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Investor Sentiment Aligned: A Powerful Predictor of Stock Returns

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.

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Investor Sentiment Aligned: A Powerful Predictor of Stock Returns

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  1. 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.

  2. 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)

  3. 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

  4. 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-dayreturns 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.

  5. 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)

  6. 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).

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