Investor Sentiment in the Stock Market

Real investors and markets are too complicated to be neatly summarized by a few selected biases and trading frictions. The "top down" approach to behavioral finance focuses on the measurement of reduced form, aggregate sentiment and traces its effects to stock returns. It builds on the two broader and more irrefutable assumptions of behavioral finance -- sentiment and the limits to arbitrage -- to explain which stocks are likely to be most affected by sentiment. In particular, stocks of low capitalization, younger, unprofitable, high volatility, non-dividend paying, growth companies, or stocks of firms in financial distress, are likely to be disproportionately sensitive to broad waves of investor sentiment. We review the theoretical and empirical evidence for these predictions.

A Catering Theory of Dividends

We develop a theory in which the decision to pay dividends is driven by investor demand. Managers cater to investors by paying dividends when investors put a stock price premium on payers and not paying when investors prefer nonpayers. To test this prediction, we construct four time series measures of the investor demand for dividend payers. By each measure, nonpayers initiate dividends when demand for payers is high. By some measures, payers omit dividends when demand is low. Further analysis confirms that the results are better explained by the catering theory than other theories of dividends.

Global, local, and contagious investor sentiment

We construct indexes of investor sentiment for six major stock markets and decompose them into one global and six local indexes. Relative market sentiment is correlated with the relative prices of dual-listed companies, validating the indexes. Both global and local sentiment are contrarian predictors of the time series of major markets' returns. They are also contrarian predictors of the time series of cross-sectional returns within major markets: When sentiment from either global or local sources is high, future returns are low on various categories of difficult to arbitrage and difficult to value stocks. Sentiment appears to be contagious across markets based on tests involving capital flows, and this presumably contributes to the global component of sentiment.International finance ; Financial markets ; Stock market

The Effect of Dividends on Consumption

Classical models predict that the division of stock returns into dividends and capital appreciation does not affect investor consumption patterns, while mental accounting and other economic frictions predict that investors have a higher propensity to consume from stock returns in the form of dividends. Using two micro data sets, we show that investors are indeed far more likely to consume from dividends than capital gains. In the Consumer Expenditure Survey, household consumption increases with dividend income, controlling for total wealth, total portfolio returns, and other sources of income. In a sample of household investment accounts data from a brokerage, net withdrawals from the accounts increase one-for-one with ordinary dividends of moderate size, controlling for total portfolio returns, and also increase with mutual fund and special dividends. We comment on several potential explanations for the results.

Comovement

A number of studies have identifed patterns of positive correlation of returns, or comovement, among different traded securities. We distinguish three views of such comovement. The traditional 'fundamentals' view explains the comovement of securities through positive correlations in the rational determinants of their values, such as cash flows or discount rates. 'Category-based' comovement occurs when investors classify different securities into the same asset class and shift resources in and out of this class in correlated ways. A related phenomenon of 'habitat-based' comovement arises when a group of investors restricts its trading to a given set of securities, and moves in and out of that set in tandem. We present models of each of the three types of comovement, and then assess them empirically using data on stock inclusions into and deletions from the S&P 500 index. Index changes are noteworthy because they change a stock's category and investor clientele (habitat), but do not change its fundamentals. We find that when a stock is added to the index, its beta and R-squared with respect to the index increase, while its beta with respect to stocks outside the index falls. The converse happens when a stock is deleted. These results are broadly supportive of the category and habitat views of comovement, but not of the fundamentals view. More generally, we argue that these non-traditional views may help explain other instances of comovement in the data.

Comovement

A number of studies have identifed patterns of positive correlation of returns, or comovement, among different traded securities. We distinguish three views of such comovement. The traditional “fundamentals†view explains the comovement of securities through positive correlations in the rational determinants of their values, such as cash flows or discount rates. “Category-based†comovement occurs when investors classify different securities into the same asset class and shift resources in and out of this class in correlated ways. A related phenomenon of “habitat-based†comovement arises when a group of investors restricts its trading to a given set of securities, and moves in and out of that set in tandem. We present models of each of the three types of comovement, and then assess them empirically using data on stock inclusions into and deletions from the S&P 500 index. Index changes are noteworthy because they change a stock’s category and investor clientele (habitat), but do not change its fundamentals. We find that when a stock is added to the index, its beta and R-squared with respect to the index increase, while its beta with respect to stocks outside the index falls. The converse happens when a stock is deleted. These results are broadly supportive of the category and habitat views of comovement, but not of the fundamentals view. More generally, we argue that these non-traditional views may help explain other instances of comovement in the data.

On the Economic Consequences of Index-Linked Investing

A market index summarizes the performance of a group of securities into number.1 The use of stock market indices in particular has been growing exponentially for years. Since Charles Dow introduced his indices in 1884, the number of distinct stock market indices reported in The Wall Street Journal has increased roughly 5 percent per year, as shown in Figure 1. Today’s Journal reports not just the Dow Jones Industrial Average (DJIA) and the S&P 500; it also reports on the Turkey Titans 20 and the Philadelphia Stock Exchange Oil Service Index. Markets are being tracked in more and more detail, and Figure 1 suggests that there is no end in sight.

Financial markets and the allocation of capital

Financial markets appear to improve the allocation of capital. Across 65 countries, those with developed financial sectors increase investment more in their growing industries, and decrease investment more in their declining industries, than those with undeveloped financial sectors. The efficiency of capital allocation is negatively correlated with the extent of state ownership in the economy, positively correlated with the amount of firm-specific information in domestic stock returns, and positively correlated with the legal protection of minority investors. In particular, strong minority investor rights appear to curb overinvestment in declining industries

Pseudo Market Timing and Predictive Regressions

A number of studies claim that aggregate managerial decision variables, such as aggregate equity issuance, have power to predict stock or bond market returns. Recent research argues that these results may be driven by an aggregate time-series version of Schultz's (2003) pseudo market timing bias. We use standard simulation techniques to estimate the size of the aggregate pseudo market timing bias for a variety of predictive regressions based on managerial decision variables. We find that the bias can explain only about one percent of the predictive power of the equity share in new issues, and that it is also much too small to overturn prior inferences about the predictive power of corporate investment plans, insider trading, dividend initiations, or the maturity of corporate debt issues.

Behavioral Corporate Finance: A Survey

Research in behavioral corporate finance takes two distinct approaches. The first emphasizes that investors are less than fully rational. It views managerial financing and investment decisions as rational responses to securities market mispricing. The second approach emphasizes that managers are less than fully rational. It studies the effect of nonstandard preferences and judgmental biases on managerial decisions. This survey reviews the theory, empirical challenges, and current evidence pertaining to each approach. Overall, the behavioral approaches help to explain a number of important financing and investment patterns. The survey closes with a list of open questions.