Investor Sentiment Aligned A Powerful Predictor of Stock

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 7 th, 2017 at Charleston, SC.

Sentiment and Stock Returns n Sentiment: u People feel excessively optimistic or pessimistic about a situation not justified by the facts at hand u Long history in finance: Keynes (1936) n Theoretically, sentiment can drive asset prices away from their fundamental values due to limits of arbitrage u n 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 u 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 n Money is scarce in recessions/downturns: F In bad times, investors expect much higher return to put money into stocks. n Shocks in supply/liquidity: F Loss of returns on the market F Loss of jobs n Risk appetite change: F Investors n are unwilling to take risks in good times Borrowing constraints: F ever more stringent

Measurement of Sentiment n Sentiment is not directly observable n Baker and Wurgler (2006, JF) construct a sentiment index as u the first principal component (PC 1) of the 6 sentiment proxies: F F F u u 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? n This paper seeks to answer Does sentiment forecast the aggregate stock market if it is aligned in the right way? u What is the economic channel/driving force? u n We find u u n 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: u u 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 n This paper finds u u n 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: u More sentiment proxies: F F F u Consumer sentiment VIX Returns on Art and Other Collectibles Combined with technical analysis: F 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).