Week 2 – Investor Dr Jia (Lucy) Lu

Sentiment (2) J.Lu@hw.ac.uk

At the end of this session, you should be able to:
 Describe investor sentiment;
 Explain measurement of sentiment and VIX correction;
 Discuss investor sentiment and stock returns, particularly on
sector-specific sentiment, and
 Analyse sentiment and crisis
Reading List:
 Chiara, L.C. and Francesco, R. (2019) Optimism in Financial Markets: Stock
Market Returns and Investor Sentiments. Journal of Risk and Financial
Management, 12 (2), pp. 85-99.
 Chiu, J.M., Chung, H.M., Ho, K.Y. and Wu, C.C. (2018) Investor Sentiment and
Evaporating Liquidity during the Financial Crisis. International Review of
Economics and Finance, 55 (1), pp. 21-36.
 Matthias, B. (2011) Retail Investor Sentiment and Behaviour An Empirical
Analysis. Wiesbaden : Gabler Verlag : Imprint: Gabler Verlag. Chapter 2.
 Coverage

 2.1 Investor Sentiment

Revisited

 2.2 Measures of
Sentiment

 2.3 VIX Correction

 2.4 Investor Sentiment &

Stock Returns

 2.5 Sentiment & Crisis

 2.1
Investor Sentiment
Revisited
 Investor sentiment is a belief about the expected cash flow and
associated risks that is not supported by the facts at hand.
 Investors who are irrational (also called, noise traders and
uninformed traders), affect stock prices by their "correlated"
demand shocks.
 These demand shocks result in an instant mispricing.
 Since betting against investor sentiment is risky and costly, stock
prices remain persistently mispriced.
 Stocks heavily affected by investor sentiment:
– Newer, smaller, more volatile, unprofitable, non-dividend paying, or
distressed.
Since sentiment is unobservable,
how do we measure sentiment?
 2.2
Measures of Sentiment
 Investor surveys Investor mood Retail investor trades

Dividend premium Proxies Closed-end fund discount

Number of IPOs and

Option implied volatility Mutual fund flows average first day IPO
return

Turnover or trading The share of equity issues Composite sentiment

volume in total equity-debt issues index
 Investor surveys: surveying investors, analysts and consumers on

their market expectations and the European Commission surveys.

 Investor mood: extract information from Twitter, TV, weather

forecasts...etc.)
 Retail investor trades: individual investors are more prone to

sentiment; young investors more prone

 Dividend premium: higher premium implies low level of sentiment.

 Closed-end fund discount: higher discounts implies low level of

sentiment.
http://www.aaii.com/sentimentsurvey
 Contd…
 Mutual fund flows: investors move between mutual funds with different
characteristics depending on the level of sentiment they have; they chase
returns.

According to fund
supermarket
interactive
investor, these are the
10 most popular funds
bought on its platform
in December 2022

Source: Money week, 2023

 Number of IPOs and average first day IPO returns: high number of IPOs
and first day return reflect high level of sentiment in the market.
 Turnover or trading volume: irrational investors are more likely to trade
leading to high liquidity (high optimism). Lower liquidity is irrationally
associated with lower trading volume.
 The share of equity issues in total equity-debt issues: higher ratio or equity
issues compared to debt issues implies higher sentiment.
 Composite sentiment index: combine different measures of sentiment.
 Proxies

 SENT measured from Principal Components analysis

using 5 variables:

 Value-weighted dividend premium

 First-day returns on IPOs
 IPO volume
 Closed-end fund discount
 Equity proportion in new issues
 • Reducing dimensionality
• Increasing interpretability
 Option implied volatility: the expected volatility of a stock over the life of
the option, e.g., VIX – the Fear index

Option prices rise when volatility increases - Do you agree and how?

https://www.youtube.com/watch?
v=JwNQbsFQkHc
 AGREE!
Option prices rise when volatility increases.
 2.3
VIX Correction
 VIX index: Chicago Board Options Exchange's volatility index.
 Measure of the level of implied volatility, not historical or statistical volatility,
from options on the S&P 500 stocks.
 The FEAR index - "investor fear gauge,“; reflects predictions of short-term
market volatility i.e. risk.
 Broadly, VIX rises during periods of financial stress and falls when investors
are calm.
 If implied volatility is high, the premium on options will be high and vice
versa.
Source: Salman, 2021
Source: Chicago Board Options Exchange, 2023
 • Has become a standard measure of investor
sentiment and has given market participants
Contd.. great confidence to keep investing and drive-up
prices.
Source: Macrotrends, 2023
When sentiment is higher,

stock returns are____

1. Higher 3. Same

2. Lower 4. Not sure

 2.4
Investor Sentiment and
Stock Returns
 Cross section of future returns is conditional on (beginning of period) proxies for
sentiment (Baker and Wurgler, 2006).
 Some firm characteristics that display no predictive power in the standard cross-
section become visible in the return generating process after conditioning on
sentiment.
 Low sentiment is associated with high returns on:
– Young vs. old stocks
– High volatility vs. low volatility stocks
– Unprofitable vs. profitable stocks
– Non dividend payers vs. payers
 Sentiment negatively predicts stock returns across countries (Schmeling, 2009).
Investor Sentiment and Future Returns
Safe = low vol.
Speculative = high vol.
 Investor Sentiment and Sector
Returns
 The previously discussed measures only capture investors'
sentiment towards the aggregate market.
 Investors usually hold distinct expectations and sentiment
towards different sectors, asset classes, individual stocks.
Examples:
 Investor sentiment towards technological industry is
different to construction, pharmaceutical, and retail trade.
 Investor sentiment towards bonds is different to sentiment
towards equity. Many macroeconomic factors affect the
beliefs regarding the performance of each of them.
 Contd..

