Investor Sentiment Aligned: A Powerful Predictor of Stock Returns

February 9, 2014 Leave a comment

Investor Sentiment Aligned: A Powerful Predictor of Stock Returns

Dashan Huang 

Singapore Management University – Lee Kong Chian School of Business

Fuwei Jiang 

Singapore Management University – Lee Kong Chian School of Business

Jun Tu 

Singapore Management University – Lee Kong Chian School of Business

Guofu Zhou 

Washington University in St. Louis – Olin School of Business
September 15, 2013

Abstract: 
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.

 

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Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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