South Asian Journal of Business Studies

Do Indian stock market sentiments impact contemporaneous returns?

Divya Aggarwal, Pitabas Mohanty,
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Divya Aggarwal, Pitabas Mohanty, (2018) "Do Indian stock market sentiments impact
contemporaneous returns?", South Asian Journal of Business Studies, Vol. 7 Issue: 3, pp.332-346,
https://doi.org/10.1108/SAJBS-06-2018-0064
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SAJBS
7,3
332
Received 12 June 2018
Revised 31 August 2018
19 September 2018
26 September 2018
Accepted 27 September 2018
Downloaded by INSEAD At 02:56 03 November 2018 (PT)
South Asian Journal of Business
Studies
Vol. 7 No. 3, 2018
pp. 332-346
© Emerald Publishing Limited
2398-628X
DOI 10.1108/SAJBS-06-2018-0064
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/2398-628X.htm
Do Indian stock market
sentiments impact
contemporaneous returns?
Divya Aggarwal and Pitabas Mohanty
Finance, XLRI Jamshedpur School of Business and Human Resources,
Jamshedpur, India
Abstract
Purpose – The purpose of this paper is to analyse the impact of Indian investor sentiments on
contemporaneous stock returns of Bombay Stock Exchange, National Stock Exchange and various sectoral
indices in India by developing a sentiment index.
Design/methodology/approach – The study uses principal component analysis to develop a sentiment
index as a proxy for Indian stock market sentiments over a time frame from April 1996 to January 2017. It
uses an exploratory approach to identify relevant proxies in building a sentiment index using indirect market
measures and macro variables of Indian and US markets.
Findings – The study finds that there is a significant positive correlation between the sentiment index and
stock index returns. Sectors which are more dependent on institutional fund flows show a significant impact
of the change in sentiments on their respective sectoral indices.
Research limitations/implications – The study has used data at a monthly frequency. Analysing higher
frequency data can explain short-term temporal dynamics between sentiments and returns better. Further
studies can be done to explore whether sentiments can be used to predict stock returns.
Practical implications – The results imply that one can develop profitable trading strategies by investing
in sectors like metals and capital goods, which are more susceptible to generate positive returns when the
sentiment index is high.
Originality/value – The study supplements the existing literature on the impact of investor sentiments on
contemporaneous stock returns in the context of a developing market. It identifies relevant proxies of investor
sentiments for the Indian stock market.
Keywords India, Principal component analysis, Stock returns, Sentiment index, Sentiments
Paper type Research paper
1. Introduction
Traditional finance theories were developed with two inherent assumptions, namely, that the
economic agents act rationally and that the capital markets are informationally efficient
(Malkiel and Fama, 1970). Challenging the normative assumptions of the traditional finance
theory, behavioural finance explains market anomalies and mispricing through models in
which irrational investor behaviour leads to market irrationality and inefficiency (Barberis and
Thaler, 2003). Offering a descriptive explanation of market irrationality, Black (1985) proposed
noise trader theory in finance. The noise trader theory attributes individual irrationality
resulting from trading on noise due to uncertain and incomplete information about future
events. Incomplete information and limits to arbitrage (Shleifer and Summers, 1990) lead asset
prices to diverge from their fundamental value as noise traders act on idiosyncratic sentiments.
The formal theoretical framework which validates sentiments by including them as a
systematic risk factor in asset pricing was developed by De Long et al. (1990a, b) and is
known as the DSSW theory based on the names of DeLong, Shleifer, Summers and
Waldman. According to the DSSW theory, sentiment-based-trades can explain market
anomalies like mean reversion of returns, excess volatility, over reactions, price bubbles and
asset under-pricing. The DSSW theory forms one of the building blocks for behavioural
finance and argues that irrational speculation driven by investor sentiments and limited
arbitrage leads to excess volatility and market mispricing. The DSSW theory of investor
sentiment has been extended by various scholars including Lakonishok et al. (1992),
 Campbell and Kyle (1993) and Brown (1999) to make the theoretical argument of Indian stock
sentiment-led asset pricing more robust. market
Post-2000, scholars started to empirically substantiate sentiments as a systematic risk factor sentiments
in asset pricing. One of the biggest challenges in all these empirical studies has been the
measurement of sentiments itself. Scholars have developed three measures to quantify
sentiments, namely, indirect market measures in the form of proxies of sentiments, direct market
measures in the form of investor surveys and a combination of both indirect and direct measures 333
of sentiments. Among the existing approaches, the most widely used and accepted approach is
the indirect market measure approach developed by Baker and Wurgler (2006, 2007). Numerous
studies have been done to empirically substantiate the significance of sentiments as a systematic
risk factor among which the prominent ones are those by Brown et al. (2003), Brown and Cliff
(2005), Baker and Wurgler (2006, 2007), Kumar and Lee (2006), Schmeling (2007), Verma and
Verma (2008), Verma and Soydemir (2009) and Yu and Yuan (2011).
However, most of these studies have been done in developed markets, particularly in the
USA. It becomes difficult to generalise the empirical evidence from developed markets to
emerging markets which are often characterised by ambiguity, uncertainty and lack of
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sophisticated technology in comparison to developed markets. Emerging markets like India

