SLIDE 1
I nvestor sentim ent and the cross-section of stock returns
Malcolm Baker – HBS Jeffrey Wurgler – NYU Stern
SLIDE 2 I ntroduction
- Classical finance theory
- “Investor sentiment” doesn’t affect prices, because
the demands of any sentimental investors are neutralized by arbs
- Challenges to classical theory
- Clear violations of market efficiency (momentum,
post-earnings announcement drift, index inclusion effects, negative stub values, etc.)
- This paper
- Theory and evidence that investor sentiment is real,
measurable time-series phenomenon that and that it has pervasive cross-sectional effects
SLIDE 3 Theory
- What is “investor sentiment”? Does it affect different
stocks in different ways?
- Observation
- Mispricings are invariably caused by two factors
- 1. An uninformed (e.g. “sentimental”) demand shock
- 2. A binding constraint on arbitrage
- I m plication
- For a wave of sentiment to have cross-sectional
effects—not just cause equal mispricings across all stocks—factor 1, 2, or both, must vary across stocks
SLIDE 4 Cross-sectional variation in sentim ent
- One potential definition of sentiment: the marginal
investor’s propensity to speculate
- Then sentiment is the relative demand for intrinsically
speculative stocks, and thus causes cross-sectional effects even when arbitrage is equally difficult across stocks.
- What is an “intrinsically speculative” stock? A stock
with a highly subjective/ uncertain valuation
- Prediction: stocks whose valuations are m ost subjective
– canonical young, unprofitable, extreme-growth potential stock, or a distressed stock – will be especially sensitive to fluctuations in propensity to speculate
SLIDE 5 Cross-sectional variation in arbitrage
- Another potential definition of sentiment: marginal
investor’s (over-) optimism or (over-)pessimism about stocks in general.
- By this definition, indiscriminate waves of sentiment will still
affect the cross-section to the extent that arbitrage forces are w eaker in certain subsets of stocks.
- Arbitrage limits that vary across stocks: fundamental risks,
transaction costs/ liquidity, short-selling costs, predatory trading risks, noise-trader risks, etc.
- Prediction: time-varying optimism or pessimism has
biggest effects on stocks that are hardest to arbitrage
SLIDE 6
Main hypothesis
Observation: Roughly speaking, the same stocks that are the hardest to arbitrage are also the most speculative / hardest to value Robust prediction: Young, sm all, unprofitable, extrem e-grow th and distressed stocks are m ost sensitive to fluctuations in investor sentim ent
SLIDE 7 Anecdotal history of investor sentim ent, 1 9 6 1 -2 0 0 2
- “high sentiment” period demand for speculative stocks
- “low sentiment” period demand for safety, “quality”
stocks
- 1960-61 “tronics” small, growth stocks bubble
- 1967-69 small, growth stocks bubble
- early 1970’s “nifty fifty” bubble
- late 1970’s through mid-1980’s small, sometimes industry-
concentrated bubbles, e.g. biotech, oil
- late 1990’s Internet bubble
SLIDE 8 Em pirical approach
Mispricing is hard to identify directly. Our approach is to look for systematic patterns
- f correction of mispricings.
E.g., if returns on young and unprofitable firms are low when beginning-of-period sentiment is estimated to be high – may represent the correction of a bubble in growth stocks. Ex post evidence of ex ante mispricing.
SLIDE 9
Measuring investor sentim ent
We consider six proxies – the average discount on closed-end equity funds, NYSE share turnover, the number of and average first-day returns on IPOs, the equity share in new issues, and the dividend premium To smooth out noise, we also form a composite index based on their first principal component: Sentiment proxies are annual, 1962 through 2001
SLIDE 10
Sentim ent I ndex
SLIDE 11
Conditional predictability: Size portfolios
SLIDE 12
Conditional predictability: Volatility portfolios
SLIDE 13
Conditional predictability: Sales growth portfolios
SLIDE 14 Et cetera
Patterns are not due to time-varying betas
- r plausible patterns of compensation for
systematic risk (The EMH explanation would require that
- lder, profitable, dividend-paying, and less-
volatile firms are (when sentiment is high) actually require higher returns than younger, unprofitable, nonpaying, highly- volatile firms. Very counterintuitive.)
SLIDE 15 Conclusion
“Investor sentiment” is a real, measurable
- phenomenon. It has large effects on the
cross-section of stocks. Several novel findings emerge – characteristics that have no unconditional predictive power have much power once
- ne conditions on sentiment!
Approach embraces, rather than ignores, evidence of bubbles and crashes
