction of defensive or sensitive stocks increases in the fund’s portfolio. The FPS increases as the fraction of cyclical stocks increases. During high sentiment periods, the sensitivity of new sales as well as redemptions increases, resulting in overall higher FPS for all funds. However, in both the low and the high sentiment periods, the FPS is lower for funds with a higher fraction of defensive or sensitive stocks and higher for funds with a higher fraction of cyclical stocks. Investors with a long investment horizon may wish to avoid mutual funds that invest primarily in cyclical stocks as funds with high FPS tend to have high liquidity costs.

Web search volume acceleration and cross-sectional returns

This study examines the effect of web search volume acceleration (WSVA) on predicting future stock returns. We find that WSVA can significantly and negatively predict future stock returns in the Chinese stock market. After controlling for firm characteristics and changing the WSVA measurement, the negative return predictability of WSVA is still significant, and WSVA provides more predictive information than is contained in the web search volume speed (WSVS). Our empirical results are unable to be explained by existing common risk factors. We find that the return predictability of WSVA becomes stronger for stocks that grab higher investor attention, during higher investor sentiment period, and for stocks that face higher limits of arbitrage, which supports for stock mispricing theory in behavioral finance.

Investor sentiment and skewness risk premium

ABSTRACT This paper provides new evidence on the pricing of market skewness risk by incorporating investor sentiment in the relation between sensitivity to innovations in implied market skewness and expected stock returns. Using both univariate and multivariate specifications, we conduct an extensive series of asset pricing tests on the cross-section of stocks during high and low sentiment periods separately. We find that market skewness risk carries a negative premium that cannot be explained away by known risk factors when sentiment is low. In contrast, the results are not conducive to a risk explanation when sentiment is high.

Investor sentiment and firm capital structure

We provide novel evidence of the role of investor sentiment in determining firms' capital structure decisions from three perspectives: leverage ratio, debt maturity and leverage target adjustment. We find that when investor sentiment is high, firms increase their leverage ratios, supporting our contention that high investor sentiment increases firms' debt capacity and facilitates the use of an aggressive leverage policy. Debt maturity is shorter in high sentiment periods, implying that firms are confident about future earnings and use shorter debt maturity to signal their financial solvency. Leverage target adjustment is slower in low sentiment periods, indicating higher costs of external finance. Furthermore, the sentiment-leverage relationship sensitivity is greater for financially constrained firms. Our extended analysis determines that leverage-increasing firms generate lower stock returns subsequent to a period of high sentiment, offering practical insights into the economic consequences of increasing leverage in high sentiment periods on corporate value for investors. Our research advances the understanding of the impact of investor sentiment on firms' financing decisions and stock returns.

A Decision Theoretic Foundation for Noise Traders and Correlated Speculation

Noise traders are a central idea in the modern theory of asset markets, yet there is not a standard model of such agents in contrast to the well-established representation of rational agents as expected utility maximizers. We propose the Hurwicz criterion, a classical criterion in decision analysis for choice under uncertainty, as a foundation for noise traders in asset markets. Hurwicz agents trade on optimism and pessimism and do not trade on information. A binary asset market is introduced with asymmetric information and heterogeneity both in rationality and in ambiguity attitudes. In this environment, noise trader behavior is endogenously positively correlated, the market is more efficient in low sentiment periods, and the favorite-longshot bias holds in equilibrium. The analysis demonstrates that aggregate market properties such as positive trading volume and the favorite longshot bias can be derived from the micro behavior of individual agents that have an axiomatic foundation.

거래량이 복권특성 종목의 기대수익률에 미치는 영향

Purpose - The purpose of this study is to examine whether trading volume amplifies the extent to which lottery-type stocks are overpriced, and whether economic sentiment index explains time-variation in the magnitude of the volume amplification effect.
 Design/methodology/approach - We examine monthly returns on 5x5 monthly bivariate portfolios formed by lottery characteristics (measured by maximum daily return) and trading volume. In addition, we perform time-series regression tests to examine how the volume amplification effect changes in high and low economic sentiment periods, after controlling for Fama-French three factors.
 Findings - Our bivariate portfolio analysis shows that the overpricing of lottery-type stocks are mostly pronounced among high trading volume stocks. In contrast, for low trading volume stocks, overpricing of lottery-type stocks appears to vanish. Furthermore, the amplification effect of trading volume on overpricing of lottery-type stock is concentrated in high economic sentiment periods.
 Research implications or Originality - This study is the first attempt to examine whether trading volume drives lottery-type stocks’ overpricing in the Korean stock market. Furthermore, our analysis unveils the time-varying nature of volume amplification effect. The results suggest that trading volume might play a important hidden role in asset pricing, opening a new line of researches in the future.

Investor sentiment and stock market anomalies in Australia

By constructing the first Australian investor sentiment index, this study explores the role of sentiment in explaining stock market anomalies. The Australian investor sentiment index is in line with the fluctuation of global economic trends and is highly correlated with the US sentiment index. We also explore the explanatory power of investor sentiment over Australian stock market anomalies. Our findings underscore the importance of investor sentiment in Australia, whereby anomaly returns are stronger following high sentiment periods. The short legs of each strategy account for a larger proportion of anomaly returns when investor sentiment increases. Further, sentiment does not significantly influence returns on the long legs of anomalies.

