Overreaction to extreme market events and investor sentiment

ABSTRACT

This article investigates the role of investor psychology, captured here by investor sentiment index, in driving individual stock price reactions to extreme movements in the broader market. In addition to confirming prior evidence of overreaction, we find much stronger overreaction when investor sentiment is low rather than high. This is consistent with the role of the contrast dimension of an uncommon event, suggested in the psychology literature, over and above the emotion of surprise it brings about. In a low sentiment environment, the contrast is sharper and hence leads to stronger overreaction.

KEYWORDS:

• Overreaction
• extreme events
• surprise
• contrast
• behavioural finance

JEL CLASSIFICATION:

• G12
• G14
• D84

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ See Amini et al. (2013) for a review.

² Defining an extreme event in terms of broader market movement avoids liquidity (Pastor and Stambaugh 2003) and microstructure issues that can distort the results (Cox and Peterson 1994). Also, this design virtually retains only events that are accompanied by new information, since an extreme market movement is uncommon in the absence of macro news.

³ http://people.stern.nyu.edu/jwurgler/. The Baker and Wurgler Sentiment Index is the first principal component of six measures of sentiment, namely, the closed-end fund discount, the NYSE share turnover, the number of and the average first-day returns on initial public offerings (IPOs), the equity share in new issues and the dividend premium. To control for macro-conditions, the raw values of the six sentiment measures are regressed on the growth of industrial production, the growth of durable consumption, the growth of nondurable consumption, the growth of service consumption, the growth of employment and a dummy variable for National Bureau of Economic Research recessions. When the index is positive (negative), the period corresponds to the high (low) sentiment regime. In naïve terms, a high (low) sentiment period can be considered a proxy for a bullish (bearish) market.

⁴ The factors are obtained from French’s website. Fama and French (1993) report that factors, namely size and book-to-market value ratio, can explain a good part of the cross section of the stocks returns that is not captured by the CAPM. The Fama–French model is more general than and nests the CAPM and as such is widely used in measuring abnormal returns (e.g. Pastor and Stambaugh 2003; Savor 2012; Stambaugh, Yu, and Yuan 2012; Novy-Marx 2012).

⁵ The findings do not change if we simply employ the Baker–Wurgler Sentiment Index for the calendar month of an event date.