and few other Asian economies are yet to fully develop and become mature enough for retail
participants to have a substantial share in the markets (Kumari and Mahakud, 2015).
The objective of this study is to identify proxies of investor sentiment which can be
leveraged to develop an investor sentiment index for Indian capital markets. The reasons for
analysing Indian stock markets are twofold. First, being an emerging market, it has unique
characteristics regarding stock market movements, volatility, the impact of foreign funds
and price discovery inefficiency. Many scholars have cited that the studies on developed
economies cannot be generalised to Indian markets (Kumari and Mahakud, 2015; Prosad
et al., 2015). Second, unlike the developed markets, Indian retail investors have continued to
shy away from stock markets. Retail investors in India do not play a significant role as
compared to developed economies due to multiple reasons including a lack of financial
education and transparency in dealings (Shah, 2016).
Moreover, the traditional preference of alternate asset class by Indian retail investors has
kept them away from stock markets. Equity investments account for only 3.8 per cent of
total savings of Indian households (Shyam and Naidu, 2017). Indian capital markets are
dominated by institutional investors and high net worth individuals who are sensitive to
global macro events (Nayyar, 2015). The fund movements by foreign institutional investors
(FIIs) have a significant influence on stock price movement and their sentiments guide the
prevailing market sentiments (Nayyar, 2015).
Addressing the need to examine influence of sentiments on asset pricing in emerging
markets like India, Kumari and Mahakud (2015) find investor sentiments to have a
significant influence on conditional volatility in stock markets after examining returns of
Sensex for Bombay Stock Exchange (BSE) and Nifty for National stock exchange (NSE), the
two benchmark indices for India’s two major stock exchanges. Our study supplements and
extends the study of Kumari and Mahakud (2015) in three ways. First, our study focusses on
examining the influence of sentiments on contemporaneous returns of Sensex, Nifty and the
different sectoral indices. Second, we have included US macro factors in building the
sentiment index apart from the unique Indian stock market and Indian macro factors. Third,
our study uses an extended sample period as compared to existing studies to analyse the
influence of sentiments on contemporaneous returns.
Similar to Kumari and Mahakud (2015), we also use Baker and Wurgler’s (2006)
approach to construct the sentiment index. We run principal component analysis (PCA) on a
combination of Indian market measures, along with Indian and US macro variables to
construct the sentiment index. Newey and West’s (1987) adjusted ordinary least square
 SAJBS (OLS) regression analysis is done to examine the impact of sentiments on stock market
7,3 benchmark index Sensex, Nifty and sectoral indices. The results show that investor
sentiments have a significant influence on both the broad-based market index and the
different sectoral indices.
The rest of the paper is organised as follows: Section 2 presents the literature review by
discussing the existing studies in developed and emerging markets. We discuss the data
334 and methodology in Section 3. Section 4 discusses the results followed by conclusion and
implications in Section 5.

