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144 Emerging Markets Finance & Trade

How Does the Change in Investor Sentiment over


Time Affect Stock Returns?
Cherng G. Ding, Hung-Jui Wang, Meng-Che Lee, Wen-Chi Hung, and
Chieh-Peng Lin
ABSTRACT: We examine how the change in investor sentiment (IS) over time (the IS trend)
affects stock returns. The turnover rates of trading shares, trading value, and transactions,
three market measures of trading activity, have been demonstrated to meet the psychometric criteria for measuring the IS trend. The ratio of market price to book value and the
short-selling turnover ratio are inappropriate proxies. The empirical results indicate that
the influence of the IS trend on returns depends on the direction of the trend (optimistic
or pessimistic) and stock characteristics of individual holdings and on arbitrage constraint.
The effectiveness of arbitrage, sentiment-driven mispricing, and market intervention are
discussed.
KEY WORDS: arbitrage, confirmatory factor analysis, investor sentiment, market intervention, sentiment-driven mispricing, stock returns.

The creation of stock market bubbles is an interesting issue in behavioral finance. Examples of bubbles include Black Monday in 1987, the Internet bubble and NASDAQ crash
in 2000, and the U.S. housing bubble leading to the global financial crisis in 2008. Shiller
(1990) conducts a survey and finds that the main reason for the market crash during the
week of October 19, 1987, was overpricing. Arbitrage did not work to drive the prices to
equilibrium. Cheung (2010) indicates that bubbles and crashes are associated with market
sentiment. The eagerness to buy stocks is driven by irrational euphoria among all investors. The aforementioned well-known stock market events demonstrate that continuously
optimistic sentiment resulting from expected prosperity induces irrational rises in stock
prices, followed by severe crashes.
Noise traders are irrational investors in financial markets. Their trading is not based
on fundamental information (Shiller 1984) and is affected by their sentiment. Their
sentiment, called investor sentiment (IS), is a belief about future asset values that is not
Cherng G. Ding (cding@mail.nctu.edu.tw), corresponding author, is a professor of statistics at the
Institute of Business and Management, National Chiao Tung University, Taipei, Taiwan. Hung-Jui
Wang (wanghomeray@gmail.com) is a Ph.D. candidate in management at the Institute of Business
and Management, National Chiao Tung University, Taipei, Taiwan, and an adjunct lecturer in the
Department of Finance and Banking, Chih-Lee Institute of Technology, Taiwan. Meng-Che Lee
(lion6666here@yahoo.com.tw) is a Ph.D. candidate in management at the Institute of Business and
Management, National Chiao Tung University, Taipei, Taiwan. Wen-Chi Hung (wchung@stpi.narl.
org.tw) is a Ph.D. candidate in management at the Institute of Business and Management, National
Chiao Tung University, Taipei, Taiwan. Chieh-Peng Lin (jacques@mail.nctu.edu.tw) is a professor
of management at the Institute of Business and Management, National Chiao Tung University,
Taipei, Taiwan. An earlier version of this paper was presented at Paper Session F1, International
Conference on Business and Information (BAI2012), Sapporo, Japan, July4, 2012. The authors
thank conference participants as well as three anonymous EMFT referees for constructive comments
and suggestions. This research was partially supported by grant NSC 98-2410-H-009-010-MY2
from the National Science Council of Taiwan.
Emerging Markets Finance & Trade / MarchApril 2014, Vol. 50, Supplement 2, pp. 144158.
2014 M.E. Sharpe, Inc. All rights reserved. Permissions: www.copyright.com
ISSN 1540496X (print)/ISSN 15580938 (online)
DOI: 10.2753/REE1540-496X5002S210

