How Does the Change in Investor Sentiment over Time Affect Stock Returns?

Abstract

We examine how the change in investor sentiment (IS) over time (the IS trend) affects stock returns. The turnover rates of trading shares, trading value, and transactions, three market measures of trading activity, have been demonstrated to meet the psychometric criteria for measuring the IS trend. The ratio of market price to book value and the short-selling turnover ratio are inappropriate proxies. The empirical results indicate that the influence of the IS trend on returns depends on the direction of the trend (optimistic or pessimistic) and stock characteristics of individual holdings and on arbitrage constraint. The effectiveness of arbitrage, sentiment-driven mispricing, and market intervention are discussed.

Keywords:

• arbitrage
• confirmatory factor analysis
• investor sentiment
• market intervention
• sentiment-driven mispricing
• stock returns