2. Literature review
The concept of investor sentiments can be resonated with the term “animal spirits” coined
by (Keynes, 1936). Till date, scholars are finding it a herculean task to come to a consensus
on understanding what sentiments are along with identifying the best approach to measure
and quantify their influence on asset markets (Smales, 2017; De Long et al., 1990a, b) are
credited to formally introduce a theoretical framework for including investor sentiment as a
systematic risk factor in asset pricing. They defined investor sentiments in the form of
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speculations resulting due to noise trading (De Long et al., 1990b). Over time, multiple
definitions have been adopted to define sentiments which include subjective beliefs with
respect to fundamental values (Shefrin, 2008), speculation about future asset value
(Schmeling, 2007; Schmitz et al., 2009) along with treating sentiments synonymous with
biases like optimism/pessimism (Baker and Wurgler, 2006).
Since one cannot observe sentiments directly, quantifying them has always been a
challenge for scholars. Quantifying sentiments, Baker and Wurgler (2006) proposed two
approaches: the bottom-up and top-down approach to measuring sentiments. While the
bottom-up approach is microscopic in nature and focusses on investor biases, the top-down
approach takes a macro overview by examining the macro variables at an aggregate level.
Quantifying sentiments at an aggregate level through top-down approach has been done by
scholars using three measures, which are indirect market measures, direct survey approach
and a combination of both direct and indirect measures (Bormann, 2013). Leveraging the
various approaches to measure investor sentiments, the research on investor sentiments
influencing stock markets has been done in two directions. Some studies examine the
relation of investor sentiments with contemporaneous returns to explain existing market
anomalies. Other studies examine the sentiment-led conditional volatility in the stock
markets to understand if sentiments can lead to better volatility predictions. Our study
contributes to the former category as it examines the influence of sentiments on stock
returns for the overall market and different sectors as well.
Quantifying sentiments, Brown and Cliff (2004) found the significant relation of direct
survey measures with indirect markets measures and stock returns for US stock markets.
Examining monthly and weekly data, they found strong evidence on co-movement of
sentiments with stock returns but weak evidence of sentiments leading to short-term stock
return predictability. Extending their results, Brown and Cliff (2005) gave persuasive
evidence of sentiment persistence in markets influencing asset valuation in the USA. Using
indirect market measures, Baker and Stein (2004) found sentiments to be a predictor for
future stock returns. Building upon the same argument, Baker and Wurgler (2006) found
that investor sentiments influence cross-section of stock returns, contingent upon the type of
stocks. For young, extreme growth, small, distressed or non-dividend paying stocks, the
influence of sentiments on the returns vary depending upon the ease of arbitrage and
information availability (Baker and Wurgler, 2007).
While the empirical evidence for sentiments influencing contemporaneous returns has
been strong, whether sentiments can lead to better volatility predictions has been a debatable
issue among scholars. Analysing daily returns of the US stock market, Wang et al. (2006)
 find returns to influence sentiment indicators and returns to predict volatility instead of Indian stock
sentiments. Extending Baker and Wurgler’s (2006) approach to other developed markets, market
various studies have found a significant influence of investor sentiments in explaining stock sentiments
market returns (Kumar and Lee, 2006; Verma and Verma, 2008; Ho and Hung, 2009; Verma
and Soydemir, 2009; Yu and Yuan, 2011; Rephael et al., 2012; Spyrou, 2012; Uhl, 2014).
Comparing institutional investor sentiments with retail investor sentiments, Wang (2003),
Schmeling (2007) and Verma and Verma (2008) found institutional investor sentiments to 335
produce more reliable volatility forecasts. Examining the influence of sentiments on stock
returns of six developed markets including Canada, France, Germany, Japan, UK and USA;
Baker et al. (2012) found sentiments to be a contrarian predictor of stock returns contingent
upon ease of arbitrage.
Post the financial crises of 2008, the studies examining the influence of investor
sentiments on stock market returns and volatility predictions have been extended to
developing markets. Chen et al. (2010) developed a sentiment index for the Hong Kong stock
market to show that sentiments have a significant influence on stock returns along with a
forecasting ability which can be used to develop profitable trading strategies. Following a
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similar approach for Chinese stock markets, Chen et al. (2014) and Chi et al. (2012) found
investor sentiments to have a stronger influence on stock market returns and volatility due
to emerging nature of Chinese markets and lack of experience of Chinese investors.
Examining Taiwanese construction companies, Chiang et al. (2011) found investor
sentiments to have a significant influence on stock returns. Contrary to existing results, Kim
and Park (2015) found no significant explanatory power between sentiments and
contemporaneous returns for the Korean Stock Exchange. Levering the volatility index
(VIX) as a measure of investor sentiments, studies by Sarwar (2012) and Bagchi (2012)
showed a significant relation between VIX and contemporaneous returns for the US and
emerging markets like Brazil, Russia, India and China.
Though studies have been done to examine the relation between sentiments and
stock returns in the Indian context, the literature on this front is limited. Exploring
biases in Indian stock markets, Prosad et al. (2015) found sentiments of optimism and
pessimism influencing stock returns. Following Baker and Wurgler (2006), Kumari and
Mahakud (2015) constructed a sentiment Index for Indian markets to examine
whether investor sentiments influence stock market volatility prediction. They found
that lagged investor sentiments and returns predict stock market volatility. Our study
complements the existing literature by examining the influence of sentiments and changes
in investor sentiments on stock market returns of Nifty, Sensex and various sectoral
indices of BSE.
Based on the theoretical framework of De Long et al. (1990b) along with support of
empirical works by Baker and Wurgler (2007) and Kumari and Mahakud (2015), we expect a
significant contemporaneous relation between sentiments and stock returns. By constructing
a sentiment index through an exploratory approach of variables identification, we expect the
sentiment index to have a significant correlation with stock indices. We expect changes in
sentiments to have a significant positive impact on stock market returns as bullish sentiments
will increase returns and vice versa. Hence, we test the hypothesis that investor sentiment will
have a significant relation with stock market returns.