MarchApril 2014, Volume 50, Supplement 2 145

justified by the facts (Baker and Wurgler 2007). According to noise trader theory (De
Long et al. 1990), IS can affect stock returns when arbitrage is limited.
From the perspective of social activity, dealing with IS change rather than with a snapshot of the process is appealing. Investing could be considered a social activity. Human
interactions spread moods and emotions, causing uniformity in financial decision making
(Prechter 2002). Investors optimistic (pessimistic) behavior influenced by social movements persists for a period of time (Olson 2006; Shiller 1984). The lasting optimistic or
pessimistic IS may push prices far from fundamentals. High market prices may eventually lead to market bubbles and crashes. Due to the dynamic nature of IS, measuring the
change in IS over time (the IS trend) is more interesting than measuring its level (for a
given time point) (Baker and Wurgler 2007). More attention should be paid to IS change
than to price change since the former is the crux of market inefficiency.
Although the influence of IS on stock returns has been empirically examined (e.g.,
Baker and Wurgler 2006, 2007; Chen et al. 2010; Demir and Danis 2011), the studies
are based on IS levels rather than on the dynamic change in emphasizing IS over time.
This paper contributes to the literature in three ways. First, rather than IS levels at each
of multiple time points, we emphasize the IS trend. As we have mentioned, observing
IS levels cannot capture the change in IS over time. Famous market bubbles and crashes
show that the lasting mood for a period would push prices far from fundamentals. Analysis
based on the IS trend is more useful since the direction of the IS change would affect
market liquidity and in turn the trading willingness of arbitragers. Analysis based on an
IS trend is an effective way to gain insight into market inefficiency.
Second, we identify market indicators for measuring IS trends using rigorous psychometric methods. A construct is a concept that cannot be directly observed and needs
to be measured indirectly in terms of a number of observable manifest variables, which
are called measures or indicators. Principal component analysis has always been used
in previous studies for multiple market indicators to form a composite index of IS (e.g.,
Baker and Wurgler 2006, 2007; Chen et al. 2010; Huang and Goo 2008). Exploratory
factor analysis (EFA), always based on the principal component method, explores the data
and provides information about how many underlying factors are needed to account for
the original variables (market indicators in this paper). However, the appropriateness of
the indicators used for IS cannot be well assessed. Confirmatory factor analysis (CFA) is
a psychometric technique for assessing whether indicators can represent (measure) their
underlying construct by examining the fit between the CFA model and the data (Hair et
al. 2010, p.693). CFA is a measurement model for assessing reliability and construct
validity of measures of constructs. With appropriate statistical tests, CFA has been widely
applied in behavior studies. However, it is seldom seen in behavioral finance. CFA is
used in Keller and Siegrist (2006) and vanEverdingen and vanRaaij (1998), but not for
dealing with IS.
Finally, the market indicators used for measuring an IS trend and for the subsequent
analysis of its influence on returns are based on individual stocks rather than on the entire
market. The IS indicators used in previous studies are mostly based on the entire market.
However, Baker and Wurgler (2007) argue that different stocks exhibit different levels of
sentiment because of different characteristics and arbitrage constraints. Kumar and Lee
(2006) find that smaller firms, lower priced firms, and firms with lower institutional ownership are associated with stronger noise trading. Dorn (2009) points out that individual
investors seem to prefer stocks in high-tech industries. Therefore, stock heterogeneity
should be considered when analyzing the influence of the IS trend on stock returns.

146 Emerging Markets Finance & Trade

This will make the results more informative in evaluating the effectiveness of arbitrage
and market intervention. We recommend that the policy of market-wide intervention be
replaced by type-dependent intervention to make market intervention flexible and more
effective. Different types of stocks should get their own prescriptions.
In this paper, market indicators for measuring an IS trend are first identified. Then,
we use the measures obtained to investigate how the change in IS over time affects stock
returns. Using empirical findings, we discuss the effectiveness of arbitrage, sentimentdriven mispricing, and market intervention.
Identifying Measures for the IS Trend
Literature Review
Investor sentiment can be captured by surveys (Juster 1981). Survey-based measures
include the American Association of Individual Investors index and the Investors Intelligence sentiment index (Indro 2004). Alternatively, market indicators could be used;
these include trading volume and turnover (Baker and Stein 2004), mutual fund flows
(Brown and Cliff 2005; Canbas* and Kandr 2009), closed-end fund discounts (CEFD)
(Canbas* and Kandr 2009; Lee et al. 1991; Zweig 1973), dividend premium (Baker and
Wurgler 2006), volume of initial public offerings (IPOs), and first-day returns on IPOs
(Ritter 1991; Stigler 1964).
Since IS surveys for individual stocks are costly and difficult to implement, it would
be better to use market proxies. The IS for individual stocks can be aggregated to see
the IS for the entire market or for subgroups. However, data may not be available for all
stocks within a specific period. New equity issues, IPO volume, and CEFD are available
for only a limited number of stocks. Aggregation is justified only when market indicators
are appropriate and the stocks selected are representative of a group.
Among market indicators for IS, measures of trading activity (Chordia et al. 2001),
the market price to book value (PBR) (Brennan and Wang 2010; Hirshleifer 2001), and
short-selling turnover ratio (SSTR: the number of shares being short sold divided by the
number of shares traded) (Chen et al. 2010) are readily available for each stock. According to extant literature, trading activity can be measured by using trading shares, trading
value, and the number of transactions (e.g., Chordia et al. 2001). The turnover rates of
trading shares, trading value, and transactions are used to better reflect trading activity,
because different stocks have varying numbers of shares outstanding and the level of
trading shares among stocks may differ considerably. Specifically, the turnover rate of
trading shares for a stock is its trading shares divided by the number of shares outstanding.
The turnover rate of trading value for a stock is its total value of share trading divided
by the market capitalization. The turnover rate of transactions for a stock is the number
of transactions divided by the number of shares outstanding.
According to noise trader theory, trading activity can reflect IS when short selling is
costly or forbidden (Baker and Stein 2004; Baker and Wurgler 2007). Scheinkman and
Xiong (2003) indicate that short selling requires borrowing securities; therefore it is costly.
Baker and Wurgler (2007) point out that short selling is more costly than opening and
closing a long position in practice. Noise traders will actively trade only when they are
optimistic and betting on rising stocks. When noise traders are pessimistic, their trading
will decrease sharply because of short-selling constraints. Hence, trading activity could,
in this situation, reflect IS. PBR, a frequently seen price-related indicator for IS, could
be used to reflect IS when betting against noise traders is risky. In this situation, stock

