Do Measure of Investor Sentiment Predict Return

Do Measures of Investor Sentiment Predict Returns?
Author(s): Robert Neal and Simon M. Wheatley

Source: The Journal of Financial and Quantitative Analysis, Vol. 33, No. 4 (Dec., 1998), pp.
523-547
Published by: Cambridge University Press on behalf of the University of Washington
School of Business Administration
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JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS VOL. 33, NO. 4, DECEMBER 1998
Do Measures of Investor Sentiment Predict

Returns?
Robert Neal and Simon M. Wheatley*
Abstract
It has long been market folklore that the best time to buy stocks is when individual investors
are bearish, and the best time to sell is when individual investors are bullish. We examine
the forecast power of three popular measures of individual investor sentiment: the level
of discounts on closed-end funds, the ratio of odd-lot sales to purchases, and net mutual
fund redemptions. Using data from 1933 to 1993, we find that fund discounts and net
redemptions predict the size premium, the difference between small and large firm returns,
but little evidence that the odd-lot ratio predicts returns.
I. Introduction
It has long been market folklore that the discounts on closed-end funds, the
ratio of odd-lot sales to purchases, and net mutual fund redemptions reflect in?
dividual investor sentiment. For example, Wiesenberger (1946) states that "pes-
simism is at its peak when discounts are largest... when investor confidence is
at a high point... discounts tend to narrow,,, while Malkiel (1977) suggests that
net mutual fund redemptions reflect "general investor sentiment." It has also long
been market folklore that the best time to buy stocks is when individual investors
are bearish, and the best time to sell is when individual investors are bullish. For
example, Hardy (1939) refers to the "tradition that the public is ... wrong so often
that movements of the odd-lot balance furnish a serviceable forecaster of stock
prices." These two strands of folklore suggest that the three sentiment measures
should predict the returns on stocks held predominantly by individual investors.
* School of Business, Indiana University, 801 W. Michigan St, Indianapolis, IN 46202, and Aus?
tralian Graduate School of Management, University of New South Wales, Kensington, NSW, Aus?
tralia, respectively. The authors thank Catherine Bonser-Neal, Gregg Brauer, Wayne Ferson, Robert
Grauer, Avraham Kamara, Jon Karpoff, Burton Malkiel, Carolina Minio-Paluelo, Jeffrey Pontiff, Ed?
ward Rice, Terry Shevlin, Tom Smith, Brad Barber (the referee), Paul Malatesta (the editor), and
seminar participants at the Federal Reserve Bank of Kansas City, Freddie Mac, Indiana University,
the Securities and Exchange Commission, Simon Fraser University, and the University of Washington
for comments. The authors also thank Martin Chew, Kevin Harper, and Doug Rolph for research as?
sistance, and the New York Stock Exchange and the Investment Company Institute for data. Previous
versions of this paper were entitled "Closed-End Fund Discounts and the Predictability of Small Firm
Returns."
523
524 Journal of Financial and Quantitative Analysis
We find that fund discounts and net redemptions predict the size premium, the dif?
ference between small and large firm returns, but little indication that the odd-lot
ratio predicts returns. These results are important because Kandel and Stambaugh
(1996) show that even weak evidence of return predictability can substantially in?
fluence an investor's portfolio choice.
Campbell and Kyle (1993) show that individual investors who trade on noise
can affect prices. In their model, "noise traders" affect prices because fundamen?
tal risk deters "smart-money" investors from aggressively betting against noise
traders. Consistent with the market folklore we describe, Campbell and Kyle's
model implies that price is elastically pulled back to fundamental value at a rate
that depends on the gap between price and value. That is, expected returns are
high when price is below fundamental value, and low when price is above value.
Without an assumption about the intertemporal behavior of noise traders,
theory gives no guide to the horizon over which to measure expected returns.
For this reason, we follow Fama and French (1988), (1989) and measure returns
over horizons of one month, one quarter, and one, two, three, and four years.
The sentiment measures are endogenous, and least squares estimators from re?
gressions on lagged endogenous variables are biased in finite samples. For this
reason, we use the same approach as Nelson and Kim (1993) and base inference
on randomization simulations. We use these simulations to simultaneously assess
the significance of results computed over the different horizons. In this way, we
eliminate the data-snooping bias associated with searching across the horizons for
rejections of the null that returns are unpredictable.
We use data from 1933 to 1993 to test the ability of fund discounts, the ra?
tio of odd-lot sales to purchases, and the ratio of mutual fund net redemptions to
assets to predict returns.1 Our results for these three measures provide some ev?
idence of predictability. First, we find a positive relation between fund discounts
and small firm expected returns, but no relation between discounts and large firm
expected returns. This is consistent with the investor sentiment hypothesis be?
cause small firm stocks are held mostly by individuals, while large firm stocks are
held mostly by institutions (Lee, Shleifer, and Thaler (1991)). Second, we find a
weak positive relation between net redemptions and small firm expected returns,
and a weak negative relation between net redemptions and large firm expected
returns. Considered jointly, these results imply that there is reliable evidence that
net redemptions predict the size premium. Finally, despite its long tradition as a
predictor of returns, we find little indication that the odd-lot ratio predicts either
small or large firm returns.
Keim and Stambaugh (1986) also examine whether the size premium is pre?
dictable. They find that the average price of a small firm's stock can predict both
small firm returns and the size premium. We compare the predictive ability of the
Keim-Stambaugh variable to the predictive abilities of our three sentiment mea?
sures. We find that Keim and Stambaugh's variable contains information to pre?
dict the size premium beyond that contained in the three sentiment measures. We
also find that net redemptions provide information to forecast the size premium
beyond that contained in Keim and Stambaugh's predictor. On the other hand,
1 Other potential measures of investor sentiment include prime and score premiums (Barber
(1994)). We do not use these data because they are available only for a short period.
Neal and Wheatley 525
we find little evidence that fund discounts and the odd-lot ratio provide informa?
tion to predict the size premium beyond that contained in Keim and Stambaugh's
variable, although the tests lack power.
As Fama (1991) emphasizes, distinguishing between rational and irrational
explanations for the behavior across time of expected returns is difficult. For ex?
ample, whether Keim and Stambaugh's price measure tracks rational or irrational
variation in the size premium is unclear. While the present value relation implies
that variation in price can reflect a rational variation in expected return, in Camp?
bell and Kyle's model, expected return is a function of price, but price depends on
sentiment. Similarly, whether fund discounts and net redemptions track rational
or irrational variation in the size premium is unclear. We consider six rational
explanations for the relation between the size premium and fund discounts. Five
of the explanations do not fit our data. The sixth explanation fits our data, but so
does the investor sentiment hypothesis. We also consider a rational explanation
for the relation between the size premium and net redemptions. The explanation
fits our data, but again, so does the investor sentiment hypothesis.
Our paper is related to the earlier work of Zweig (1973), Hardy (1939), and
the recent work of Swaminathan (1996). Like Wiesenberger (1946), Zweig argues
that closed-end fund discounts reflect investor sentiment. He finds that changes
in fund discounts predict changes in the Dow Jones Industrial Average from 1966
to 1970. In contrast, we find no evidence that discounts predict large firm re?
turns. Using data from 1928 to 1938, Hardy reports that the odd-lot ratio predicts
changes in the Standard Statistics average of NYSE stocks. Using data from 1941
to 1993, we find little indication of a link between the odd-lot ratio and returns.
Finally, in independent work, Swaminathan uses monthly data from 1965 to 1990
to test whether fund discounts predict returns. Like us, he finds that discounts
predict the size premium. Our work differs from his, however, in four ways.
First, we examine additional measures of investor sentiment, the odd-lot ratio,
and net redemptions. Second, we compare the forecasting abilities of Keim and
Stambaugh's predictor and the three sentiment measures. While Swaminathan
concludes that discounts are the only variable that can predict the size premium,
we find little evidence that discounts provide information to forecast the premium
beyond that contained in Keim and Stambaugh's predictor. Third, we use more
than twice as many years' worth of discount data. Finally, using our longer time
series, we find no indication that discounts can predict future earnings growth or
inflation. Swaminathan argues that a rational explanation for the forecast power
of discounts arises from their ability to anticipate future earnings growth and in?
flation.
The rest of the paper is organized as follows. Section II describes the data,
provides summary statistics, and explains the methodology we use. Section III
presents empirical results. Section IV considers alternative explanations for the
discount and net redemption results. Section V concludes the paper.
II. Data, Summary Statistics, and Methodology

