By LARRY SWEDROE
Research, beginning with the 2006 study Investor Sentiment and the Cross-Section of Stock Returns by Malcolm Baker and Jeffrey Wurgler, has found that investor sentiment — the general mood investors exhibit toward a particular market or asset—can be an important determinant of investment performance. Investors who exhibit relatively high sentiment tend to be overconfident and engage in excessive trading, resulting in subpar investment performance because they are trading on “noise” and emotions. Such activity can lead to mispricing. Eventually, any mispricing would be corrected when the fundamentals are revealed, making investor sentiment a contrarian predictor of stock market returns. Examples of times when investor sentiment ran high are the 1968-69 electronics bubble, the biotech bubble of the early 1980s, and the dot-com bubble of the late 1990s.
Baker and Wurgler constructed an investor sentiment index based on five metrics: the value-weighted dividend premium (the difference between the average market-to-book ratio of dividend payers and non-payers), the first-day returns on initial public offerings (IPOs), IPO volume, the closed-end fund discount, and the equity share in new issues. Originally, the Baker-Wurgler index included a sixth metric; however, the NYSE turnover ratio was dropped. (Data is available at Wurgler’s New York University web page.)
Baker and Wurgler’s original work generated great interest among researchers into the role that investor sentiment plays. Their original findings have been confirmed and supported by the findings from the 2011 study Investor Sentiment and the Mean-Variance Relation, the 2012 studies Global, Local, and Contagious Investor Sentiment and The Short of It: Investor Sentiment and Anomalies, and the 2020 study Investor Sentiment: Predicting the Overvalued Stock Market, which found:
- Investor sentiment plays a significant role in market volatility and generates return predictability of a form consistent with the correction of investor overreaction.
- The Baker-Wurgler investor sentiment index is a reliable contrarian predictor of subsequent monthly, six-month and 12-month market returns but only during high-sentiment periods, and the economic significance is nontrivial.
- Broad waves of sentiment have greater effects on hard-to-arbitrage (due to greater costs and greater risks) and hard-to-value stocks (small-cap, high return volatility, growth and distressed stocks). These stocks will exhibit high “sentiment beta.”
- Returns to anomalies are stronger following high investor sentiment — about 70 percent of benchmark-adjusted profits from long/short anomaly strategies occurred in months following levels of investor sentiment above their median value. In addition, there was little evidence of overpricing in the long leg of anomaly portfolios.
- Not only do local and global sentiment predict the cross-section of a country’s returns, but investor sentiment also is contagious — investor sentiment contains a market-wide component with the potential to influence prices on many securities in the same direction at the same time.
The economic theory behind the findings is that because of the impediments to short selling, overpricing becomes more difficult to eliminate, the result being that overpricing should be more prevalent than underpricing. The reason is that limits to arbitrage result in investors with the most optimistic views about a stock being able to exert the greatest effect on the stock’s price; and their views are not counterbalanced by those of the relatively less optimistic investors, who are inclined to take no position if they view the stock as undervalued, rather than take a short position. Thus, when the most optimistic investors are too optimistic and overvalue the stock, overpricing results. In contrast, underpricing is less likely because the cross-section of views includes the views of rational investors.
The conventional view is that naive retail investors are the ones driving prices during periods of high sentiment, leading to overvaluations. New research calls that view into question.
Active fund managers and the role of investor sentiment
Timothy Chue and G. Mujtaba Mian contribute to the literature on the role of investment sentiment with their June 2022 study, Investor Sentiment and Mutual Fund Stock Picking, in which they examined whether mutual fund managers’ stock picking becomes less active (i.e., deviates less from their benchmark) when investor sentiment is high. They stated: “Such behaviour, if found, suggests that fund managers become less discriminant between stocks in their information collection and trading, and can contribute to the prevalence of relative mispricing when sentiment is high.” They used a fund’s active share — the percentage of a fund’s portfolio that differs from the fund’s benchmark index — as a proxy for the activeness of its manager’s stock selection. Their data sample contained 2,245 U.S. domestic, active (non-index) equity mutual funds covering the period 1985 through the third quarter of 2009. Using two measures of investment sentiment and controlling for two measures of market turmoil (VIX, the implied volatility of S&P 500 index options, and the FEARS index), they found:
- Actively managed mutual funds engaged in less stock picking during periods of high investor sentiment, with the average active share of mutual funds declining by an economically significant 2-3 percent at times when there is a one-standard-deviation increase in investor sentiment—institutional investors are susceptible to changes in investor sentiment, becoming less discriminating across individual stocks during periods of heightened market volatility.
- Consistent with prior research, the impact of sentiment on mispricing was concentrated in periods of positive sentiment.
- The negative relationship between investor sentiment and active share was robust to controlling for stock return co-movement, which is important because stock return co-movement tends to rise during periods of high investor sentiment.
- Their findings were driven by sentiment rather than by confounding macroeconomic conditions.
They noted that their finding that active institutional investors are affected by investor sentiment is consistent with those of the authors of the 2019 study Sentiment Metrics and Investor Demand, who found that institutional investors are net buyers (sellers) of volatile stocks from individual investors during high (low) sentiment periods (with momentum strategies explaining a significant portion of the behavior).
Their findings Chue and Mian led to conclude: “As mutual funds focus less on the differences between individual companies and become less active in their stock selection, relative mispricing increases and the returns on cross-sectional anomalies become more pronounced. Our results call into question the conventional view that it is only the preponderance of retail investors during high sentiment periods that allows sentiment to exert greater influence on prices.”
Investors’ first takeaway should be to avoid being a noise trader — don’t get caught up in sentiment, following the herd over the investment cliff. Stop paying attention to prognostications in the financial and social media. Most of all, have a well-developed, written investment plan. Develop the discipline to stick to it, rebalancing when needed and harvesting losses as opportunities present themselves.
A second takeaway is that actively managed funds do not provide sanctuary from overvaluation created by investor sentiment. In fact, in aggregate, they are contributing to the overvaluation — providing yet another reason to avoid using actively managed funds. That finding provides another explanation for their persistent underperformance.
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