MarchApril 2014, Volume 50, Supplement 2 147

price could be influenced by IS; otherwise, stock prices reflect fundamental (intrinsic)
values (Baker and Wurgler 2007). Finally, when noise traders dominate the short-selling
trading and short selling is easy to implement, SSTR can be used as a market indicator
for IS. It is negatively correlated with the sentiment (Chen et al. 2010). Relevant issues
are discussed below.
Methods
Data
Individual investors spend far less time than do institutional investors on investment
analysis and are easily affected by their sentiments. Individual investors tend to buy or
sell stocks in concert with each other. They are regarded as noise traders (Chen et al.
2013). Stock markets with more individual holdings and trading are better targets for
IS studies. The Chinese, Korean, and Taiwanese stock markets are typical (Barber et al.
2009). Unfortunately, the Chinese stock market forbids margin trading and places several
limitations on foreign investment. The percentage of individual holdings in the Korean
market is lower than that in the Taiwanese market. Barber et al. (2009) analyze trading
records in the Taiwanese stock market and find that individual investors are overconfident
and enjoy trading. Lai et al. (2010) indicate that investors in Taiwan have systematic
psychological biases. Thus, the Taiwanese stock market is selected for this study.
Monthly transaction data for all listing stocks in Taiwan were collected from January
2007 to October 2008. They are available in the Taiwan Economic Journal database.
There are three reasons for choosing this research period. First, the bimonthly surveys
on Taiwan investor sentiment conducted by Shih Hsin University (http://contract.shu.edu
.tw/~emotion/ [in Chinese]) show the longest optimistic period and pessimistic period in
the survey records. In 2007, an optimistic trend from January to June was followed by
a pessimistic trend of six months. In 2008, the optimistic trend occurred from January
to April and was followed by a pessimistic trend of six months. The periods with salient
survey-based IS trends are attractive because they facilitate confirming IS trends obtained
with market indicators with survey-based results. Second, Taiwan government market
stabilization funds entered the stock market in the second half of 2008 due to the global
financial crisis. This timing is suitable for examining the effects of market intervention
by comparing the pessimistic periods in 2007 and 2008. Finally, the level of institutional
ownership reached 59.74 percent in 2007 and 60.16 percent (the highest on record) in
2008, enhancing the function of the arbitrage mechanism and making sentiment less
likely to form. The period is suitable for detecting whether the market indicators used
qualify as IS proxies. If IS still exists during such periods, then the indicators apply to
the periods with a higher percentage of individual investors.
In summary, the research period is composed of four subperiods: JanuaryJune2007,
JulyDecember2007, JanuaryApril2008, and MayOctober2008. The first and the
third subperiods show optimistic IS trends; the second and the fourth subperiods show
pessimistic IS trends.
Measurement of the IS Trend (Change over Time)
The linear IS trend during a selected period for an individual stock could be assessed by
the increment between the initial IS level and the last IS level (Baker and Wurgler 2007).
Alternatively, the case-by-case regression (Bollen and Curran 2006, sec.2.4) with time

148 Emerging Markets Finance & Trade

as the independent variable and one IS indicator as the dependent variable could be used.
The case-by-case regression (based on the ordinary least squares method) performs better
since it takes into account all levels during the period and can include control variables.
A positive value of the estimated linear regression coefficient (slope) for an individual
stock reflects its optimistic trend. In contrast, a negative value of the estimated coefficient
exhibits its pessimistic trend.
Baker and Wurgler (2007) indicate that market indicators for IS may partially reflect
fundamentals of stocks because rational investors trade based on fundamental information.
Therefore, the effects of fundamentals of stocks should be partialled out to purify the IS
effect. Following Baker and Wurglers (2007) suggestion, we include the change rate of
industrial production, the change rate of the consumer price index, the unemployment
rate, the change rate of recession index, and earnings per share as control variables.
The piecewise case-by-case regression model is given as follows:


