Working Paper: NBER ID: w10449
Authors: Malcolm Baker; Jeffrey Wurgler
Abstract: We examine how investor sentiment affects the cross-section of stock returns. Theory predicts that a broad wave of sentiment will disproportionately affect stocks whose valuations are highly subjective and are difficult to arbitrage. We test this prediction by studying how the cross-section of subsequent stock returns varies with proxies for beginning-of-period investor sentiment. When sentiment is low, subsequent returns are relatively high on smaller stocks, high volatility stocks, unprofitable stocks, non-dividend-paying stocks, extreme-growth stocks, and distressed stocks, consistent with an initial underpricing of these stocks. When sentiment is high, on the other hand, these patterns attenuate or fully reverse. The results are consistent with predictions and appear unlikely to reflect an alternative explanation based on compensation for systematic risk.
Keywords: Investor Sentiment; Stock Returns; Market Bubbles; Asset Pricing
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Investor sentiment (G41) | Cross-section of stock returns (G17) |
| Low investor sentiment (G19) | Subsequent returns on small stocks (G17) |
| Low investor sentiment (G19) | Subsequent returns on high-volatility stocks (G17) |
| Low investor sentiment (G19) | Subsequent returns on unprofitable stocks (G17) |
| Low investor sentiment (G19) | Subsequent returns on non-dividend-paying stocks (G35) |
| Low investor sentiment (G19) | Subsequent returns on extreme growth stocks (G17) |
| Low investor sentiment (G19) | Subsequent returns on distressed stocks (G33) |
| High investor sentiment (G41) | Attenuation or reversal of returns on small stocks (G17) |
| High investor sentiment (G41) | Attenuation or reversal of returns on high-volatility stocks (G17) |
| High investor sentiment (G41) | Attenuation or reversal of returns on unprofitable stocks (G17) |
| High investor sentiment (G41) | Attenuation or reversal of returns on non-dividend-paying stocks (G35) |
| High investor sentiment (G41) | Attenuation or reversal of returns on extreme growth stocks (G17) |
| High investor sentiment (G41) | Attenuation or reversal of returns on distressed stocks (G33) |
| Investor sentiment (G41) | Expectational errors around earnings announcements (G14) |