China's illiquidity premium: Due to risk-taking or mispricing?

This study focuses on China's A-share market and investigates the existence and underlying source of the illiquidity premium. We observe a significant and positive relationship between stock illiquidity and expected returns. Moreover, relative to illiquid stocks, liquid stocks are more susceptible to overpricing during high sentiment periods and earn lower abnormal returns following high sentiment periods, thus supporting the sentiment-driven mispricing explanation. We also find evidence that the illiquidity premium fails to reflect exposure to underlying risk. Overall, China's illiquidity premium derives from mispricing instead of risk-taking.

Fund-level Investor Sentiment and Mean-variance Relation: Evidence From Singapore-listed ETFs

This paper tests the influences of fund-level sentiment on the mean-variance relation in ETF market. We find that in low (high)-sentiment periods, the expected excess return is positively (negatively) related to the conditional variances. Sentiment traders undermine the otherwise positive risk-return tradeoff and even twist it into a negative one in high-sentiment periods. The impact of sentiment is stronger during the global pandemic.

CEO political connection and stock sentiment beta: Evidence from China

This study examines the impact of CEO political connection on stock sentiment beta. We theorize that CEO political connection contributes to elevated stock sentiment sensitivity because investors overvalue executives' political connection in a transitioning economy. Panel regression results with data of Chinese listed companies from 2009 to 2019 support our hypotheses. The impact of CEO political connection on stock sentiment risk is more pronounced during high sentiment periods and among non-state-owned enterprises. Investors often ignore politically connected CEOs' deficiency in internal management reflected by low quality internal information, ineffective supervision and control, and high management risk. These deficiencies contribute to higher stock sentiment beta. Noise trading uplifts stock sentiment beta, especially for companies with politically connected CEO. Encouragingly, the national anti-corruption campaign has curbed investors' adulation of political connections. This study warns investors and corporate boards against CEO political connection and calls for a more prudent treatment.

Revisiting the ICAPM under the distortion of risk–return tradeoff in short‐horizon stock returns

We suggest that the distortion of the positive risk–return relation in the ICAPM is a consequence of trading by informed investors to exploit mispricing. We hypothesize and demonstrate that a non-positive (strongly positive) risk–return relation following positive (negative) market returns is attributed to short-selling (purchasing) of overpriced (underpriced) stocks along with optimistic (pessimistic) expectations conditional on good (bad) market news. We verify this asymmetry in the risk–return relation through the indirect risk–return relation conditional on good (bad) market news. We also find that the attenuation (reinforcement) of the positive risk–return relation is more profound in high- (low-) sentiment periods.

ANALYST FORECAST DISPERSION, INVESTOR SENTIMENT, AND THE CROSS-SECTION OF STOCK RETURNS

This paper explores the role investor sentiment plays in the relationship between analyst forecast dispersion and stock returns. With short sale constraints, stock prices are determined by the optimistic investors. There are more optimistic investors during the high sentiment periods when investors suffer more from psychological bias. This is the first paper to document that following the high sentiment periods, stocks with the most analyst forecast dispersion are overpriced, earning significantly negative returns, while those with the least analyst forecast dispersion are not overpriced as the degree of belief dispersion is low. However, following the low sentiment periods, both are not overpriced. A portfolio that longs the least dispersed stocks and shorts the most dispersed stocks yields significantly positive returns only following the high sentiment periods. My findings can potentially reconcile the puzzling risk effect and mispricing effect in the literature. The risk (mispricing) effect suggests a positive (negative) relation between analyst forecast dispersion and future stock returns. Presumably, the magnitude of the mispricing effect depends on the proportion of irrational investors and their bias, which is positively related to investor sentiment. During the high sentiment period, the mispricing effect takes over, and the overall effect is negative. During the low sentiment period, the percentage of irrational investors is mediate, and the mispricing effect and the risk effect counter each other, leading to insignificant relation.

Firm Misvaluation and Corporate Social Responsibility*

AbstractThis paper shows that overvalued firms have better performance in corporate social responsibility. Using hypothetical mutual fund outflow pressure, I establish causality from misvaluation to corporate social responsibility performance. Further analysis reveals that the effect of firm misvaluation on corporate social responsibility performance is stronger for firms with greater financial strengths, higher socially responsible investor ownership, higher long‐term institutional investor ownership, and during high corporate social responsibility sentiment periods. Overall, the results reveal the incentives of firms to engage in corporate social responsibility activities in overvaluation to cater to investors who prefer better corporate social responsibility performance.

Investor sentiment, style investing, and momentum

Investor sentiment is an important condition for style investing in affecting asset price predictability. We find that style returns have predictive power for future stock returns in high sentiment periods, but not low sentiment periods. The correlation between style returns and stock returns explains the variation in momentum profits in high sentiment periods, but not low sentiment periods. Sentiment has an interaction effect with style returns, but not market returns. While positive style returns predict future stock returns under high sentiment, negative style returns do not. The effect of investor sentiment on style investing is independent of prior market returns.