Yit = b0i + b1iTimet + b2iE1t + b3iE2t + b4iE3t + b5iTimet * E1t


+ b6iTimet * E2t + b7iTimet * E3t + f1C1t + f2C2t + f3C3t
+ f4C4t + f5C5t + eit, i = 1,...,n; t = 1,...,T,

(1)

where Yit denotes a market indicator of stock i at time t, T is the total number of time points
(twenty-two in this study), n is the total number of stocks (692 in this study), Time is the
main predictor (with Timet=t), and E1, E2, and E3 are dummy variables to represent the
four subperiods, with different slopes. Given that the slope changes at July2007, January2008, and May2008 (Time=7, 13, and 17), we define E1=1 if Time<7, and E1=0
otherwise; E2=1 if 7Time<13, and E2=0 otherwise; E3=1 if 13Time<17, and
E3=0 otherwise. C1tC5t denote the five control variables mentioned above. To a market
indicator, the slopes associated with time (1+5 for the first subperiod, 1+6 for the
second subperiod, 1+7 for the third subperiod, and 1 for the fourth subperiod) are
adjusted growth effects (as fundamentals are held constant), which can better represent
the IS trend.
Psychometric Methods
The typical procedure using psychometric methods to identify appropriate measures for
a construct has long been available (e.g., Gerbing and Anderson 1988; Hinkin 1998).
The procedure involves assessing the reliability and validity of measurements by using
CFA. Multiple indicators are usually needed for a construct to capture the domain of
interest to achieve content validity (Hinkin 1998). Moreover, the CFA model needs to be
identified. When there is only one construct to be measured and the number of indicators
for the construct is three, a simple way to identify the CFA model is to restrict an error
variance to be a constant.
Composite reliability (denoted by CR), based on CFA, is commonly used for assessing reliability. A reliability of 0.7 may serve as an acceptable criterion (Hinkin 1998).
Reliability should be assessed after unidimensionality has been established (Gerbing
and Anderson 1988). Standardized reliability should be used when items have different
measurement units and item standard scores are summed to form construct scores (Cortina
1993). Unidimensionality means that each indicator reflects only its underlying factor
and can be assessed by using EFA (with the principal component method), confirmed
by CFA (for an excellent review, see, e.g., Hair et al. 2010, ch.3 and part1, ch.12). The

MarchApril 2014, Volume 50, Supplement 2 149

correlation matrix of the original indicators usually serves as the input. The criteria of
eigenvalue greater than 1 and proportion of the total variance explained are commonly
used to determine the number of factors in EFA (Hair et al. 2010, p. 109).
Convergent validity refers to the extent to which indicators actually represent the
underlying construct they are designed to measure. A simple way to assess convergent
validity is to test for significance of estimated loadings (Anderson and Gerbing 1988) by
using the t-statistic (the estimated loading divided by the standard error of the estimated
loading), which is asymptotically normal. Weak evidence for convergent validity results
when the estimated loadings are all significantly nonzero. Strong evidence for convergent
validity is achieved when the squared standardized loadings are greater than or equal to
0.5 (Bagozzi and Yi 1991).
CFA provides indexes for assessing model fit. Two criteria indicating acceptable
model fit, CFI (comparative fit index)0.95 and SRMR (standardized root mean square
residual)0.09, are recommended (Iacobucci 2010). Once unidimensionality, reliability,
and validities are all supported and model fit is acceptable, construct scores can be obtained
by averaging the indicators for measuring the construct (Hair et al. 2010, p. 128).
Results
Assessment of Unidimensionality, Convergent Validity, and
Reliability for Trading Activity
First, after the adjusted growth effects of the turnover rates of trading shares, trading
value, and transactions are obtained, along with the piecewise case-by-case regression
for the four subperiods; then, their correlations, computed for each subperiod, are used
as the input of EFA. One factor is extracted in EFA, and unidimensionality is supported.
The CFA results (Table1) show highly significant factor loadings and strong evidence
of convergent validity, and confirm unidimensionality. The standardized CR is greater
than 0.90, demonstrating satisfactory reliability. The model fit is adequate (CFI>0.99;
SRMR<0.01). We conclude that the turnover rates of trading shares, trading value, and
transactions satisfy psychometric requirements for measuring the IS trend.
Since the adjusted growth effects of the three turnover rates are internally consistent
and unidimensionality has been achieved, they are first scaled (divided by their respective standard deviations to remove the effects of different measurement units) and then
averaged to stand for the IS trend to simplify subsequent analysis. It appears that the
mean IS trends across the three indicators and across all individual stocks for the four
subperiods are 0.2820 (p<0.001), 2.1056 (p<0.001), 0.3287 (p<0.001), and 0.3420
(p<0.001). Since the results for the entire market agree with those based on the surveys
conducted by Shih Hsin University, the three turnover rates are further confirmed to be
appropriate IS measures.
Issues with PBR and SSTR
According to noise trader theory, PBR, a price-related indicator, could be another appropriate IS measure when it satisfies the following assumptions. The first assumption,
emphasized by DeLong et al. (1990), is that investors are subject to sentiments. The
second assumption, indicated in Shleifer and Vishny (1997), is that betting against those
investors is risky; it reflects a limitation of the arbitrage mechanism. Alternatively, SSTR

