Strategy Summary:The paper begins by creating an aligned investor sentiment index via the partial least squares (PLS) method.
- Data are available from Baker and Wurgler (2006) and span from 1965 through 2010 (546 months).
- The sentiment index is a linear combination of six individual measures: Closed-end fund discount rate, share turnover, number of IPOs, first-day returns of IPOs, dividend premium and equity share in new issues.
Next, the paper forecasts aggregate stock market returns using this new index, both in-sample and out-of-sample. The authors compare their statistical results (β, R-square, t-stats) with the measures in the existing literature.
The findings are as follows:
- Sentiment index exhibits statistically and economically significant predictability. It is important not only cross-sectionally, but also at aggregate market level.
- The in-sample R-square is more than 5 times greater than that in Baker and Wurgler (2006), and out-of-sample R-square is more than 10 times greater.
- Adding sentiment index in conjunction with economic variables can substantially improve the forecasting performance.
- The sentiment index in this paper is more volatile, so it may better capture the short-term variation with future stock return.
- Table 7 examines how the sentiment index predicts different portfolios.
- Stocks that are speculative, small, distressed (high book-to-market ratio) or high growth opportunity (low book-to-market), or past losers are more sensitive to investor sentiment.
Investor Sentiment Aligned: A Powerful Predictor of Stock Returns
- Dashan Huang, Fuwei Jiang, Jun Tu, and Guofu Zhou
- A version of the paper can be found here.
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The widely used Baker and Wurgler (2006) sentiment index is likely to understate the predictive power of investor sentiment because their index is based on the ﬁrst principal component of six sentiment proxies that may have a common noise component. In this paper, we propose a new sentiment index that is aligned for explaining stock expected returns by eliminating the noise component. We ﬁnd that the aligned sentiment index has much greater power in predicting the aggregate stock market than the Baker and Wurgler (2006) index: it increases the R-squares by more than ﬁve times both in-sample and out-of-sample, and outperforms any of the well recognized macroeconomic variables. Its predictability is both statistically and economically signiﬁcant. Moreover, the new index improves substantially the forecasting power for the cross-section of stock returns formed on industry, size, value, and momentum. Economically, the driving force of the predictive power of investor sentiment appears stemming from market underreaction to cash ﬂow information