Value Investing

Market Sentiment As A Factor In Asset Pricing

Market Sentiment As A Factor In Asset Pricing

Jitka Hilliard

Auburn University

Shen Zhang

Auburn University

Arun Narayanasamy

Northern Illinois University

January 15, 2016


This paper explores whether market sentiment should be used as an additional factor in the asset-pricing model. We use a unique dataset from Investor Intelligence as a direct measure of market sentiment. We form ten portfolios based on their correlations with the new market sentiment measure. Following Fama and French (1993) we build a market sentiment factor (SENT) and add this factor to the Carhart four-factor model. We find that SENT is significant for all portfolios in the sentiment augmented four-factor model and increases explanatory power of the model measured by adjusted R2s. We also find that the addition of SENT factor reduces the explanatory power of all other risk factors in the four-factor model.

Market Sentiment As A Factor In Asset Pricing – Introduction

The objective of any equilibrium asset pricing model is to establish the relationship between asset returns and its systematic risk factors. In empirical tests, the Fama-French (1993) factors capturing the size and value (P/B) effects and Carhart’s (1997) momentum factor are added to the CAPM. This model is referred to as the four-factor model and used extensively in empirical studies. More recently, Fama and French (2015) suggest addition of factors capturing the profitability and investment patterns into the asset-pricing model. Recent research in the area of market sentiment also suggests that sentiment of investors has a significant impact on stock returns.

Investor sentiment is defined as the overall attitude of investors. It reflects investors’ expectations toward a particular security or the whole market. In this paper, we focus solely on the market sentiment and its effect on equity returns. Market sentiment cannot be directly measured but is influenced by various factors like GDP, interest rates, and other national and global events. As the general feeling of the market, market sentiment reflects the aggregate expectation of the future market movement.

This paper is largely motivated by the research of Baker and Wurgler (2006, BW hereafter). They construct a sentiment measure in the form of an index. This sentiment index is based on six proxies that were previously shown to influence the sentiment of investors. Baker and Wurgler find that firms that are difficult to value — young stocks, small stocks, unprofitable stocks, non-dividend stocks, high volatility stocks, and distressed stocks— tend to have low returns in periods following periods of high sentiment, and vice versa.

How efficiently firms operate in the market and the overall conducive market environment aids in increasing cash flows and profitability of the firm and are priced in the financial markets. This link results in a relay effect and translates into market wide investor sentiment. The economic link between the relayed market sentiment and cross sectional asset returns remains relatively unexplored. This paper directly studies the effect of market sentiment on the cross section of portfolio returns by creating a sentiment factor (SENT) that captures the expected return effect of market sentiment.

There are a number of potential reasons why market sentiment may affect cross section of portfolio returns. First, governments make various fiscal and monetary policy decisions. These decisions affect the overall business environment in the country. Second, firms make capital structuring and capital budgeting decisions. These decisions affect the riskiness of their cash flows and the profitability of the firms. Third, the manner in which firms operate (efficient or inefficient use of firm resources) might affect the profits and market shares. All these events cascade into creating the overall market sentiment.

Different stocks react differently to market sentiment. The stocks with high correlation to market sentiment perform better during increasing market sentiment periods while stocks with low or negative correlation to market sentiment perform better during the periods of decreasing market sentiment. This suggests that market sentiment may help to explain equity returns.

We ask the pivotal question whether market sentiment could be used as an additional factor in the asset-pricing model, explaining asset returns. We form ten portfolios based on the correlations of the stock returns with the market sentiment and investigate differences in monthly returns on these portfolios. We follow the method used in Fama and French (1993) and form a sentiment factor (SENT) that captures return premiums of portfolios with high versus low correlations of returns with the market sentiment. We use this factor as an additional factor in the Carhart four-factor model and investigate the performance of this new sentiment augmented model.

Asset Pricing
Market Sentiment As A Factor In Asset Pricing

Asset Pricing

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