The Investment Scientist

Market Sentiment and Stock Returns

Posted on: July 31, 2007

Someone asked:”Do you know of any researches/studies carried out that help predict possible upward/downward movements of equity markets?” The following is my answer.

Investors are driven to a large extent by greed and fear, and usually they are driven to the wrong directions. Warren Buffet once said:”Be fearful when everyone else is greedy; and be greedy when everyone else is fearful.” In real life, not many people can do that.

Professor Baker of Harvard and Wurgler of NYU did a study relating investor sentiment and future stock returns. They found when investors are optimistic, the subsequent one year returns are lower; when investors are pessimistic, the subsequent one year returns are higher. (See Chart) They also found small cap stocks are more influenced by investor sentiment than large cap stocks, extreme value stocks and extreme growth stocks are also more sensitive to investor sentiment. Here is their paper – http://www.people.hbs.edu/mbaker/cv/papers/sentiment.pdf

stock-market-sentiment-return.gif

1 Response to "Market Sentiment and Stock Returns"

Michael–where on the Fama/french website did you find the data on the small cap value information you posted regarding the FED cutting rates by 200 bps or more and the subsequent returns? thanks. SL

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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