A. Data
Most closed-end fund studies use discounts taken from the Wall Street Jour?
nal (WSJ). The WSJ, however, has only published discounts on a regular basis
since 1965. Thompson (1978), on the other hand, uses discounts taken from
Wiesenberger's annual survey of mutual funds, Investment Companies Services.
Wiesenberger's survey has published end-of-year fund prices and net asset values
since 1943. Moreover, the first edition of the survey contains end-of-year fund
data from 1933 to 1942. The benefit of using Wiesenberger's data is that one
can examine a longer period. The cost is that, while the WSJ reports discounts
weekly, Wiesenberger's survey reports discounts only annually. The benefits of
using Wiesenberger's data to test whether discounts predict returns are likely to
outweigh the costs, however, because discounts are only slowly mean-reverting.
For example, using data from 1933 to 1993, the first-order autocorrelation co?
efficient for a value-weighted annual index of domestic fund discounts is 0.736.
Consequently, we use discounts computed from Wiesenberger's survey. We col?
lected share prices and net asset values from this source from 1933 to 1991, when
Wiesenberger reduced its coverage of closed-end funds. For 1992 and 1993, we
collected end-of-year share prices and net asset values from the WSJ.
Following Lee, Shleifer, and Thaler, we restrict our attention to stock funds.
We also exclude funds that hold primarily foreign (non-U.S.) assets. This is be?
cause foreign fund discounts can track variation in domestic (U.S.) expected re?
turns even when investor sentiment remains constant through time (Bonser-Neal,
Brauer, Neal, and Wheatley (1990)), and we wish to restrict our attention to
sentiment-induced shifts in expected returns. To understand why foreign fund
discounts can track variation in domestic expected returns unrelated to sentiment
changes, note that an increase in the domestic price of risk, all else constant, will
raise domestic expected returns. If stock markets are segmented internationally,
an increase in the domestic price of risk will lower foreign fund prices, but not
their net asset values. As a result, an increase in the domestic price of risk will si?
multaneously raise domestic expected returns and increase the discounts of funds
that invest in foreign stocks. Foreign fund discounts can also track sentiment-
induced variation in domestic expected returns (Bodurtha, Kim, and Lee (1995)).
For example, a fall in domestic sentiment, not matched by a fall in foreign senti?
ment, will raise both domestic expected returns and foreign fund discounts.
Many funds at some time in their lives have had preferred stock or debt out?
standing. Levered funds report net asset values net of the par, not market, value
of any outstanding preferred stock or debt. Thus, the reported net asset values of
these funds can be a misleading guide to the value of the funds' underlying assets
net of their liabilities. Also, because outstanding debt is recorded at par, negative
net asset values are sometimes reported for levered funds. Levered domestic stock
funds reported negative net asset values 122 times between 1933 and 1950. Com?
puting discounts when net asset values are negative, however, is difficult. Because
of these problems, we exclude funds from our sample in years in which they were
levered.
We construct a value-weighted index of end-of-year discounts. To compute