3. Data
The study is done on data with monthly frequency over the period from April 1996 to
January 2017. The choice of sentiment proxies is based on two considerations. The primary
consideration is the theoretical relation of the proxies with the stock market based on
finance literature. The secondary consideration is the availability of the data with respect to
the time period of the study. For stock returns, the study has computed returns of Sensex,
 SAJBS Nifty and various sectoral indices of BSE. Table I gives a summary of some important
7,3 characteristics of Sensex, Nifty and the sectoral indices along with descriptive statistics of
their returns being examined. The returns are computed as: rt ¼ Ln(Pt/Pt−1).

3.1 Variables taken for construction of sentiment index

We use the approach of Baker and Wurgler (2007) to construct a composite market
336 sentiment index for the Indian stock market. The variables we consider for this study
belong to three main categories, namely: the Indirect market measures unique to the Indian
stock exchange; Indian macro variables; and US macro variables. Since there are no unique
and universally accepted sentiment proxies, this study uses an exploratory approach in
identifying the sentiment proxies. Moreover, without any theoretical underpinnings on the
number of variables to be taken, we have aimed to take a broad set of indicators which are
reflective of Indian stock market sentiments.
The indirect market measures unique to the BSE are taken for the sentiment index
construction. The proxies for investor sentiments include price to earnings ratio (PE), price
to book ratio (PB), dividend yield (DivY), relative strength indicator (RSI) and money flow
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indicator (MFI). The data are sourced from the BSE website (www.bseindia.com). PE
measures investor confidence and the willingness to pay for the earnings of the firm (Baker
and Wurgler, 2007). We expect a positive relation of PE with stock market sentiments.
Similarly, PB reflects the pricing of a firm’s book value in the market. A higher ratio indicates
high confidence in the firm. We expect a positive relation of PB with stock market sentiments,
similar to PE. Unlike PE and PB, the dividend yield is expected to have a negative relation with
stock market sentiments (Baker and Wurgler, 2006, 2007; Kumari and Mahakud, 2015). A high
dividend yield reflects weak growth opportunities by the firm and indicates caution.
Relative strength indicator (RSI) indicates the presence of bullish or bearish sentiment in
the stock market. RSI is calculated as a ratio of the sum of positive returns over the absolute
value of the sum of negative returns over a period of P ten days. The mathematical
P 10 formula for
computing RSI is as follows: RSIð10Þt ¼ 100  10 i ðP ti  P ti1 Þþ = i 9 P ti  P ti1 9,
where (Pti−Pti−1)+ is the sum of all positive returns. An RSI value of 80 indicates that the
market is overbought, and a value of 20 indicates a market is oversold. We expect a positive
relation of RSI with market sentiments.
While RSI contains information with respect to the only price, the money flow Indicator
(MFI) includes both price and turnover. To estimate MFI, we use the approach by Chen et al.
(2010). First, we calculate a typical price which is the average of monthly high, low and close
index price. Money flow is defined as the product of the monthly typical price and monthly
turnover. The money flow is considered positive money flow if the current typical price
is higher than yesterday’s typical price and vice versa. By taking a time frame of ten
months, we compute a money ratio. Money ratio is defined as the ratio of positive
money flow by negative money flow over the period of ten months. MFI is then estimated
from the equation MFI ¼ (100−(100/1+Money Ratio)). We expect a positive relation of MFI
with market sentiments.
For Indian macro variables, we have used variables which impact trading and growth
activities of the nation. They include consumer price index (CPI), index of industrial
production (IIP), net FIIs investments and bank rate. The data are sourced from the
Reserve Bank of India website (www.rbi.org.in) and Capitaline database. We expect a
positive relation of CPI, IIP and net FII investments with market sentiments as they indicate
increased confidence and growth in the economy. Bank rate refers to the rate at which the
central bank lends to commercial banks. It serves as a proxy for the overall interest rate in
the economy and affects the cost of operations, resulting in an adverse effect on profits.
A higher bank rate makes investors shy away from stock markets. Hence, we expect a
negative relation of the bank rate with stock markets (Chen et al., 2010, 2014).
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Characteristics Sensex Nifty Auto Capital Consumer FMCG Healthcare Information Metals and Oil and Public sector
goods durables technology mining gas units
Summary characteristics of indices as of January 2017
Number of
stocks 30 50 14 10 26 69 68 57 10 10 54
Market
capitalisation 54,474.1 110,473.2 9,579.8 1,414.9 4,787.5 11,347.8 6,805.5 11,504.5 6,303.8 12,413.8 19,131.0
Trading
volume 484.0 4,051.2 147.8 17.8 113.2 104.0 152.3 108.6 89.0 123.7 214.4
PE 23.6 22.9 26.3 38.2 28.3 40.6 25.8 17.2 30.7 12.1 19.3
PB 3.0 3.3 4.5 7.9 3.4 8.0 3.4 3.6 1.6 1.9 1.3
Dividend yield 1.3 1.3 0.9 0.5 1.0 1.4 0.7 2.1 3.7 3.0 2.9
Statistics Sensex Nifty Auto Capital Consumer FMCG Healthcare Information Metals and Oil and Public sector
goods durables technology mining gas units
Descriptive Statistics of Index Returns for time period April 1996 to January 2017
Mean 0.008 (0.991) 0.014 0.012 0.012 0.012 0.012 0.010 0.011 0.012 0.010
Median 0.010 (0.985) 0.019 0.020 0.021 0.020 0.021 0.017 0.006 0.018 0.012
Maximum 0.248 (0.752) 0.276 0.410 0.451 0.410 0.274 0.479 0.457 0.266 0.363
Minimum (0.273) (1.306) (0.314) (0.411) (0.346) (0.411) (0.279) (0.540) (0.516) (0.378) (0.335)
SD 0.070 0.070 0.083 0.101 0.105 0.101 0.071 0.116 0.115 0.085 0.090
Skewness (0.367) (0.512) (0.378) (0.294) (0.305) (0.294) (0.529) (0.462) (0.303) (0.343) (0.057)
Kurtosis 0.911 4.553 4.167 4.977 5.134 4.977 5.224 6.858 5.203 5.794 5.585
Notes: PE, price to earnings ratio; PB, price to book ratio; FMCG, fast moving consumer goods. Market cap, free float market cap and trading volume are in INR billions
Source: BSE and NSE website, CMIE database
sentiments
Indian stock

