Investor Sentiment Aligned: A Powerful Predictor of Stock Returns
Singapore Management University – Lee Kong Chian School of Business
Singapore Management University – Lee Kong Chian School of Business
Singapore Management University – Lee Kong Chian School of Business
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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