value weights, we use end-of-year fund market capitalizations computed from the
Center for Research in Security Prices (CRSP) tapes. Excluding bond, foreign,
and levered funds, and funds not on the CRSP tapes yields a sample of 74 unlev?
ered CRSP-listed domestic stock funds. The number of funds in the portfolio in
any one year ranges from four in 1933 to 30 in 1989.
We obtained monthly dollar odd-lot purchases and sales from 1941 to 1993
from the New York Stock Exchange. To ensure the odd-lot data are comparable
to the discount data, we temporally aggregate the monthly data to create annual
series of odd-lot purchases and sales. An alternative scheme would be to use
December odd-lot data. Since the ratio of odd-lot sales to purchases is slowly
mean-reverting, however, it should make little difference to tests of its predictive
ability which scheme one chooses. We obtained monthly mutual fund redemp?
tions, sales, and assets from 1960 to 1993 from the Investment Company Institute.
Again, to ensure comparability, we temporally aggregate the monthly data to cre?
ate annual series of redemptions and sales. To compute annual net redemption to
asset ratios, each year we divide annual redemptions less sales by the end-of-year
value of fund assets.
Our analysis focuses on the return behavior of two size-based NYSE-AMEX
decile portfolios. The decile portfolios are value-weighted, and are formed on the
basis ofthe market value of equity at the beginning of each year. Decile 1 contains
the smallest firms, decile 10 the largest. We also follow Keim and Stambaugh
(1986) and examine the power of a measure of small firm stock prices to predict
returns. Their measure of the level of small firm stock prices is minus the average
logarithm of the price of a stock in quintile 1. Because we use decile returns, we
use minus the average logarithm of the price of a stock in decile 1. This price
measure and the decile returns are from the CRSP tapes.
B. Summary Statistics
Table 1 summarizes the sample characteristics ofthe discount, the odd-lot ra?
tio, the net redemptions to assets ratio, the Keim-Stambaugh price variable (minus
the average logarithm of the price of a stock in decile 1), the small firm (decile 1)
return, the large firm (decile 10) return, and the size premium (decile I's?decile
10's return). All the returns in the table are annual.
Between 1933 and 1993, domestic funds traded, on average, at discounts of
about 12%. Discounts have varied considerably over time, however. For exam?
ple, the discount was as high as 30% in 1940, and as low as -10% (a premium)
in 1969, while most recently, in 1993, it was 2%. On average, between 1941 and
1993, odd-lot sales exceeded purchases, although recorded odd-lot purchases do
not reflect odd-lots accumulated from stock dividends and dividend reinvestment
plans. The odd-lot ratio has also varied considerably over time, ranging from
0.743 in 1956 to 2.647 in 1982. In 1993, the odd-lot ratio was 1.177. Between
1960 and 1993, annual mutual fund sales as a percentage of assets on average,
exceeded redemptions by about 8%. Net redemptions have been as high as 5% in
1976, as low as ?35% in 1986, and were ?19% in 1993. The sample autocorrela-
The statistics are computed using annual data from 1933 to 1993. DISC is the discount
on a value-weighted portfolio of closed-end funds, ODDL is the ratio of odd-lot sales to
purchases, REDM is the ratio of mutual fund redemptions less fund sales to fund assets,
PONE is minus the average logarithm of the price of a stock in NYSE-AMEX decile 1, DEC1
is the return on decile 1 (small firms), and DEC10 is the return on decile 10 (large firms).
From 1933 to 1991, discounts are calculated from prices and net asset values reported
in Wiesenberger's Annual Survey, while from 1992 to 1993, discounts are calculated from
prices and net asset values reported in the Wall Street Journal. The fund portfolio is con?
structed using fund market capitalizations from the Center for Research in Security Prices
(CRSP) tapes to calculate the value weights. Dollar odd-lot sales and purchases from 1941
to 1993 are from the NYSE. Mutual fund redemptions, sales, and assets from 1960 to 1993
are from the Investment Company Institute. The decile returns and the average logarithm of
the price of a stock in decile 1 are from the CRSP tapes.
* (**) denotes significant at the 5% (1%) level using a two-tailed test.
tion coefficients of fund discounts, the odd-lot ratio, and net redemptions decline
at a rate that suggests each series is slowly mean-reverting.
Figure 1 plots the three sentiment measures and the Keim-Stambaugh price
variable against time. Some ofthe series move together, while others do not. This
behavior is reflected in the correlation coefficients between the series reported in
Table 1. The highest correlation coefficient between any pair is the coefficient
between the discount and net redemptions, which is 0.537. The lowest correlation
coefficient between any pair is the coefficient between the odd-lot ratio and net
redemptions, which is ?0.128.
Table 1 indicates that decile 1 annual returns are, on average, about 16%
higher than decile 10 annual returns. This largely results from the behavior of
decile 1 returns in January. Decile 1 February-to-December returns differ little,
on average, from decile 10 February-to-December returns (Blume and Stambaugh
(1983)). Table 1 also indicates that the annual size premium exhibits strong posi?
tive serial dependence.
FIGURE 1
Time-Series Plots of the Sentiment Measures and the Keim-Stambaugh Price Variable
Figure 1A
1993
Figure 1B
1933 1943 1953 1963 1973 1983 1993
(continued on next page)
C. Methodology
The sentiment measures and the Keim-Stambaugh price variable are endoge?
nous, and least squares estimators from regressions on lagged endogenous vari?
ables are biased in finite samples. For this reason, we use the same approach
as Nelson and Kim (1993). We assess significance by comparing test statistics
to their empirical distributions, computed from randomization simulations, under
the null hypothesis that returns are unpredictable.
Each forecasting regression can be written
(1) r(t,t+T) = a(T)+x(t)P(T)+e(t,t+T), T > 0,
FIGURE 1 (continued)
Time-Series Plots of the Sentiment Measures and the Keim-Stambaugh Price Variable
Figure 1C
S 1.5
Figure 1D
where r(t, t+T) is the return from the end of year t to the end of year t+ 7, x(t) is
alx^ vector of predetermined variables measured at the end of year r, e(t, t + T)
is a disturbance, a(T) is the regression intercept, and P(T) is a K x 1 vector of
slope coefficients. For each forecasting regression, we compute, when possible,
least squares estimates at horizons of one month, one quarter, and one, two, three,
and four years. A forecasting horizon of one quarter corresponds to T = 0.25, a
horizon of two years corresponds to T = 2. When T > 1, the data are overlapping
and the disturbance e(t, t + T) is serially dependent.
Because we use annual data, the one-month returns are always January re?
turns, and the one-quarter returns are always first-quarter returns. Some of the
regressions exclude January returns. For these regressions, we do not compute
estimates for a one-month horizon and quarterly horizon regressions use only
February and March returns. Other regressions exclude February through De?
cember returns. For these regressions, the estimates at horizons of one month,
one quarter, and one year use only January returns. For this reason, regressions
that exclude February through December returns are only estimated at horizons
of one, two, three, and four years.
We assume that each predetermined variable evolves as an AR(1) process,
(2) *,-(*+1) = 7;+ tf/*;W+ *&?('+!)> 7=1,2,...,*:.
Here Xj(t + 1) is theyth element of x(t + 1), jj and Sj are regression parameters,
r)j(t+1) is white noise, and e(t, t+1) and 7#(f +1) are, in general, correlated. Least
squares estimates of the slope coefficient vector /?(T) are biased in finite sam?
ples because x(t) is a vector of lagged endogenous variables. Stambaugh (1986)
shows that the bias depends on the contemporaneous relations between innova?
tions in the series of predetermined variables and returns, on the speed at which
each predetermined variable is expected to revert to its mean, and on the sample
size. Also, while least squares estimates of P(T) are consistent, r-statistics for
tests that each element of the vector is zero need not be asymptotically standard
normal (Dickey and Fuller (1979)). Finally, small sample bias in asymptotic stan?
dard errors can produce misleading inference, particularly when the data contain
overlapping observations (Nelson and Kim (1993)). We conduct simulations to
quantify these biases.
For each predetermined variable, we estimate an AR(1) model. We do not es?
timate vector autoregressive models because, with a maximum of 61 observations,
the coefficient estimates are unlikely to be precise. The number of observations
depends on the sentiment measure. For fund discounts, we use return data from
1934 to 1993; for the odd-lot ratio, return data from 1942 to 1993; and for net
redemptions, return data from 1961 to 1993. Let N denote the number of years of
return data we use. Then there are N monthly, quarterly, and annual return obser?
vations, and (N ? 1), (N ? 2), and (N ? 3) two-, three-, and four-year returns.
We place the monthly, quarterly, and annual returns in the first, second, and third
columns of an N x (K + 3) matrix. We place contemporaneous innovations in the
K predetermined variables in the last K columns of the matrix. That is, we place
the innovation rjj(t + 1) (a hat denotes an estimate) in the same row as the annual
return r(t, t+ 1).
For each replication, we sample without replacement from the N rows of the
matrix. This randomization shuffles the data to remove any predictability. We
then use the randomized annual returns to construct two-, three-, and four-year
returns. In some of the regressions, the dependent variable is the difference be?
tween two returns. In this case, we place the two sets of monthly, quarterly, and
annual returns in the first six columns of an N x (K + 6) matrix, and, again, con?
temporaneous innovations in the K predetermined variables in the last K columns
of the matrix. We randomize the N rows to remove any predictability. We then
use the two randomized annual return series to compute two sets of two-, three-,
and four-year returns. Finally, we take the difference between the two sets of
randomized returns.
Let rj*(t) denote the randomized innovation for predetermined variable j in

row r. We compute the first randomized observation for predetermined variable j
as
(3) *;(o) = (l-8j)-l%

that is, an estimate of the unconditional mean of the predetermined variable, and
successive observations as
(4) x*(t+l) = ^j + 6jxj(t)+fj;(t+l), t+l = l,2,...,(N-l).

In this way, the contemporaneous relation between innovations in the predeter?
mined variables and returns is preserved, the serial dependence in the predeter?
mined variables is preserved, but the predictability in returns is removed.
We conduct 1000 replications for each set of regressions over the typically
six horizons. At each horizon, we calculate from the replications, for each slope
coefficient, the mean of the 1000 coefficient estimates. Bias-adjusted slope co?
efficient estimates are then computed, for each replication, by subtracting these
means from the corresponding unadjusted slope coefficient estimates. For each
replication, we use the bias-adjusted estimates to compute, at each horizon, t-
statistics for each element of the parameter vector P(T). We also use the es?
timates to compute Wald statistics for tests that more than one element of the
vector is zero. The t- and Wald statistics are computed using Hansen's (1982)
formula or, when necessary, Newey and West's (1987) formula. We correct for
serial dependence caused by the use of overlapping data and, if tests indicate the
need, at one further lag. To assess significance, we compare each statistic to its
corresponding simulated distribution computed from the 1000 replications under
the null hypothesis that returns are unpredictable.
There is no theoretical guide to the horizon over which to test for sentiment-
induced shifts in expected returns. For this reason, we use the results at each
horizon to compute two aggregate test statistics. Following Kim, Nelson, and
Startz (1991), the first statistic is the minimum/7-value computed over the hori?
zons, typically six. The second statistic is the mean t- or Wald statistic computed
over these horizons. We use the results ofthe simulations to compute an empirical
distribution for each of these statistics under the null hypothesis that returns are
unpredictable. In this way, we eliminate the bias that arises from snooping across
the horizons for rejections of the null hypothesis that returns are unpredictable.
III. Results
In this section, we examine whether the three investor sentiment measures

