TAILIEUCHUNG - Investor Sentiment and the Cross-Section of Stock Returns

Maghyereh (2002) investigated the long-run relationship between the Jordanian stock prices and selected macroeconomic variables, again by using Johansen’s (1988) cointegration analysis and monthly time series data for the period from January 1987 to December 2000. The study showed that macroeconomic variables were reflected in stock prices in the Jordanian capital market. Gunasekarage, Pisedtasalasai and Power (2004) examined the influence of macroeconomic variables on stock market equity values in Sri Lanka, using the Colombo All Share price index to represent the stock market and (1) the money supply, (2) the treasury bill rate (as a measure of interest rates),. | THE JOURNAL OF FINANCE VOL. LXI NO. 4 AUGUST 2006 Investor Sentiment and the Cross-Section of Stock Returns MALCOLM BAKER and JEFFREY WURGLER ABSTRACT We study how investor sentiment affects the cross-section of stock returns. We predict that a wave of investor sentiment has larger effects on securities whose valuations are highly subjective and difficult to arbitrage. Consistent with this prediction we find that when beginning-of-period proxies for sentiment are low subsequent returns are relatively high for small stocks young stocks high volatility stocks unprofitable stocks non-dividend-paying stocks extreme growth stocks and distressed stocks. When sentiment is high on the other hand these categories of stock earn relatively low subsequent returns. Classical finance theory leaves no role for investor sentiment. Rather this theory argues that competition among rational investors who diversify to optimize the statistical properties of their portfolios will lead to an equilibrium in which prices equal the rationally discounted value of expected cash f lows and in which the cross-section of expected returns depends only on the cross-section of systematic Even if some investors are irrational classical theory argues their demands are offset by arbitrageurs and thus have no significant impact on prices. in this paper we present evidence that investor sentiment may have significant effects on the cross-section of stock prices. We start with simple theoretical predictions. Because a mispricing is the result of an uninformed demand shock in the presence of a binding arbitrage constraint we predict that a broadbased wave of sentiment has cross-sectional effects that is does not simply raise or lower all prices equally when sentiment-based demands or arbitrage Baker is at the Harvard Business School and National Bureau of Economic Research Wurgler is at the NYU Stern School of Business and the National Bureau of Economic Research. We thank an anonymous referee Rob

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