150 Emerging Markets Finance & Trade

Table 1. CFA results for the IS trend based on the adjusted growth effects of
turnover rates of trading shares, trading value, and transactions
IS trend
Adjusted growth
effect of
Turnover rate of trading
shares
Turnover rate of trading
value
Turnover rate of
transactions
Model fit
CFI
SRMR
Reliability (CR)

JanuaryJune
2007
(optimistic)

JulyDecember
2007
(pessimistic)

JanuaryApril
2008
(optimistic)

MayOctober
2008
(pessimistic)

0.9952***

0.9950***

0.9950***

0.9950***

0.9851***

0.9859***

0.9850***

0.9822***

0.8661***

0.8590***

0.6058***

0.8298***

0.9900
0.0053
0.9655

0.9994
0.0001
0.9641

0.9994
0.0015
0.9086

1.0000
0.0001
0.9567

Notes: Standardized factor loadings are presented. The standardized reliability is reported because
of different measurement units of the indicators. To identify the CFA model, we have restricted the
variance of the error associated with the turnover rate of trading shares to be 0.01. ***Significant at
the 0.001 level.

could be a proper but reverse indicator for IS when noise traders dominate short-selling
trading and short selling is easy to implement. The appropriateness of PBR and SSTR
for measuring IS deserves further investigation.
The adjusted growth effects of PBR and SSTR are also obtained with the piecewise
case-by-case regression. By conducting EFA for the adjusted growth effects of the five
indicators (three turnover rates, PBR, and SSTR), two common factors are extracted
for each of the four subperiods, implying that unidimensionality is not supported. The
factor patterns after the varimax rotation (Table2) reveal that the adjusted growth effects
of the three turnover rates reflect a common factor and those of PBR and SSTR reflect
another factor. It appears that PBR and SSTR cannot be IS measures.
In the Taiwanese stock market, the level of institutional ownership was about 60 percent in 2007 and 2008. Since the market was occupied more by institutional investors,
who are believed to be rational, stock prices might reflect intrinsic values more than IS
during the period. It is less risky to trade against noise traders. This may explain why
PBR could not reflect IS. However, naked short selling (i.e., sellers must borrow stocks
before short selling) is forbidden in Taiwan. International stock markets such as the New
York Stock Exchange and the London Stock Exchange do not allow naked short selling,
either (DAvolio 2002; Saffi and Sigurdsson 2011). In Taiwan, the initial margin shortselling ratio is 90 percent, and the margin purchasing ratio is 60 percent. Since 2007,
the ratio of short-selling shares to trading shares has been between 0.91percent and
2.73percent. In contrast, the ratio of margin purchasing value to trading value has been
between 18.53percent and 25.80 percent. The fact that short selling is much more difficult
to implement than margin purchasing might explain why SSTR could not reflect IS.

0.0569
0.0747
0.1369
0.7351
0.7415
1.0430
0.7883

0.9766
0.9651
0.9268
0.3280
0.1781
2.8987
0.5797

Turnover rate of trading shares


Turnover rate of trading value
Turnover rate of transactions
PBR
SSTR
Eigenvalue
Cumulative proportion of the total
variance explained

0.9648
0.9603
0.7753
0.1375
0.0466
2.4976
0.4995

Factor 1
0.0136
0.0382
0.1787
0.7123
0.7289
1.0498
0.7095

Factor 2

JanuaryApril 2008

0.9761
0.9730
0.9240
0.2484
0.1437
2.8602
0.5720

Factor 1

0.0642
0.0519
0.0668
0.6181
0.8341
1.0645
0.7849

Factor 2

0.9755
0.9700
0.9076
0.2092
0.1115
2.8006
0.5601

Factor 1

0.0486
0.0106
0.1322
0.6348
0.8183
1.0644
0.7730

Factor 2

MayOctober 2008

Pessimistic period
JulyDecember 2007

Notes: The varimax rotation is used. Boldface values indicate the factor on which each indicator predominantly loads.