337
market

characteristics of
indices and
Table I.

of index returns
descriptive statistics
Summary
 SAJBS With globalisation and trade linkages with the USA, the US macro variables are used to
7,3 reflect the economic activity of US markets. Economic and political uncertainty index of the
USA (EPU-US) along with Fed Rate is taken to assess their impact on Indian market
sentiments. The data for both series are sourced from Fred research website (https://fred.
stlouisfed.org/). Similar to bank rate, Fed rate also impacts investments in stock markets.
A higher Fed rate makes investing in Indian markets less attractive, leading to an outflow of
338 funds from Indian markets back to the US markets. EPU-US measures the uncertainty in the
US markets. A higher uncertainty in the US markets adversely affects the trade linkages
and propagates negative sentiments in the markets. Hence, we expect a negative relation of
both the proxies with Indian stock market investor sentiments.
Based on our literature support, we expect the following relation of the proxies in
constructing the sentiment index:
Sentiment_Indext ¼ CPIt þIIPt Bank ratet þNet FII I nvt t þMFIt þRSIt
DivYt þPBt þPEt EPUU SAt Fed_Ratet : (1)
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3.2 Methodology for constructing sentiment index

The most widely acknowledged method of sentiment measures is Baker and Wurgler’s
(2007) approach of constructing a comprehensive sentiment index, which uses the PCA. As
mentioned above, we have used 11 proxies over the time frame of 20 years to construct the
index. We use the Hmisc package (Harrell and Dupont, 2006) of R software to conduct
the PCA analysis (Phan, 2016). After forming the sentiment index through PCA analysis, the
study examines the relation of sentiment index with stock returns by using OLS regression
analysis. The next section discusses the results of the analysis.

4. Results and discussion

This section discusses and analyses the empirical results of the study. The preliminary
analysis consists of graphical and descriptive statistics.

4.1 Summary statistics

Figure 1 shows the co-movement of sentiment index with Sensex and Nifty. The figure
shows the co movement of major dips in Sensex and Nifty around the 2008 crises, with the