predict returns, and whether the sentiment measures predict the size premium,
conditional on the price variable. First, however, we consider the forecast perfor?
mance of other commonly used predictors of returns.
A. Preliminary Analysis
We examine the predictive ability of eight additional variables. We consider

the seven variables that Ferson and Constantinides (1991) chose to track variation
across time in expected returns: i) the one-month U.S. Treasury bill rate, ii) the
spread between the three-and one-month bill rates, iii) the spread between the
AAA bond yield and the one-month bill rate, iv) the spread between the BAA and
AAA bond yields, v) the dividend yield on the value-weighted NYSE-AMEX in?
dex, vi) the spread between the dividend yields on the equally and value-weighted
NYSE-AMEX indices, and vii) an alternative measure of the level of small firm
stock prices, the average of decile 1 's price level index over the previous year
divided by the most recent value of the index. We also examine the predictive
ability of: viii) the Dow's book-to-market ratio (Kothari and Shanken (1997) and
Pontiff and Schall (1998)). The bill rates, dividend yields, and the decile 1 price
level are from the CRSP tapes. The AAA and BAA bond yields are from the Fed?
eral Reserve Bulletin and the Citibase tapes. The Dow's year-end book value is
from Value Line's publication, A Long-Term Perspective, while the Dow's year-
end level is from the WSJ. To conserve space, we do not report the results of our
preliminary analysis in a table, but instead provide a summary.
Using data from 1933 to 1993, we regress decile 1 and decile 1?decile 10
returns on the eight predictors at six horizons: one month, one quarter, and one,
two, three, and four years. With two series of returns and eight predictors, there
are 16 sets of coefficients. None of the mean t-statistics computed across the
six horizons for the 16 sets of coefficients are significant at the 5% level. Also,
neither of the mean Wald statistics for the two return series for tests that the vari?
ables jointly predict returns are significant at the 5% level. Next, we replace the
Ferson-Constantinides price variable with the Keim-Stambaugh measure. In these
regressions, there is strong evidence that the Keim-Stambaugh measure predicts
decile 1 and decile 1?decile 10 returns, but little indication that the other seven
variables either individually or together predict returns. For the Keim-Stambaugh
measure, the mean r-statistics computed across the six horizons for the decile 1
and decile 1?decile 10 slope coefficients are both significant at the 1% level. In
contrast, neither of the mean Wald statistics for tests that the other seven variables
jointly predict returns are significant at the 5% level.
We also conducted two other tests. First, we regressed decile 1 and decile
1?decile 10 returns on the Keim-Stambaugh measure and each ofthe seven other
variables separately. Second, we regressed decile 1 and decile 1?decile 10 returns
on the Keim-Stambaugh measure and the other variables, first using only January
returns and then excluding January returns. These additional tests confirm that
the Keim-Stambaugh measure has predictive ability, but the other predetermined
variables do not.
The important difference between the Ferson-Constantinides and Keim-
Stambaugh price measures is that, while the Ferson-Constantinides measure is
detrended and reverts quickly to its mean (the first-order autocorrelation coef?
ficient in annual data is 0.001), the Keim-Stambaugh measure is slowly mean
reverting (the first-order autocorrelation coefficient in annual data is 0.830). It is
likely that detrending removes the ability of the Ferson-Constantinides measure
to track slow mean reversion in decile 1 expected returns.
Because we find little evidence that the Ferson-Constantinides variables or
the Dow's book-to-market ratio can predict either decile 1 or decile 1?decile 10
returns, at least from 1933 to 1993, we ignore these variables in the empirical
work that follows. Instead, we compare the predictive abilities of the three senti?
ment measures and the Keim-Stambaugh measure.
B. Univariate Regressions
We examine the ability of the fund discount, the odd-lot ratio, net redemp?
tions, and the Keim-Stambaugh measure to predict decile 1 returns, decile 10
returns, and the size premium.
Table 2 indicates that there is a significant positive relation between the dis?
count and decile 1 and decile 1?decile 10 expected returns, even when January
returns are excluded. A one standard deviation increase in the discount of 8.9 per?
centage points (from Table 1) is associated with a 786 (8.9 x 100 x 0.883) basis
point increase in decile 1 annual expected returns and an 8,745 (8.9 x 100 x 9.826)
basis point increase in decile 1 four-year expected returns. The relation between
discounts and the size premium appears strongest at a horizon of three years. The
null hypothesis we test is that there is a non-positive relation between discounts
and the size premium. The alternative hypothesis is that there is a positive relation
between the two. When all months are used, a one-sided/7-value at a horizon of
three years is 0.7%, and there is a 3.1% probability of reporting a/7-value of 0.7%
or less at one of the six horizons under the null that returns are unpredictable.
There is no significant relation, however, between discounts and decile 10 re?
turns. Thus, discounts predict small firm returns and the size premium, but not
large firm returns. These results are consistent with the noise trader model, which
predicts that sentiment measures will forecast the returns to stocks in which in?
dividual investors are active, but need not forecast the returns to stocks in which
they are not active.
We also examine the stability of the results over time by splitting the data
into two subsamples of equal length. We find a positive, albeit less significant,
relation between discounts and the size premium in both subperiods. Using Jan?
uary through December returns, the mean r-statistic (one-sided/7-value) in the first
subperiod is 1.863 (0.059) while, in the second subperiod, it is 2.278 (0.017).
The second set of results examines the ability of the odd-lot ratio to predict
returns.2 Table 3 provides no indication that the odd-lot ratio predicts either decile
1 returns, decile 10 returns, or the size premium. In contrast, Barber (1995) finds
a significant negative contemporaneous relation between changes in the odd-lot
ratio and the size premium, which is consistent with the idea that the odd-lot ratio
measures investor sentiment. Thus, there is evidence that changes in the odd-lot
ratio measure changes in investor sentiment, but no evidence that the odd-lot ratio
measures the level of investor sentiment. It is likely that changes in the popularity
of dividend reinvestment plans and stock dividends mask any sentiment-induced
shifts in the odd-lot ratio. Because these changes evolve slowly over time, it
is likely that they have a greater impact on the odd-lot ratio's ability to predict
returns, than on the contemporaneous relation between returns and changes in the
ratio.
2Dyl and Maberly (1992) examine the ability of returns to predict the odd-lot ratio. They find that
the odd-lot ratio is higher after a bear market and lower after a bull market.
TABLE 2
Univariate Regressions of Returns on the Discount on a Value-Weighted Portfolio of