Factor 2

Factor 1

Adjusted growth effects of

JanuaryJune 2007

Optimistic period

Table 2. EFA results for the adjusted growth effects of the three turnover rates, PBR, and SSTR

MarchApril 2014, Volume 50, Supplement 2 151

152 Emerging Markets Finance & Trade

The Influence of the IS Trend on Stock Returns


Previous studies claim that the levels of IS affect returns. However, it would be more
interesting to examine the influence of the IS trend on returns since the effectiveness
of arbitrage could be affected by the direction of the IS change. During the optimistic
period, noise traders are inclined to trade actively. In the meantime, rational investors
could benefit by arbitrage trading since active trading increases market liquidity. Lower
arbitrage constraint (by which margin trading is easier to conduct) would help achieve
market efficiency because stocks would be easier to borrow to conduct short selling. In
contrast, high arbitrage constraint could hardly attain the purpose because arbitragers
are not encouraged to trade. Thus, we hypothesize the following:
Hypothesis 1: During the optimistic period, lowering arbitrage constraint can help
improve market efficiency for the stocks with more noise traders.
During the pessimistic period, market liquidity declines because noise trading
decreases. Lower liquidity leads to higher arbitrage risk, reducing the willingness of
arbitragers to bet against noise traders. In this situation, the stocks with greater sentiment
change and lower arbitrage constraint would be more attractive for noise traders since
lower arbitrage constraint can enhance the influence of noise trading on returns (Shleifer
and Vishny 1997). In other words, such stocks would lead to more negative returns. We
hypothesize the following:
Hypothesis 2: During the pessimistic period, lowering arbitrage constraint makes
the market more inefficient for the stocks with more noise traders.
The efficient market hypothesis (Fama 1970) indicates that investors are rational and
stock prices always reflect fundamental values. Therefore, we predict the following:
Hypothesis 3: For the stocks with more rational traders, stock returns are not affected by the IS trend regardless of optimism or pessimism and whether arbitrage
constraint is high or low.
In summary, the direction of the IS change would affect market liquidity and, in turn,
the willingness of rational investors to bet against noise traders. When the arbitrage
mechanism cannot work well, psychological factors should be considered in asset pricing (Brennan and Wang 2010), and market intervention is needed for improving market
efficiency.
It has been indicated that small-sized stocks and the stocks with more noise traders (i.e.,
with more individual holdings) tend to be traded more sentimentally (Dorn 2009; Kumar
and Lee 2006). On the other hand, the stocks with more rational traders (i.e., with more
institutional holdings) are traded less emotionally since institutional investors are generally
more rational than individual investors (i.e., their trading is based on fundamentals more
than on sentiment). Stocks with more noise traders, called NT stocks in this paper, tend
to be smaller, and those with more rational traders, called RT stocks, tend to be larger.
In Taiwan, the stocks in the industries of information service, biotechnology/medical
care, electronic products distribution, electrical/cable, paper/pulp, rubber, and iron/steel
can be representative of NT stocks because their individual holdings range from 56.69
percent to 72.23 percent and their sizes are mostly relatively smaller. The financial/insurance stocks and automobile stocks have relatively higher institutional holdings (63.99
percent and 75.39, respectively) and their sizes are mostly relatively larger, so they are
representative of RT stocks. The sample stocks used in this paper are divided into groups

MarchApril 2014, Volume 50, Supplement 2 153

of NT stocks, RT stocks, and others (denoted by OT). The numbers of NT, RT, and OT
stocks are 106, 39, and 547, respectively.
In the Taiwan market, the credit amount of margin trading for the component stocks
in the MSCI Taiwan index (compiled by Morgan Stanley Capital International Inc.) or
those in the exchange-traded fund is twice as much as that for others. Thus, the component
stocks are considered to be those with lower arbitrage constraint (LAC), and others are
with higher arbitrage constraint (HAC). Margin trading is easier to conduct for the former
than for the latter. The numbers of LAC and HAC stocks are 159 and 533, respectively.
Six groups of stocks can be formed based on the characteristics of individual holdings (NT/RT/OT) and arbitrage constraint (LAC/HAC). Let NT-LAC denote the group
of the NT stocks with LAC. NT-HAC, RT-LAC, RT-HAC, OT-LAC, and OT-HAC are
defined similarly. The numbers of stocks in the above six groups are 16, 90, 24, 15, 122,
and 425, respectively. Five dummy variables, D1D5, are used to represent the six groups
by defining D1=1 for NT-LAC and D1=0 otherwise; D2=1 for NT-HAC and D2=0
otherwise; D3=1 for RT-LAC and D3=0 otherwise; D4=1 for RT-HAC and D4=0
otherwise; D5=1 for OT-LAC and D5=0 otherwise. The regression model including
the moderating effects is given by