Sentiment Index 30,000

Sensex
4 Nifty 25,000
Sentiment Index

2 20,000
Sensex/Nifty

15,000
0
10,000
–2
5,000

–4 0
Figure 1.
Co-movement of 1996 2000 2004 2008 2012 2016
sentiment index with Time
Sensex and Nifty
Source: Author’s estimates
 sentiment index as well. To test the preliminary relation of sentiment index with Sensex and Indian stock
Nifty, Pearson correlation test was done. Sentiment index showed a positive correlation of market
0.39 and 0.38 with Sensex and Nifty, respectively, at 1 per cent significance level. sentiments
The summary statistics for index returns are shown in Table I. The monthly average
Sensex returns over the time frame of the study are 0.008 per cent. The minimum and
maximum returns are (0.27) and 0.25 per cent, respectively, with a standard deviation of 0.07.
A kurtosis of 0.83 and skewness of (0.33) suggest the data series have shorter tails and are 339
skewed to the left as compared to a normal distribution. But since the skewness is
between −0.5 and 0.5, it shows that the distribution is approximately symmetric.
The summary statistics of the sentiment proxies and indices are given in Table II. A kurtosis
of below 3 indicates the data series to be platykurtic indicating the tails to be shorter. Most of
the series except MFI and RSI are positively skewed to the right. With skewness values close
to 1, it shows that the data are highly skewed. Moreover, the data series have a high standard
deviation except for bank rate and Fed rate indicating volatility in the series.

4.2 Construction of sentiment index

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The choice for selecting a number of principal components to consider for analysis depends
upon the objective of the study ( Jackson, 2005). We believe that for the components to be
considered for analysis, they should explain at least 85 per cent of the variability. The first
five principal components of the variables taken in the study explain 87.4 per cent of the
variability. Hence, we consider exploring them for the analysis to construct the sentiment
index. To select the principal component, we first find the correlation of the first five
components with the sentiment proxies taken. Table III shows the correlation coefficients
along with the significance value of the components with the proxies. Since PC1 has the
highest number of significant correlation coefficients along with the expected signs, we
proceed with PC1 to construct the sentiment index. The loadings of PC1 are used to
construct the sentiment index which gives the following equation:

Sentiment_Indext ¼ 0:08CPIt þ0:28IIPt 0:20Bank ratet þ0:14Net FII I nvt t

þ0:29MFIt þ 0:38RSIt 0:42DivY t þ0:46PBt þ0:43PEt

0:18EPUU SAt þ0:02Fed_Ratet : (2)

Div Fed
CPI IIP Bank FII_NetIv Yield PB PE EPU_USA rate
Units index index rate (%) (INR bn) MFI RSI ratio ratio ratio index (%)

Panel A: sentiment proxies

Mean 84.93 210.90 0.07 33.63 53.35 58.57 1.53 3.27 18.03 98.46 0.02
Median 70.78 177.20 0.07 13.57 54.96 59.07 1.46 3.00 18.20 81.49 0.02
Maximum 159.17 440.40 0.12 295.07 94.11 99.92 2.46 6.70 29.90 253.92 0.07
Minimum 39.92 127.40 0.06 (173.55) 8.01 14.66 0.83 1.70 9.80 38.21 0.00
SD 35.70 72.76 0.02 73.55 16.39 18.93 0.36 0.90 3.44 47.12 0.02
Skewness 0.72 1.03 0.98 0.86 (0.57) (0.09) 0.58 1.10 0.33 1.27 0.37
Kurtosis (0.87) (0.12) 0.04 1.64 0.27 (0.85) (0.24) 1.19 0.432 0.99 (1.48)
Notes: CPI, consumer price index; IIP, index of industrial production; FII_NetIv, foreign institutional Table II.
investors net investment; MFI, money flow indicator; RSI, relative strength indicator; Div Yield, dividend Descriptive statistics
yield; PB, price to book; PE, price to earnings; EPU_USA, economic and political uncertainty USA for time period April
Source: Author’s estimates 1996–January 2017
 SAJBS PC1 PC2 PC3 PC4 PC5
7,3
CPI 0.16* (0.63)* 0.66* (0.09) 0.31*
IIP 0.56* (0.50)* (0.50)* 0.12*** (0.05)
Bank rate (0.39)* 0.49* 0.60* (0.29)* (0.11)
FII_NetIv 0.27* (0.27)* 0.42* 0.14** (0.79)
MFI 0.55* 0.60* 0.19* 0.42* 0.06
340 RSI 0.72* 0.23* 0.23* 0.51* 0.10
Div Yield (0.81)* 0.03 (0.19)* 0.46* (0.01)
PB 0.88* 0.03 (0.27)* (0.14)** (0.06)
PE 0.83 (0.15)** 0.07 (0.36)* 0.06
EPU_USA (0.33)* (0.69)* (0.22)* (0.00) (0.19)*
Fed rate 0.04 0.83* (0.37)* (0.30)* (0.20)*
Variability 0.3291 0.2310 0.1446 0.0919 0.0755
Cumulative variance 0.3291 0.5621 0.7067 0.7986 0.8741
SD 1.9026 1.6009 1.2611 1.0056 0.9113
Table III.
Correlation Notes: CPI, consumer price index; IIP, index of industrial production; FII_NetIv, foreign institutional
investors net investment; MFI, money flow Indicator; RSI, relative strength indicator; Div Yield, dividend
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coefficients
of principal yield; PB, price to book; PE, price to earnings; EPU_USA, economic and political uncertainty USA.
components (PC) with *,**,***Significant at 1, 5 and 10 per cent levels, respectively
sentiment proxies Source: Author’s estimates