Closed-End Funds
The results are based on monthly return and annual discount data from 1933 to 1993. DEC1 (t, t+ T) is the
return from time t to t + 7"on NYSE-AMEX decile 1 (small firms), DEC10(f, t + T) is the return on decile 10
(large firms), and DISC(0 is the discount on a value-weighted portfolio of closed-end funds at time t. The
table reports bias-adjusted slope coefficient estimates for horizons (7") of one month (M), one quarter
(O), and one, two, three, and four years, while t is always the end of a year. At horizons of two, three,
and four years, overlapping data are used. The f-statistics are in parentheses and are computed using
Hansen's (1982) formula, or, when necessary, Newey and West's (1987) formula. Simulated p-values are
in brackets and are for one-sided tests of the hypothesis that the slope coefficient (3{T) < 0. The table
also reports, for each set of tests, the minimum p-value and the mean test-statistic computed from the
results at different horizons. The simulated probability of observing a minimum p-value at least as small
as the reported value and a one-sided simulated p-value for the mean test-statistic appear in brackets.
From 1933 to 1991, discounts are calculated from prices and net asset values reported in Wiesenberger's
Annual Survey, while from 1992 to 1993, discounts are calculated from prices and net asset values
reported in the Wall Street Journal. The fund portfolio is constructed using fund market capitalizations
from the Center for Research in Security Prices (CRSP) tapes to calculate the value weights. The decile
returns are from the CRSP tapes.
Again, we examine the stability of the results over time by splitting the data
into two subsamples of equal length. Interestingly, we find a positive relation
between the odd-lot ratio and the size premium in the first subperiod. Using
January through December returns, the one-sided /7-value at a horizon of four
years in the first subperiod is 0.1%. In addition, there is a 4.1% probability of
reporting a /7-value of 0.1 % or less at one of the six horizons under the null that
the size premium is unpredictable. The mean r-statistic (one-sided/7-value) in the
first subperiod is 1.695 (0.062). On the other hand, the mean r-statistic (one-sided
/7-value) in the second subperiod is ?1.096 (0.823).
TABLE 3
Univariate Regressions of Returns on the Odd-Lot Ratio
RETN(f,f+7") q(7")+/J(7")ODDL(f)+e(f, t+ 7"), RETN = DEC1, DEC10, DEC1-DEC10
The results are based on monthly return and annual odd-lot data from 1941 to 1993. DEC1(f, t + T) is
the return from time t to t + T on NYSE-AMEX decile 1 (small firms), DEC10(f, t + T) is the return on
decile 10 (large firms), and ODDL(f) is the ratio of odd-lot sales to purchases at time t. The table reports
bias-adjusted slope coefficient estimates for horizons (7") of one month (M), one quarter (Q), and one,
two, three, and four years, while t is always the end of a year. At horizons of two, three, and four years,
overlapping data are used. The f-statistics are in parentheses and are computed using Hansen's (1982)
formula, or, when necessary, Newey and West's (1987) formula. Simulated p-values are in brackets and
are for one-sided tests of the hypothesis that the slope coefficient 0(T) < 0. The table also reports, for
each set of tests, the minimum p-value and the mean test-statistic computed from the results at different
horizons. The simulated probability of observing a minimum p-value at least as small as the reported
value and a one-sided simulated p-value for the mean test-statistic appear in brackets. Dollar odd-lot
sales and purchases are from the NYSE. The decile returns are from the CRSP tapes.
Next, we examine the ability of net redemptions to predict returns. Although

the net redemption decile 1 coefficients are generally positive, the minimum p-
values and mean t-statistics for these coefficients are not significant at the 5%
level. The net redemption coefficients for decile 10 are uniformly negative al?
though, again, the mean f-statistics for the coefficients are not significant at the
5% level.3 Table 4 indicates that, in part because of the decile 10 results, there is
evidence that net redemptions predict decile 1 -decile 10 returns. A one standard
deviation increase in net redemptions of 9.4 percentage points (from Table 1) is
associated with a 614 (9.4 x 100 x 0.653) basis point increase in the one-year
size premium and a 6,406 (9.4 x 100 x 6.815) basis point increase in the four-
3Warther (1995) finds a positive relation between unexpected net fund sales and both large and
small firm returns one week later. He does not, however, test for a relation at horizons of more than
one month.
year size premium. These results are consistent with the noise trader model. We
do not examine the stability of the results over time by splitting the series into
subsamples because there are only 33 years' worth of redemption data.
TABLE 4
Univariate Regressions of Returns on Net Mutual Fund Redemptions
RETN(f,f+7") = a(T)+p(T)REDM(t)+e(t,t+T)9 RETN = DEC1,DEC10,DEC1-DEC10
The results are based on monthly return and annual redemption data from 1960 to 1993.
DEC1 (f,f + T) is the return from time f to f + T on NYSE-AMEX decile 1 (small firms),
DEC10(f, t + T) is the return on decile 10 (large firms), and REDM(f) is the ratio, at time t,
of mutual fund redemptions less fund sales to fund assets. The table reports bias-adjusted
slope coefficient estimates for horizons (7") of one month (M), one quarter (Q), and one,
two, three, and four years, while f is always the end of a year. At horizons of two, three,
and four years, overlapping data are used. The f-statistics are in parentheses and are
computed using Hansen's (1982) formula, or, when necessary, Newey and West's (1987)
formula. Simulated p-values are in brackets and are for one-sided tests of the hypothesis
that the slope coefficient (3( T) < 0. The table also reports, for each set of tests, the minimum
p-value and the mean test-statistic computed from the results at different horizons. The
simulated probability of observing a minimum p-value at least as small as the reported value
and a one-sided simulated p-value for the mean test-statistic appear in brackets. Mutual
fund redemptions, sales, and assets are from the Investment Company Institute. The decile
returns are from the CRSP tapes.
Finally, Table 5 shows that there is a strong positive relation between the
Keim-Stambaugh price variable and decile 1 and decile 1-decile 10 expected re?
turns, but no relation between this variable and decile 10 expected returns. In
these univariate regressions, the relation between the small firm price variable
and the size premium is significant at the 5% level, even when Januarys are ex?
cluded. Again, we examine the stability of the results over time by splitting the
data into two subsamples of equal length. There is a positive relation between the
Keim-Stambaugh measure and the size premium in both subperiods. Across all
horizons, the minimum one-sided p-value (p-value) is 0.009 (0.037) in the first
subperiod and 0.000 (0.006) in the second subperiod. The mean f-statistic (one-
sided p-value) in the first subperiod is 1.661 (0.069) and, in the second subperiod,
itis 1.526 (0.065).
C. Multivariate Regressions
To determine whether the three sentiment measures provide information to

predict the size premium beyond that contained in the average price of a small
firm's stock, we regress decile 1 -decile 10 returns on each measure together with
the Keim-Stambaugh variable. Because the time series of sentiment measures are
different lengths, we examine the sentiment measures one at a time. The results
of these regressions appear in Tables 6 through 8.
Table 6 indicates that one cannot reject at the 5% level the hypothesis that
the discount provides no information to predict the size premium beyond that
contained in the small firm price variable. On the other hand, the tests have low
power. For example, the discount estimates, while not significant, suggest that a
one standard deviation increase in the discount of 8.9 percentage points is associ?
ated with an additional four-year size premium of 5,576 (8.9 x 100 x 6.265) basis
points. One can, however, reject at the 5% level the hypothesis that the small firm
price variable provides no information to predict the size premium beyond that
contained in the discount.
Table 7 indicates that the odd-lot ratio and the size premium, conditional on
the small firm price variable, are negatively related. We can think of no theoretical
rationale for this relation. There is evidence in Table 8, however, that net redemp?
tions provide information to predict the size premium beyond that contained in
the small firm price variable. The predictive power of net redemptions appears
especially strong for the January size premium. There is also evidence that the
price variable provides information to predict the size premium not contained in
net redemptions.4
To summarize, we find that the sentiment measures have predictive power.
The univariate tests show that closed-end fund discounts and mutual fund net
redemptions can forecast the size premium. The ratio of odd-lot sales to pur?
chases also has forecast power, but only in the first half of the sample period.
The multivariate tests that condition on the small firm price variable show that net
redemptions have additional forecast power while discounts do not. The odd-lot
ratio also has additional forecast power, but the signs of the estimated coefficients
are counterintuitive.
4We also regressed the size premium on the three sentiment measures and the small firm price
variable together. The slope coefficient estimates, however, are sufficiently imprecise that it is difficult
to draw any conclusions from the results.
TABLE 5
Univariate Regressions of Returns on the Keim-Stambaugh Price Variable
RETN(f, f+r) = a(r)+0(r)PONE(f)+e(f,r+r), RETN = DEC1,DEC10,DEC1-DEC10
0.684 -0.065 0.748 0.270 0.022 0.248 0.161 -0.079 0.252