Returns = 0 + 1D1 + 2D2 + 3D3 + 4D4 + 5D5 + 6IS_trend


+ 7IS_trend*D1 + 8IS_trend*D2 + 9IS_trend*D3
+ 10IS_trend*D4 + 11IS_trend*D5 + ,

(2)

where Returns is obtained by (PclosedPprev)/Pprev, where Pclosed is the closing price on the
last trading day of the observation period and Pprev is that of the previous period. The
regression coefficients associated with the cross-product terms are the moderating effects.
The focus of this analysis is on how the influence of an IS trend on stock returns depends
on the stock groups NT-LAC, NT-HAC, RT-LAC, and RT-HAC. The corresponding
regression effects, given respectively by 6+7, 6+8, 6+9, and 6+10, need to be
specifically addressed. The White test (White 1980) is used to examine heteroskedasticity.
If heteroskedasticity is significant, the heteroskedasticity-consistent covariance matrix
estimator is used to test for regression effects; otherwise, the test is based on the standard
ordinary least squares covariance matrix.
Empirical Results
The regression results indicate that the coefficients associated with the cross product
terms are not all zero in the four subperiods except the final one (the pvalues for testing
H0:b7=b8=b9=b10=b11=0 are 0.0002, 0.0001, 0.0017, and 0.1957, respectively).
Since the moderating effects are mostly significant, the regression effects by group were
examined and summarized in Table3. The results indicate that returns are unrelated to the
IS trend for RT stocks, regardless of whether the period is optimistic or pessimistic and
whether arbitrage constraint is lower or higher. It appears that the arbitrage mechanism
works for RT stocks, supporting H3.
During the optimistic periods of 2007 and 2008, returns are significantly related to
the IS trend for NT-HAC stocks since higher arbitrage constraint limits arbitrage trading. For NT-LAC stocks, returns are insignificantly related to the IS trend, and therefore
market efficiency is achieved, supporting H1. During the pessimistic period in 2007, the
IS change affects returns for NT-LAC and NT-HAC, and the influence on the former is
greater than on the latter (the difference of the regression effects is 0.1696, p<0.0001).

154 Emerging Markets Finance & Trade

Table 3. The influence of the IS trend on stock returns by stock type


Type of stocks (by
two characteristics)
NT-LAC
NT-HAC
RT-LAC
RT-HAC
OT-LAC
OT-HAC

JanuaryJune
2007
(optimistic)

JulyDecember
2007
(pessimistic)

JanuaryApril
2008
(optimistic)

MayOctober
2008
(pessimistic)

0.0475
0.1091***
0.3197
0.0368
0.0065
0.0841***

0.2293***
0.0597***
0.0930
0.2045
0.1337***
0.0747***

0.0090
0.1033**
0.1267
0.0768
0.0117
0.0471***

0.1378
0.0364
0.2124
0.0673
0.0048
0.0058

Notes: Results are based on the regression model in Equation (2). The chi-square statistics for examining heteroskedasticity for the four subperiods are 33.21 (p=0.0106), 45.33 (p=0.0002), 34.33
(p=0.0076), and 21.53 (p=0.2034), respectively (all with 17 degrees of freedom). Since the sample
size is large, heteroskedasticity is judged based on the 0.01 significance level. The heteroskedasticityconsistent covariance matrix is used to test for the regression effects for the second and third subperiods (with significant heteroskedasticity); the standard ordinary least squares covariance matrix is used
for the other two subperiods. ** Significant at the 0.01 level; *** significant at the 0.001 level.

The result confirms that lower liquidity reduces the trading willingness of arbitragers,
and the mechanism to lower arbitrage constraint can strengthen the positive influence of
the IS change on returns. Thus, H2 is supported. During the pessimistic period in 2008,
when the global financial crisis occurred, government stabilization funds diminished the
influence of investors panic on returns, leading to the insignificant regression effects.
The results support the moderating role of individual holdings and arbitrage constraint
on the influence of the IS trend on returns. The effectiveness of arbitrage depends on the
situation. Moreover, IS does play a mispricing role due to irrational traders and the limited arbitrage, consistent with Baker and Wurglers (2007) sentiment-driven mispricing
view. It also appears that government intervention plays an important role in improving
market efficiency.
Discussion
The efficient market hypothesis claims that the arbitrage mechanism can itself achieve
market efficiency and no constraint should be imposed. Thaler (1999) points out that the
precondition of an efficient market is that arbitrage trading is made mainly by rational
investors. Our empirical results have confirmed that the arbitrage mechanism can function
for RT stocks regardless of whether the IS trend is optimistic or pessimistic and whether
arbitrage constraint is high or low. For NT stocks, market inefficiency exists when arbitrage constraint is higher, but lower arbitrage constraint cannot ensure market efficiency.
It appears that, for LAC stocks, the IS trend is positively related to returns when noise
traders are pessimistic. Thus, regulation of margin trading should depend on the type of
stocks and the direction of the IS trend. For RT stocks, no regulation is needed. For NT
stocks, when sentiment is optimistic, the short-selling cost should be set lower because
higher arbitrage cost limits the trading willingness of arbitragers; when sentiment is
pessimistic, the short-selling cost should be set higher to reduce the willingness of noise
traders to conduct margin trading.