4.3 Relation between sentiment index and contemporaneous returns

To examine the stationarity of the series, we perform Augmented Dickey Fuller (ADF) unit
root test with trend and intercept. The ADF unit root test for sentiment index at level had a
t-statistic of (3.19) with a p-value of 0.03. Similarly, for Sensex and Nifty returns, the data
series were stationary at level. The null hypothesis of non-stationarity was rejected at level,
indicating that both series are stationary and integrated of order 0, i.e. I (0). For all other
returns series of various sectoral indices, the null hypothesis of non-stationary was rejected
at level in the ADF unit root tests. Table IV shows the results of the ADF tests for
stationarity for all the series considered in the study.
When both the series are stationary at level, i.e. integrated of order 0, OLS regression can
be used to find the relationship between sentiment index and Sensex returns. The nature of
the data series does not allow to test for long-run association between the two using tests
like Johansen cointegration or auto-regressive distributed lag bound test which requires
series to have a higher or different integration order. We regress index returns on both
sentiment and the change in sentiment:

Rt ¼ aþ b  Sentimentt þb1  Change in Sentimentt þet : (3)

Here Rt is the return of the index. The equation is estimated for Sensex return, Nifty returns
and sectoral indices. To address the issue of autocorrelation and heteroscedasticity,
Newey–West standard error method is used. The Durbin–Watson (DW) test statistic is
reported to check for autocorrelation issues. The multicollinearity among independent
variables was analysed through variance inflation factors (VIFs). The results of the
regression equation are given in Table V.
The results show a positive coefficient of sentiment index and changes in sentiment
index with Sensex returns. However, only the changes in sentiment index are statistically
significant. A high Adj R2 of 61 per cent shows that the model has high explanatory power.
A DW statistic of close to 2 shows that the model does not suffer from autocorrelation
issues. The results of the sentiment index for Nifty returns and sectoral returns are similar
to Sensex return. All the models had a DW statistic close to 2, indicating no presence of
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Return series
Sentiment Capital Consumer Information Metals and Oil and Public sector
index Sensex Nifty Auto goods durables FMCG Healthcare technology mining gas units

Variables
ADF(t) −3.1911 −14.9302 −15.163 −12.5421 −12.2005 −13.4438 −12.2005 −14.8168 −13.5392 −12.0986 −13.599 −13.6736
p-value 0.0309** 0.000* 0.000* 0.000* 0.000* 0.000* 0.000* 0.000* 0.000* 0.000* 0.000* 0.000*
Critical value
1% −3.9956 −3.9956 −3.9956 −4.0015 −4.0015 −4.0015 −4.0015 −4.0015 −4.0015 −4.0015 −4.0015 −4.0015
5% −3.2428 −3.2428 −3.2428 −3.4309 −3.4309 −3.4309 −3.4309 −3.4309 −3.4309 −3.4309 −3.4309 −3.4309
10% −3.1374 −3.1374 −3.1374 −3.1391 −3.1391 −3.1391 −3.1391 −3.1391 −3.1391 −3.1391 −3.1391 −3.1391
Stationarity Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Notes: FMCG, fast moving consumer goods. The sample period for sectoral returns is March 1999-January 2017; for sentiment index, Sensex returns and Nifty returns,
it is from March 1996 to January 2017. t-statistics at *,**,***significant at 1, 5 and 10 per cent levels, respectively
Source: Author’s estimates
sentiments
Indian stock

341
market

ADF unit root tests

Table IV.

results for stationarity

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7,3

342

Table V.
SAJBS

Regression results
Index Capital Consumer Information Metals and Oil and Public sector
return Sensex Nifty Auto goods durables FMCG Healthcare technology mining gas units
Time
period May 1996–January 2017 April 1999–January 2017