 If you are investor, your sentiment is probably different

towards two different firms even if they operate in the
same industry (e.g. Apple and Google).

 A recent study by Salhin, Sherif and Jones (2016) investigates

how sentiment affects stock returns in different sectors.
 Confidence Indicators

• Source: Salhin A., Sherif M. and Jones E.A.E., Managerial Sentiment, Consumer
Confidence and Sector Returns, International Review of Financial Analysis, Vol. 47,
October, 2016.
UK GDP Growth Rate

Source: Salhin, Sherif M. and Jones (2016).

Correlation Matrix

Source: Salhin, Sherif M. and Jones (2016).

 Sector-Specific Sentiment

 Does the sentiment-return relationship persist across different

sectors?
 Market sentiment significantly impacts stock market returns
confirming previous studies.
 However, breaking down market sentiment reveals different
behaviour between sentiment and stock returns.
 The significance of the sentiment-returns
relationship, in the aggregate market,
relies mainly on the Manufacturing
sector.
 At sector level, only returns of
Manufacturing and Construction
industries are predicted using their
"specific" sentiment.
 The relationship for Retail Trade and
Services industries does not show any
significance.
 Intuition: Sentiment is a good predictor
of returns in sectors with less hard-to-
value outputs.
 2.5
Sentiment and Crises
Some history:
• "Tronic boom" of 1959-1962
 High demand for younger, smaller and growth stocks. Stocks
prices of electronics companies went very high and then
crashed (Malkiel, 1990).

• “The Nifty Fifty” of the early 1970s

 A period of low sentiment caused an over-valuation of
companies that are old, large and have high earnings and
dividend growth.
 "Biotech bubble" of the mid 1980s
 A period of high sentiment. Same scenario like the "tronics
boom". High demand for younger and smaller biotechnology
companies.
 "Dot com bubble" of the early 1990s
 The rise of the internet companies and the overvaluation of
their stock prices.
 "Subprime mortgage crisis" of 2006-2008
 A bubble in the housing market led to a crash in many aspects
of the financial sector.
 Investor Sentiment and Bubbles

 Bubble expectations and investor sentiment vary across time

(Shiller, 2000).

 Overconfidence cause bubbles in stock markets; investors are

willing to pay more than the intrinsic value of a stock on the hope
that, in the future, they find a buyer who is willing to pay more
than what they paid initially. The result will be a bubble
(Scheinkman and Xiong, 2003).
 Inexperienced investors who
are more prone to sentiment
speed up the formation of
bubbles by allocating their
investments to assets with
inflated prices (Greenwood
and Nagel, 2009).

 Investor sentiment increases

the likelihood of a stock market
crisis (Zouaoui et al. 2011).
 Question 1
Strong form efficiency version of the efficient market
hypothesis (EMH) states that all information in a market,
whether public or private, is accounted for in a stock's price.

Suppose you observed that companys’ CEOs make abnormally

high returns on investments in their own company’s stock.
Would this invalidate the strong-form efficiency market
hypothesis?
 Investor sentiments

“Wall Street’s blue-chip S&P 500 share index rose 0.3% wiping
out almost all the losses suffered after the discovery of the
Omicron coronavirus variant and ending the day just 0.1% shy of
its all-time closing high. The tech-heavy Nasdaq Composite
climbed 0.6%” (FT, 09/12/2021).

Critically discuss the impact of investor sentiment on stock

market with relevant theories and supporting evidence under
Pandemic.
  Each student is to produce a maximum 2000-word
essay (the word-count includes everything except the
reference list and title page). There is no +/- 10% rule
on the word limit this course.

 Submission over the word limit will be deducted 10%

Individual Coursework from the final mark.
(30%)
 Format: Times New Roman, 12, 1.5 line spacing.

 This essay requires a minimum of 10 references .

 Submission of Coursework. An electronic Word file of

your coursework MUST be submitted to the correct
Turnitin link (Canvas).

 The assessment marking criteria will be uploaded on

the Canvas.

 Submission date: 16th February 2024 (Friday by 4pm -

Edinburgh)
 Content Weighting
Introduction 10%
The relevant theories of efficient market 20%
hypothesis (EMH) and behaviour finance

C30CY
Coursework Discuss the effect of investor sentiment 50%
Marking on stock market with examples of the
COVID-19 pandemic.
Criteria
(investor
sentiment) – Conclusion 10%

2024 edition · Overall coherence of the essay –

logical and clear structure
10%

Academic writing
Referencing - Adequate
acknowledgement of sources and
proper referencing

Total Mark 100

Important Notes on Coursework:
 When questions have multiple parts, unless otherwise
stated, there is no formal split between parts of the question.
 Short word limit means selection and parsimony are very
important.
 Review the marking scheme on canvas for guidance on the
marking requirements.
IPOs (1)