MarchApril 2014, Volume 50, Supplement 2 155

Baker and Wurgler (2007) indicate that, if the current IS level is high, then the current
returns are high but the subsequent returns are low. It seems that even when the current
price deviates from intrinsic value due to sentiment, market mechanism will draw it
back in the subsequent period. If market mechanism always corrected price deviation at
the next period, market bubbles and crashes would not happen. However, bubbles and
crashes still occur. Market bubbles always start from continuously optimistic sentiment,
leading to an irrational rise of market price. Since the IS pattern is formed through a
process over time, trend should receive more attention than level. Our results indicate that
IS, a mispricing factor, affects returns for NT stocks, and the influence depends on the
direction of IS change (optimistic or pessimistic) and the degree of arbitrage constraint.
More noise traders and higher arbitrage constraint could lead to significant mispricing
when the sentiment is optimistic. Moreover, when the sentiment declines, lower arbitrage
constraint could result in more negative returns and fail to improve market efficiency.
These findings will help policymakers adjust intervention means.
The survey released by the U.S. government in 1988 reveals that the market collapse
of October 1987 resulted, for the most part, from investors psychological factors. The
circuit breaker mechanism (i.e., trading halt) was established by the U.S. government to
help relieve investors panic. According to the report by the International Organization
of Securities Commissions (2010), many emerging markets and developed markets have
adopted circuit breaker mechanisms to deal with investors panic problems. Supporters
(e.g., Greenwald and Stein 1991) of the circuit breaker mechanism claim that circuit
breakers provide investors with a cooling-off period to calm fear and panic. However,
opponents (e.g., Lee et al. 1994) argue that halts are unhelpful for price discovery and
do not actually reduce volatility in trading following the lifting of the halt.
Since the halt mechanism based on price fluctuations cannot determine whether the
fluctuations result from fundamentals or IS, preventive mechanisms should be designed
to identify potential bubble stocks instead of merely focusing on stock price. This papers
proposed approach of capturing the IS trend is useful for achieving this purpose. Intervention tools such as advance collection of funds, limitations of margin purchasing, and
trading halt could be used to limit continuous IS rise for relevant stocks.
We strongly recommend that the change in IS over time should receive more attention than price fluctuations, and the information should be included in the market
monitoring system. The practical operation for the circuit breaker could be based on the
timely dynamic sentiment information. The magnitude of the IS changes obtained for
different types of stocks can help determine the degree of intervention and improve its
effectiveness.
Conclusion
As mentioned by Baker and Wurgler (2007), measuring investor sentiment and understanding the change in investor sentiment over time are important in helping to interpret
limited arbitrage. In this paper, measures for IS are identified based on individual stocks
by using psychometric methods. The turnover rate of trading shares, the turnover rate
of trading value, and the turnover rate of transactions, three market measures of trading
activity, are identified to be appropriate measures for the IS trend. In contrast, PBR, a
price-related indicator, and SSTR do not meet the psychometric criteria. The appropriateness of these indicators can be further examined in future empirical studies.

156 Emerging Markets Finance & Trade

We demonstrate that the influence of the IS trend on stock returns depends on the direction of the IS change (optimistic or pessimistic), the stock characteristics of individual
holdings, and arbitrage constraint. The three hypotheses are all empirically supported.
The findings are helpful for decision makers adjusting intervention policies to improve
market efficiency.
The change in IS over time, after partialling out the effects of fundamentals, can serve
as a preventive index for market inefficiency since it is the crux of price fluctuations. It
should be included in the market monitoring system. If there exists a significant IS change
for some types of stocks, intervention may be needed, particularly when the change is
sharp. In the future, empirical studies using the data from different stock markets can
be conducted to further confirm the results obtained. In addition, more sophisticated
techniques such as latent growth modeling (e.g., Bollen and Curran 2006) can be used to
further analyze the change in IS over time and how it is influenced by stock characteristics.
New IS measures for individual stocks could be further studied.
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