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You are on page 1of 16

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

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.

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

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

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:

+ 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

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

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 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

JanuaryJune 2007

Optimistic period

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

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

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

+ 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).

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.

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.

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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