Changes in sentiment
Coefficient 0.0893 0.0890 0.0930 0.1065 0.0925 0.1065 0.0550 0.0689 0.1277 0.0867 0.0966
t-stat 19.2082 18.841 13.7680 12.2593 9.5432 12.2593 8.2231 5.7416 13.5878 11.6468 12.4999
p-value 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
Sentiment
Coefficient 0.0012 0.0013 (0.0040) (0.0001) 0.0022 (0.0001) 0.0009 0.0032 (0.0000) (0.0011) (0.0045)
t-stat 0.7961 0.9179 (1.9370) (0.0423) 0.6717 (0.0423) 0.4377 0.8042 (0.0005) (0.4367) (1.7608)
p-value 0.4267 0.3596 0.0540 0.9663 0.5025 0.0344 0.6620 0.4221 0.9996 0.6628 0.0797
R2 0.6097 0.6039 0.4733 0.4220 0.3128 0.4220 0.2512 0.1458 0.4731 0.3950 0.4255
Adj R2 0.6065 0.6007 0.4683 0.4166 0.3068 0.4166 0.2441 0.1377 0.4681 0.3892 0.4201
DW
statistics 2.18 2.23 1.89 1.76 1.77 1.76 1.85 1.78 1.83 1.97 2.03
Note: FMCG, fast moving consumer goods
Source: Author estimates
 autocorrelation. The VIF for both sentiment index and changes in sentiment index was Indian stock
1.025, indicating no presence of multicollinearity in all the models. market
Indices for metals and mining, capital goods, fast moving consumer goods (FMCG) and sentiments
automobiles sectors have a higher change in sentiment β whereas healthcare has the lowest.
Moreover, regression models of the automobile have the highest explanatory power
followed by metals and mining, capital goods and FMCG. It may be concluded that stocks
more dependent on industrial activity like metals and mining along with capital goods are 343
more sensitive to changes in sentiment index, since they are highly impacted by any
changes in funds flow and foreign activity.
Our results are in conformity with the results of Baker and Wurgler’s (2006) study. Baker
and Wurgler’s (2006) empirically showed significant sentiment sensitivity for stocks
dependent upon age, growth stage, firm size, profitability level, dividend paying nature and
even volatility level. Our study has examined the same in the Indian context but has looked
at sentiment-led stock returns based on sectoral indices. Our study has not looked at
influence of sentiments on stock market volatility but at stock returns. Moreover, our study
has used US-specific variables in developing a sentiment index. Our study also supports the
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results of sentiments having a significant relation with stock returns and volatility by
Prosad et al. (2015) and Kumari and Mahakud (2015), respectively.

5. Conclusion and implications

The study develops a composite sentiment index by using Baker and Wurgler’s (2006)
approach. Analysing monthly returns of Indian benchmark stock indices and sectoral
indices over the time frame of 1996–2016, this study shows that contemporaneous returns
are influenced by a change in market sentiments. The results show that change in
sentiments play a significant role in influencing stock market returns. The influence of
change in sentiments is more pronounced for sectors which are more capital intensive like
metals and mining, capital goods, etc. The findings conform with the noise trader theory
(Black, 1985) and the DSSW theory (De Long et al., 1990b), indicating the need to
acknowledge investor sentiments as a systematic risk factor.
The results of our study contribute to the existing literature in three unique ways. First,
they highlight the need to examine influence of sentiments led stock returns in a more
granular way through sectoral indices. Second, changes in sentiment index having a
significant relation with stock returns highlight the need to consider sentiment as a
systematic risk factor. Third, we have included cross country variables to measure
sentiment which gives higher explanatory power for significant relation between sentiments
and stock returns. Since Indian stock markets are dominated by institutional investors, the
results of change in sentiments having a more pronounced influence on capital intensive
sectors are justified. The results imply that investors interested in emerging markets like
India can develop better understanding of stock returns by examining influence of
sentiments on sectoral returns.
The study has practical implications for investors and policy makers. Both retail and
institutional investors need to incorporate investor sentiments as a systematic risk factor in
asset pricing models to improve their asset returns. Understanding how different sectors are
influenced by investor sentiments can enable to develop more profitable trading strategies
and better return making portfolios. The study shows that investor sentiments are also
influenced by market fundamentals and macro factors. Designing stable policies by policy
makers can reduce volatility in the markets.
Future studies can be done by examining at more granular level, the proxies taken for
creation of the sentiment index, temporal dynamics of changes in sentiments on stock
returns and sentiments led stock volatility predictions with respect to investor groups. With
no theoretical reasoning on the number of proxies to be taken, this study is subject to certain
 SAJBS limitations due to the ambiguity surrounding the creation of a sentiment index. An index
7,3 created with different time period frequency may give new insights into short-term temporal
dynamics between sentiments and stock returns. A distinction between retail and individual
investor’s sentiments can be done to analyse the impact of their sentiments on stock returns.
Future studies can be done in these directions to enrich the existing literature on the
influence of investor sentiments on stock returns in the Indian context.
344
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Corresponding author
Divya Aggarwal can be contacted at: fb14007@astra.xlri.ac.in
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