Abstract
Institutional investors often need accurate forecasts of yearly stock market returns to advise clients, rebalance portfolios or implement active asset allocation decisions. Traditional macroeconomic variables are of little use for predicting short-horizon returns such as a year. We show that a simple model that incorporates interactions between sentiment-related factors provide more accurate forecasts of market returns than the best traditional macroeconomic variable. Predictive regression and stochastic dominance tests show that this result holds both in and out of sample.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
Specifically, the fee is 5 per cent on the annual amount of withdrawals above 10 per cent of the original principal if withdrawals are done within the fixed annuity’s maturity period.
References
Alhakami, A.S. and Slovic, P. (1994) A psychological study of the inverse relationship between perceived risk and perceived benefit. Risk Analysis 14 (6): 1085–1096.
Amihud, Y. and Hurvich, C.M. (2004) Predictive regressions: A reduced-bias estimation method. Journal of Financial and Quantitative Analysis 39 (4): 813–841.
Ang, A. and Bekaert, G. (2007) Stock return predictability: Is it there? Review of Financial Studies 20 (3): 651–707.
Baker, M. and Wurgler, J. (2006) Investor sentiment and the cross-section of stock returns. Journal of Finance 61 (4): 1645–80.
Baker, M. and Wurgler, J. (2007) Investor sentiment in the stock market. Journal of Economic Perspectives 21 (2): 129–151.
Ben-Raphael, A., Kandel, S. and Wohl, A. (2012) Measuring investor sentiment with mutual funds flows. Journal of Financial Economics 104 (2): 363–382.
Bordalo, P., Gennaioli, N. and Shleifer, A. (2013) Salience and asset prices. American Economic Review Papers and Proceedings 103 (3): 623–628.
Brunnermeier, M.K. and Parker, J.A. (2005) Optimal expectations. American Economic Review 95 (4): 1092–1118.
Campbell, J.Y. and Shiller, R. (1987) Cointegration and tests of present value models. Journal of Political Economy 95 (5): 1062–1088.
Campbell, J.Y. and Shiller, R. (1988) The dividend-price ratio and expectations of future dividends and discount factors. Review of Financial Studies 1 (3): 195–228.
Cutler, D., Poterba, J. and Summers, L. (1991) Speculative dynamics. Review of Economic Studies 58 (3): 529–546.
Engel, C., Mark, N. and West, K. (2008) Exchange rate models are not as bad as you think. NBER Macroeconomics Annual 22: 381–443.
Ferson, W.E., Sarkissian, S. and Simin, T. (2003) Spurious regression in financial economics. Journal of Finance 58 (4): 1393–1414.
Fong, W.M. (2012) Do expected business conditions explain the value premium? Journal of Financial Markets 15 (2): 181–206.
Fong, W.M. (2013) Risk preferences, investor sentiment and lottery stocks: A stochastic dominance approach. Journal of Behavioral Finance 14 (1): 42–52.
Fong, W.M. and Toh, B. (2014) Investor sentiment and the MAX effect. Journal of Banking and Finance 46 (9): 190–201.
Frazzini, A. and Lamont, O. (2008) Dumb money, mutual fund flows and the cross-section of stock returns. Journal of Financial Economics 88 (2): 299–322.
Goyal, A. and Welch, I. (2007) A comprehensive look at the empirical performance of equity premium prediction. Review of Financial Studies 21 (4): 1455–1508.
Greenwood, R. and Shleifer, A. (2014) Expectations of returns and expected returns. Review of Financial Studies 27 (3): 714–746.
Jurado, K., Ludvigson, S.C. and Ng, S. (2015) Measuring uncertainty. American Economic Review 105 (3): 1177–1216.
Lettau, M. and Ludvigson, S. (2001) Consumption, aggregate wealth, and expected stock returns. Journal of Finance 56 (3): 815–849.
Lettau, M. and Ludvigson, S. (2005) Measuring and modeling variation in the risk-return tradeoff. In: Y. Ait-Sahalia and L.P. Hansen (eds.) Handbook of Financial Econometrics, Amsterdam: North-Holland.
Lewellen, J. (2004) Predicting returns with financial ratios. Journal of Financial Economics 74 (2): 209–235.
Linton, O., Maasoumi, E. and Whang, Y.J. (2005) Consistent testing for stochastic dominance under general sampling schemes. Review of Economic Studies 72 (3): 735–765.
Lowenstein, G.F., Weber, E.U., Hsee, C.K. and Welch, N. (2001) Risk as feelings. Psychological Bulletin 127 (2): 267–286.
Moon, R., Rubia, A. and Valkanov, R. (2005) Long-horizon Regressions When the Predictor Variable Is Slowly Varying. San Diego: University of California. Working Paper.
Sirri, E.R. and Tufano, P. (1998) Costly search and mutual fund flows. Journal of Finance 53 (5): 1589–1622.
Slovic, P., Finucane, M., Peters, E. and MacGregor, D.G. (2002) The affect heuristic. In: T. Gilovich, D. Griffin and D. Kahneman (eds.) Heuristics and Biases: The Psychology of Intuitive Judgment, Cambridge, UK: Cambridge University Press, pp. 397–420.
Shiller, R. (1981) Do stock prices move too much to be justified by subsequent changes in dividends. American Economic Review 71 (3): 421–436.
Stambaugh, R.F. (1999) Predictive regressions. Journal of Financial Economics 54 (3): 315–421.
Stambaugh, R.F., Yu, J. and Yuan, Y. (2012) The short of it: Investor sentiment and anomalies. Journal of Financial Economics 104 (2): 288–302.
Valkanov, R. (2003) Long-horizon regressions: Theoretical results and applications. Journal of Financial Economics 68 (2): 201–232.
Vissing-Jorgensen, A. (2003) Perspectives on behavioral finance: Does ’irrationality’ disappear with wealth? Evidence from expectations and actions. NBER Macroeconomics Annual 18: 139–208.
Yagan, D. (2012) Why Do Individual Investors Chase Stock Market Returns? Evidence of Beliefs in Long-run Market Momentum. Harvard University. Working paper.
Author information
Authors and Affiliations
Rights and permissions
About this article
Cite this article
Fong, W. Market-wide sentiment and market returns. J Asset Manag 16, 316–328 (2015). https://doi.org/10.1057/jam.2015.17
Received:
Revised:
Published:
Issue Date:
DOI: https://doi.org/10.1057/jam.2015.17