(1.819) (-1.088) (2.126) (3.811) (1.259) (3.696) (0.868) (-1.483) (1.579)
[0.082] [0.809] [0.042] [0.006] [0.145] [0.006] [0.219] [0.869] [0.069]
1.067 -0.147 1.222 0.330 0.019 0.311 0.248 -0.151 0.417
(1.738) (-1.616) (2.113) (4.490) (0.994) (4.214) (0.939) -1.857) (1.891)
[0.102] [0.895] [0.055] [0.006] [0.215] [0.010] [0.216] [0.910] [0.062]
Minimum 0.001 0.132 0.000 0.000 0.125 0.000 0.088 0.547 0.010
p-Value [0.003] [0.315] [0.006] [0.003] [0.205] [0.004] [0.217] [0.841] [0.031]
Mean Test- 2.354 -0.297 2.696 3.788 1.117 3.732 0.857 -1.026 1.622
Statistic [0.011] [0.590] [0.002] [0.003] [0.161] [0.001] [0.164] [0.831] [0.034]
The results are based on monthly return and annual price data from 1933 to 1993.
DEC1(f, f + 7") is the return from time f to f + T on NYSE-AMEX decile 1 (small firms),
DEC10(f, t + T) \s the return on decile 10 (large firms), and PONE(f) is minus the aver?
age logarithm of the price of a stock in decile 1 at time f. The table reports bias-adjusted
slope coefficient estimates for horizons (T) of one month (M), one quarter (Q), and one,
two, three, and four years, while f is always the end of a year. At horizons of two, three,
and four years, overlapping data are used. The f-statistics are in parentheses and are
computed using Hansen's (1982) formula, or, when necessary, Newey and West's (1987)
formula. Simulated p-values are in brackets and are for one-sided tests of the hypothesis
that the slope coefficient p(T) < 0. The table also reports, for each set of tests, the min?
imum p-value and the mean test-statistic computed from the results at different horizons.
The simulated probability of observing a minimum p-value at least as small as the reported
value and a one-sided simulated p-value for the mean test-statistic appear in brackets. The
decile returns and the average logarithm of the price of a stock in decile 1 are from the
CRSP tapes.
Finally, we also conduct Boudoukh-Richardson-Smith (1993) tests of the

hypothesis that expected decile 1 returns are non-negative. The tests do not reject
the hypothesis. In fact, we find little indication that the expected size premium is
ever negative.
TABLE 6
Multivariate Regressions of the Size Premium on the Discount on a Value-Weighted

Portfolio of Closed-End Funds and the Keim-Stambaugh Price Variable
DEC1 (f, t+T)- DEC10(f, t + T) a(T) + ft (r)DISC(f) + ft>(r)PONE(f) + e(f, t + T)
The results are based on monthly return data and annual discount and price data from
1933 to 1993. DEC1 (t, t+ T) is the return from time t to t+T on NYSE-AMEX decile 1 (small
firms), DEC10(f, t + T) is the return on decile 10 (large firms), DlSC(r) is the discount on a
value-weighted portfolio of closed-end funds at time f, and PONE(f) is minus the average
logarithm of the price of a stock in decile 1. The table reports bias-adjusted slope coefficient
estimates and Wald statistics for horizons (7") of one month (M), one quarter (Q), and one,
two, three, and four years, while t is always the end of a year. At horizons of two, three,
and four years, overlapping data are used. The f-statistics are in parentheses and, like the
Wald statistics, are computed using Hansen's (1982) formula, or, when necessary, Newey
and West's (1987) formula. Simulated p-values are in brackets, and those beneath the t-
statistics are for one-sided tests of the hypotheses that /^ (7") < 0 and /M7") < ?- Tne Wald
statistics are for tests of the hypothesis that P\(T) = p2(T) = 0. The table also reports, for
each set of tests, the minimum p-value and the mean test-statistic computed from the results
at different horizons. The simulated probability of observing a minimum p-value at least as
small as the reported value and a one-sided simulated p-value for the mean test-statistic
appear in brackets. From 1933 to 1991, discounts are calculated from prices and net asset
values reported in Wiesenberger's Annual Survey, while from 1992 to 1993, discounts are
calculated from prices and net asset values reported in the Wall Street Journal. The fund
portfolio is constructed using fund market capitalizations from the Center for Research in
Security Prices (CRSP) tapes to calculate the value weights. The decile returns and the
average logarithm of the price of a stock in decile 1 are from the CRSP tapes.
TABLE 7
Multivariate Regressions of the Size Premium on the Odd-Lot Ratio and the
Keim-Stambaugh Price Variable
DEC1(f,f+r)-DEC10(f,f+7") a(T) + /?i(T)ODDL(f) + /?2(T)PONE(f) + e(f, t + T)
All Months Januarys Only Januarys Excluded

Horizon ODDL PONE WALD ODDL PONE WALD ODDL PONE WALD
M -0.058 0.104 19.455

(-2.947) (4.143) [0.000]
[0.996] [0.000]
Q -0.092 0.194 33.407 -0.022 0.069 17.187
(-1.943) (4.729) [0.000] (-0.850) (2.976) [0.002]
[0.966] [0.000] [0.788] [0.002]
-0.241 0.184 15.623 -0.057 0.105 19.455 -0.133 0.058 6.518
(-2.418) (2.908) [0.005] (-2.875) (4.204) [0.000] (-1.651) (1.338) [0.077]
[0.978] [0.002] [0.998] [0.000] [0.912] [0.093]
-0.750 0.634 16.646 -0.122 0.229 25.403 -0.381 0.251 8.525
(-2.949) (3.292) [0.024] (-3.040) (4.750) [0.005] (-2.241) (2.051) [0.096]
[0.988] [0.005] [0.991] [0.002] [0.965] [0.048]
-1.367 1.278 15.855 -0.107 0.285 24.913 -0.657 0.544 12.175
(-3.267) (3.235) [0.060] (-1.667) (4.460) [0.016] (-2.848) (2.644) [0.085]
[0.985] [0.011] [0.887] [0.006] [0.979] [0.026]
-2.059 2.126 22.380 -0.054 0.325 18.651 -0.906 0.866 20.853
(-3.947) (3.845) [0.058] (-0.416) (4.140) [0.069] (-3.436) (3.690) [0.067]
[0.990] [0.009] [0.603] [0.016] [0.980] [0.012]
The results are based on monthly return data and annual odd-lot and price data from 1941
to 1993. DEC1(f, t+ T) is the return from time t to t+Ton NYSE-AMEX decile 1 (small firms),
DEC10(f, t + T) is the return on decile 10 (large firms), ODDL(f) is the ratio of odd-lot sales
to purchases at time t, and PONE(f) is minus the average logarithm of the price of a stock in
decile 1. The table reports bias-adjusted slope coefficient estimates and Wald statistics for
horizons (7") of one month (M), one quarter (Q), and one, two, three, and four years, while
t is always the end of a year. At horizons of two, three, and four years, overlapping data are
used. The f-statistics are in parentheses and, like the Wald statistics, are computed using
Hansen's (1982) formula, or, when necessary, Newey and West's (1987) formula. Simulated
p-values are in brackets, and those beneath the f-statistics are for one-sided tests of the
hypotheses that P^(T) < 0 and P2CO < 0. The Wald statistics are for tests of the hypothesis
that /?i(7") = /?2(7") = 0. The table also reports, for each set of tests, the minimum p-value
and the mean test-statistic computed from the results at different horizons. The simulated
probability of observing a minimum p-value at least as small as the reported value and a
one-sided simulated p-value for the mean test-statistic appear in brackets. Dollar odd-lot
sales and purchases are from the NYSE. The decile returns and the average logarithm of
the price of a stock in decile 1 are from the CRSP tapes.
IV. Alternative Explanations for Why Discounts and Net

