Investor Sentiment Measures
Brown University – Department of Economics
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University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)
Our paper examines two potential proxies for investor sentiment – the closed end fund discount (CEFD) and consumer confidence (CC). We can validate these proxies against a recently available more direct proxy for investor sentiment from UBS/Gallup. We find that the CEFD has no correlation with the UBS/Gallup survey, while the consumer confidence index does. The latter correlation would likely not be observed if either the consumer confidence index or the UBS/Gallup survey were not measures of some form of generic sentiment.
This direct validation is not dependent on a price role for sentiment in financial markets. Going further, our paper finds that only consumer confidence but not the closed-end fund discount plays a robust role in financial market pricing. Changes in consumer confidence can explain the excess returns on small decile stocks. The pathway does not seem to operate only through the real underlying economy (consumption and corporate profits), and it is unaffected by controlling for a measure of CEO confidence changes.
Our evidence satisfies a necessary condition for a behavioral perspective (DeLong/Shleifer/Summers/Waldmann 1990), but it is not a sufficient condition. Absent quantitative predictions by either the behavioral or the classical perspective about the exact influence of sentiment/confidence, empirical evidence cannot reject either.
The behavioral theory of DeLong, Shleifer, Summers, and Waldmann (1990) predicts that noise trader sentiment can persist in financial markets. They argue that changes in noise trader sentiment must be difficult to predict to avoid arbitrage. Assets that are disproportionally exposed to noise trader risk are both riskier and have to offer an extra return premium. In sum, the theory predicts that sentiment can influence security pricing under two necessary conditions:  the assets are held predominantly by sentiment (noise) traders, and  transaction costs are high enough to prevent systematic arbitrage by arbitrageurs.
Lee, Shleifer, and Thaler (1991), henceforth LST, first explore the empirical implications of this theory by assuming that noise traders are individual investors. Because individual investors were already known to disproportionally hold closed-end funds (henceforth, CEF), LST interpret the closed-end fund discount (henceforth, CEFD) as a (negative) sentiment factor. Lee, Shleifer, and Thaler (1991) then wring further implications and empirical support from this insight. Their most important implication is that decreases in the CEFD (i.e., more optimism) should be positively correlated with the returns of assets that are disproportionally held by noise sentiment traders. LST identify the smallest decile of firms as such. They find that small firms outperform large firms when the CEFD decreases.
Although Lee, Shleifer, and Thaler (1991) discount other possible factors determining the CEFD, first and foremost agency (transaction) costs, they concede that multiple factors are likely to influence the CEFD. Ross (2005) explores these factors in more detail and argues that transaction costs are more important than LST realized. In any case, the behavioral and the transaction cost views of the closed-end fund discount are not mutually exclusive. Moreover, Spiegel (1997) and Berk and Stanton (2004) have recently proposed a rational explanation for some of the time-pattern in the CEFD, although neither focuses on the correlation between the extreme size decile return spread and sentiment.
Interest in the CEFD as a sentiment index has not waned. Indeed, Lee, Shleifer, and Thaler (1991) has been a seminal paper, both in the novelty of its ideas and its subsequent impact: as of March 2004, a quick citation search yields over 100 cites to it. A search in SSRN shows that “investor sentiment” finds 53 matches, compared to 78 for the phrase “APT.” If anything, investor sentiment has become a subject of more intense interest. The CEFD remains the only widely used proxy of investor sentiment, and is itself a component in some other measures of investor sentiment, though all of these have remained fairly boutique.
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