Investor Sentiment Aligned:
A Powerful Predictor of Stock Returns
Dashan Huang
Fuwei Jiang
Jun Tu
Guofu Zhou
Singapore Management University (Huang, Jiang, Tu)
Washington University in St. Louis (Zhou)
For the Q-Group Presentation
on April 7th, 2017 at Charleston, SC.
Sentiment and Stock Returns

Sentiment:
 People
feel excessively optimistic or pessimistic
about a situation not justified by the facts at hand
 Long history in finance: Keynes (1936)

Theoretically, sentiment can drive asset prices away
from their fundamental values due to limits of arbitrage


e.g., short-sell constraint, margin constraint, noise trader risk
Empirically, sentiment strongly predicts stocks that
are speculative, hard to arbitrage, or in the short legs
of long-short strategies
 e.g., Baker and Wurgler (2006, 2007), Baker, Wurgler, and Yuan (2012,
JFE), Stambaugh, Yu, and Yuan (2012, JFE)
Why Sentiment Matter?: Some Macro Points

Money is scarce in recessions/downturns:
 In
bad times, investors expect much higher
return to put money into stocks.

Shocks in supply/liquidity:
Loss of returns on the market
 Loss of jobs


Risk appetite change:


Investors are unwilling to take risks in good times
Borrowing constraints:
 ever
more stringent
Measurement of Sentiment

Sentiment is not directly observable

Baker and Wurgler (2006, JF) construct a sentiment index as

the first principal component (PC1) of the 6 sentiment proxies:








Closed-end fund discount rate, CEFD
Share turnover, TURN
Number of IPOs, NIPO
First-day returns of IPOs, RIPO
Dividend premium, PDND
Equity share in new issues, S
explains well the cross-sectional stock returns
influential: > 1111 google citations
Bottom Line:
the BW index cannot explain the
time variation of the aggregate stock market return.
What Do We Do?

This paper seeks to answer
Does sentiment forecast the aggregate stock market if it
is aligned in the right way?
 What is the economic channel/driving force?


We find





sentiment strongly forecasts the aggregate stock market;
it outperforms greatly marcoeconomic predictors, at least in the
month-by-month horizon;
The value of predictability is of economic/practical significance;
The forecasting power of sentiment comes from the investor's
underreaction to cash flow information
Theoretical basis:


Econometrically, a method eliminating a common noise of the proxies
Economically, market trends and sentiment are related (e.g., De Long
et al. (1990, JPE), and Zhou and Zhu (2014, working paper)
Conclusions and Future Works

This paper finds





sentiment strongly forecasts the aggregate stock market if it is aligned
properly;
it outperforms greatly marcoeconomic predictors, at least in the
month-by-month horizon;
The value of predictability is of economic/practical significance;
The forecasting power of sentiment comes from the investor's
underreaction to cash flow information
Future Research:

More sentiment proxies:




Consumer sentiment
VIX
Returns on Art and Other Collectibles
Combined with technical analysis:

More theory in addition to Zhou and Zhu (2014), and more empirical work
along lines of Neely, et al (2014) and Han and Zhou (2013).