Redemptions Predict the Size Premium
While the evidence that discounts and net redemptions predict the size pre?
mium is consistent with the investor sentiment hypothesis, there are also rational
TABLE 8
Multivariate Regressions of the Size Premium on Net Mutual Fund Redemptions and the
Keim-Stambaugh Price Variable
DEC1 (f, t+T)- DEC10(f, t + T) a(T) + pi(T)REDM(t) + p2(T)PONE(t) + e(t,t + T)
All Months Januarys Only Januarys Excluded

Horizon REDM PONE WALD REDM PONE WALD REDM PONE WALD
M 0.304 0.068 12.489

(2.413) (2.147) [0.009]
[0.017] [0.026]
The results are based on monthly return data and annual redemption and price data from
1960 to 1993. DEC1 (f, t + 7") is the return from time t to t + T on NYSE-AMEX decile 1 (small
firms), DEC10(f, t + T) is the return on decile 10 (large firms), REDM(f) is the ratio, at time
t, of mutual fund redemptions less fund sales to fund assets, and PONE(f) is minus the
average logarithm of the price of a stock in decile 1. The table reports bias-adjusted slope
coefficient estimates and Wald statistics for horizons (7") of one month (M), one quarter (Q),
and one, two, three, and four years, while t is always the end of a year. At horizons of two,
three, and four years, overlapping data are used. The f-statistics are in parentheses and,
like the Wald statistics, are computed using Hansen's (1982) formula, or, when necessary,
Newey and West's (1987) formula. Simulated p-values are in brackets, and those beneath
the f-statistics are for one-sided tests of the hypotheses that /?i(7") < 0 and P2(T) < 0.
The Wald statistics are for tests of the hypothesis that p^(T) = p2(T) = 0. The table also
reports, for each set of tests, the minimum p-value and the mean test-statistic computed
from the results at different horizons. The simulated probability of observing a minimum
p-value at least as small as the reported value and a one-sided simulated p-value for the
mean test-statistic appear in brackets. Mutual fund redemptions, sales, and assets are from
the Investment Company Institute. The decile returns and the average logarithm of the price
of a stock in decile 1 are from the CRSP tapes.
explanations. In this section, we consider several rational explanations for the

evidence, some of which we are able to reject, others of which we cannot reject.
A. Discounts
1. Management Expenses
It has long been argued that variation in fund discounts should reflect varia?
tion in the present value of management expenses, although Malkiel (1977) finds
little empirical support for the idea. Two expense-related explanations for the re?
lation between discounts and small firm expected returns have been suggested to
us.
The first is that discounts change over time as the rate at which investors dis?
count future managerial expenses changes, and changes in this rate track variation
in small firm expected returns. If this explanation were correct, one would expect
discounts and small firm expected returns to be negatively, not positively, related.
That is, high fund discounts should be associated with low rates at which the mar?
ket discounts future managerial expenses. We find, however, that fund discounts
and small firm expected returns are positively related.
The second explanation was offered by an anonymous referee from another
journal. Suppose that the present value of a fund's expenses is constant. If ex?
pected net asset value returns rise, the fund's net asset value will fall, and the
present value of expenses as a proportion of the fund's net asset value will rise,
that is, the discount will rise. Thus, discounts will predict net asset value returns
and, therefore, perhaps small firm returns. The trouble with this explanation is
that discounts do not predict net asset value returns (Pontiff (1995)). Closed-end
funds typically hold large firm stocks (Lee, Shleifer, and Thaler (1991)) and dis?
counts do not predict large firm returns.
2. Taxes
Another commonly argued rationale for the existence of fund discounts is

