I nvestor sentim ent and the cross-section of stock returns Malcolm Baker – HBS Jeffrey Wurgler – NYU Stern
I ntroduction � Classical finance theory � “Investor sentiment” doesn’t affect prices, because the demands of any sentimental investors are neutralized by arbs � Challenges to classical theory � Clear violations of market efficiency (momentum, post-earnings announcement drift, index inclusion effects, negative stub values, etc.) � This paper � Theory and evidence that investor sentiment is real, measurable time-series phenomenon that and that it has pervasive cross-sectional effects
Theory � What is “investor sentiment”? Does it affect different stocks in different ways? � Observation � Mispricings are invariably caused by two factors � 1. An uninformed (e.g. “sentimental”) demand shock � 2. A binding constraint on arbitrage � I m plication � For a wave of sentiment to have cross-sectional effects—not just cause equal mispricings across all stocks—factor 1, 2, or both, must vary across stocks
Cross-sectional variation in sentim ent � One potential definition of sentiment: the marginal investor’s propensity to speculate � Then sentiment is the relative demand for intrinsically speculative stocks, and thus causes cross-sectional effects even when arbitrage is equally difficult across stocks. � What is an “intrinsically speculative” stock? A stock with a highly subjective/ uncertain valuation � Prediction: stocks whose valuations are m ost subjective – canonical young, unprofitable, extreme-growth potential stock, or a distressed stock – will be especially sensitive to fluctuations in propensity to speculate
Cross-sectional variation in arbitrage � Another potential definition of sentiment: marginal investor’s (over-) optimism or (over-)pessimism about stocks in general. � By this definition, indiscriminate waves of sentiment will still affect the cross-section to the extent that arbitrage forces are w eaker in certain subsets of stocks . � Arbitrage limits that vary across stocks: fundamental risks, transaction costs/ liquidity, short-selling costs, predatory trading risks, noise-trader risks, etc. � Prediction : time-varying optimism or pessimism has biggest effects on stocks that are hardest to arbitrage
Main hypothesis � Observation : Roughly speaking, the same stocks that are the hardest to arbitrage are also the most speculative / hardest to value � Robust prediction: Young, sm all, unprofitable, extrem e-grow th and distressed stocks are m ost sensitive to fluctuations in investor sentim ent
Anecdotal history of investor sentim ent, 1 9 6 1 -2 0 0 2 � “high sentiment” period � demand for speculative stocks � “low sentiment” period � demand for safety, “quality” stocks � 1960-61 “tronics” small, growth stocks bubble � 1967-69 small, growth stocks bubble � early 1970’s “nifty fifty” bubble � late 1970’s through mid-1980’s small, sometimes industry- concentrated bubbles, e.g. biotech, oil � late 1990’s Internet bubble
Em pirical approach � Mispricing is hard to identify directly. Our approach is to look for systematic patterns of correction of mispricings. � E.g., if returns on young and unprofitable firms are low when beginning-of-period sentiment is estimated to be high – may represent the correction of a bubble in growth stocks. Ex post evidence of ex ante mispricing.
Measuring investor sentim ent � We consider six proxies – the average discount on closed-end equity funds, NYSE share turnover, the number of and average first-day returns on IPOs, the equity share in new issues, and the dividend premium � To smooth out noise, we also form a composite index based on their first principal component: � Sentiment proxies are annual, 1962 through 2001
Sentim ent I ndex
Conditional predictability: Size portfolios
Conditional predictability: Volatility portfolios
Conditional predictability: Sales growth portfolios
Et cetera � Patterns are not due to time-varying betas or plausible patterns of compensation for systematic risk � (The EMH explanation would require that older, profitable, dividend-paying, and less- volatile firms are (when sentiment is high) actually require higher returns than younger, unprofitable, nonpaying, highly- volatile firms. Very counterintuitive.)
Conclusion � “Investor sentiment” is a real, measurable phenomenon. It has large effects on the cross-section of stocks. � Several novel findings emerge – characteristics that have no unconditional predictive power have much power once one conditions on sentiment! � Approach embraces , rather than ignores , evidence of bubbles and crashes
Recommend
More recommend