that they reflect the taxes investors will eventually face on funds' unrealized cap?
ital gains. Malkiel (1977) finds some empirical support for the idea. It is possible
that the association between discounts and the tax liability attached to unrealized
capital gains could give rise to a relation between discounts and the size pre?
mium. To understand why, note that an increase in anticipated tax rates will raise
the present value of the tax liability associated with unrealized capital gains and,
thus, fund discounts. An increase in anticipated tax rates can also raise pre-tax
expected returns. In particular, the increase is likely to raise the pre-tax expected
returns on high expected return assets, like small firms, by more than on low ex?
pected return assets, like large firms. Thus, an increase in anticipated tax rates can
raise the expected value of the size premium. Our results, however, are consistent
with only part of this story. While we find discounts predict the size premium,
discounts do not predict large firm returns.
Another tax-related argument involves tax-loss selling. Lee, Shleifer, and
Thaler (1991) show that discounts tend to widen when small firm prices fall.
Thus, large discounts are likely to coincide with tax-loss selling opportunities,
and this could produce a positive relation between discounts and small firm ex?
pected returns at horizons of less than one year (the maximum period over which
gains and losses have been deemed short term). We find, however, that discounts
predict small firm returns several years ahead. Thus, tax-loss selling is unlikely
to explain the relation between discounts and small firm returns.
3. Window Dressing
Haugen and Lakonishok (1988) argue that window dressing by institutional
investors can produce seasonal dependence in returns. Window dressing is the
process by which fund managers change the composition of their portfolios to im-
press sponsors. Haugen and Lakonishok suggest that managers of pension funds
window dress before year-end evaluations. In particular, they argue that managers
tend to dump losers at year-end, but reenter the market for these stocks at the start
of the new year. Lakonishok, Shleifer, Thaler, and Vishny (1991) provide some
evidence consistent with this hypothesis.
Discounts tend to widen when small firm prices fall. Thus, large discounts
may coincide with window dressing induced selloffs of small firms by institu?
tional investors. Again, however, we find that discounts predict small firm returns
several years ahead, and so it is unlikely that window dressing can explain the
relation between discounts and small firm returns.
4. Market Segmentation
Swaminathan (1996) provides an interesting explanation for the relation be?
tween discounts and the size premium based on the idea that capital markets are
segmented. He notes that several factors discourage institutions from investing
in the shares of small firms and closed-end funds. For this reason, he argues, the
markets for large and small firm stocks may be segmented and, because funds are
typically small firms that invest in large firms, the markets for closed-end funds
and funds' underlying assets may be segmented. If these markets are segmented,
and if, in addition, individual investors are more risk averse than institutional
investors, then funds may trade at discounts. Moreover, as the price individual in?
vestors place on risk moves over time, so fund discounts and the expected returns
on small firms may move together over time.
Distinguishing between the investor sentiment hypothesis and Swaminathan's
segmentation hypothesis is difficult. Both hypotheses assume that institutions are
averse to holding the stocks of small firms. Price movements that the sentiment
hypothesis attributes to changes in investor sentiment, the segmentation hypothe?
sis attributes to changes in the price individuals place on risk.
To distinguish between the two hypotheses, Swaminathan tests whether dis?
counts can predict macroeconomic aggregates. Evidence of predictability, he ar?
gues, would be inconsistent with the sentiment hypothesis. His list of aggregates
from the Citibase tapes includes real consumption, real durables consumption,
real nondurables and services consumption, real after-tax corporate profits, and
the consumer price index. He regresses the growth in each aggregate at various
horizons on the discount, and finds that, for some aggregates, the test statistics at
some horizons appear statistically significant when compared to their theoretical
asymptotic distributions. In particular, his results suggest that discounts predict
corporate profits and inflation at horizons of two to four years.
As we emphasize in Section II, snooping across horizons and comparing test
statistics to their theoretical asymptotic distributions can generate misleading in-
ferences. While Swaminathan uses a methodology much like ours to test whether
discounts predict returns, he does not use the methodology to test whether dis?
counts predict macroeconomic aggregates. To investigate whether his results can
be attributed to finite sample or snooping biases, we reestimate Swaminathan's
regressions using the methodology of Section II and our discount data. Using
data from 1947 to 1993, the two-sided p-values associated with mean test statis?
tics for the null that discounts have no forecast power range between 0.204 and
0.451. Using data from 1965 to 1990, the period Swaminathan studies, they range
between 0.135 and 0.665.5 Thus, we conclude that there is little indication that
discounts can predict at least this selection of macroeconomic aggregates. It is
not even clear, however, that evidence that discounts predict macroeconomic ag?
gregates would be inconsistent with the sentiment hypothesis, since changes in
investor sentiment can have real effects.
Thus, our empirical results are consistent with both the investor sentiment
hypothesis and Swaminathan's segmentation hypothesis.
5. Net Redemptions
There is a rational explanation for the positive relation we find between
net redemptions and the size premium. Suppose the stock market increases in
value relative to the bond market. If institutions try to maintain constant portfolio
weights for stocks and bonds, then they will be net sellers of stock.6 It follows that
other investors must buy stock, and thereby increase the fraction of their wealth
they allocate to stock. Non-institutional investors will only be willing to do this,
however, if they are compensated by an increase in expected returns. Since small
firm stocks are held mostly by individuals while large firm stocks are held mostly
by institutions (Lee, Shleifer, and Thaler (1991)), it is likely that large firm ex?
pected returns will have to rise by more than small firm expected returns. In this
case, an increase in the value of stocks can reduce net mutual fund redemptions
and increase the expected returns of large firms relative to small firms. Consistent
with this hypothesis, Warther (1995) finds a negative relation between stock re?
turns and net redemptions, and we find a negative relation, albeit weak, between
net redemptions and large firm expected returns. Our evidence is also consistent
with the investor sentiment hypothesis, however, since we find a positive relation,
although again weak, between net redemptions and small firm expected returns.
V. Conclusions
In this paper, we examine the power of three popular measures of investor

sentiment to predict returns: the level of discounts on closed-end funds, the ratio
of odd-lot sales to purchases, and net mutual fund redemptions. Using data from
1933 to 1993, we find that fund discounts and net redemptions predict the size
premium, the difference between small and large firm returns, but little indication
that the odd-lot ratio predicts returns.
5 The results of the tests are contained in an appendix, available from the authors on request.
6Leibowitz, Kogelman, and Bader (1992) state that "through a combination of mean-variance
analysis and tradition, most (pension) funds have settled on a long-term strategic allocation target of
50-60% investment in equity-like assets, with the balance primarily in fixed-income securities."
We also evaluate eight other variables that the literature suggests predict re?
turns. Using data from 1933 to 1993, none of these variables provide information
to predict the size premium beyond that contained in the average price of a small
firm's stock. The evidence on whether the sentiment measures provide informa?
tion to predict the size premium beyond that contained in the average price of
a small firm's stock is mixed. We find that net redemptions provide additional
information that is both economieally and statistically significant. On the other
hand, although point estimates suggest the additional information that discounts
provide is economieally significant, the standard errors are large enough that one
cannot judge the information to be statistically significant.
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Do Measures of Investor Sentiment Predict Returns?

Author(s): Robert Neal and Simon M. Wheatley

Cambridge University Press, University of Washington School of Business

Do Measures of Investor Sentiment Predict

Robert Neal and Simon M. Wheatley*

II. Data, Summary Statistics, and Methodology

We construct a value-weighted index of end-of-year discounts. To compute

1933 1943 1953 1963 1973 1983 1993

(continued on next page)

(1) r(t,t+T) = a(T)+x(t)P(T)+e(t,t+T), T > 0,

(2) *,-(*+1) = 7;+ tf/*;W+ *&?('+!)> 7=1,2,...,*:.

Let rj*(t) denote the randomized innovation for predetermined variable j in

(3) *;(o) = (l-8j)-l%

(4) x*(t+l) = ^j + 6jxj(t)+fj;(t+l), t+l = l,2,...,(N-l).

In this section, we examine whether the three investor sentiment measures

We examine the predictive ability of eight additional variables. We consider

Univariate Regressions of Returns on the Discount on a Value-Weighted Portfolio of

Univariate Regressions of Returns on the Odd-Lot Ratio

RETN(f,f+7") q(7")+/J(7")ODDL(f)+e(f, t+ 7"), RETN = DEC1, DEC10, DEC1-DEC10

Next, we examine the ability of net redemptions to predict returns. Although

Univariate Regressions of Returns on Net Mutual Fund Redemptions

RETN(f,f+7") = a(T)+p(T)REDM(t)+e(t,t+T)9 RETN = DEC1,DEC10,DEC1-DEC10

To determine whether the three sentiment measures provide information to

Univariate Regressions of Returns on the Keim-Stambaugh Price Variable

RETN(f, f+r) = a(r)+0(r)PONE(f)+e(f,r+r), RETN = DEC1,DEC10,DEC1-DEC10

0.684 -0.065 0.748 0.270 0.022 0.248 0.161 -0.079 0.252

Finally, we also conduct Boudoukh-Richardson-Smith (1993) tests of the

Multivariate Regressions of the Size Premium on the Discount on a Value-Weighted

DEC1 (f, t+T)- DEC10(f, t + T) a(T) + ft (r)DISC(f) + ft>(r)PONE(f) + e(f, t + T)

DEC1(f,f+r)-DEC10(f,f+7") a(T) + /?i(T)ODDL(f) + /?2(T)PONE(f) + e(f, t + T)

All Months Januarys Only Januarys Excluded

M -0.058 0.104 19.455

IV. Alternative Explanations for Why Discounts and Net

DEC1 (f, t+T)- DEC10(f, t + T) a(T) + pi(T)REDM(t) + p2(T)PONE(t) + e(t,t + T)

All Months Januarys Only Januarys Excluded

M 0.304 0.068 12.489

explanations. In this section, we consider several rational explanations for the

Another commonly argued rationale for the existence of fund discounts is

In this paper, we examine the power of three popular measures of investor

Malkiel, B. G. "The Valuation of Closed-End Investment Company Shares." Journal ofFinance, 32

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(2) ,-(+1) = 7;+ tf/;W+ &?('+!)> 7=1,2,...,*:.