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RBF
5,1
The effect of US individual
investor sentiment on
industry-specific stock
58 returns and volatility
UIN Maliki At 18:52 03 September 2018 (PT)
Mustafa Sayim
Alliant School of Management, Alliant International University,
San Diego, CA, USA
Pamela D. Morris
School of Business and Management, Kaplan University,
Ft. Lauderdale, FL, USA, and
Hamid Rahman
Alliant School of Management, Alliant International University,
San Diego, CA, USA
Abstract
Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim,
Purpose – This paper examines the effect of rational and irrational investor sentiment on the stock
return and volatility of US auto, finance, food, oil and utility industries.
Design/methodology/approach – The American Association of Individual Investors Index (AAII) is
used as a proxy for US individual investor sentiment. The US market fundamentals are regressed on
investor sentiment in order to capture the effect of macroeconomic risk factors on investor sentiment.
Then impulse response functions (IRFs) are generated from a VAR model to investigate the effect of
unanticipated movements in US investor sentiment on both industry-specific stock return and
volatility.
Findings – The results show a significant impact of investor sentiment on stock return and volatility
in all the industries. We find that the positive rational component of US individual investor sentiment
tends to increase the stock return in these industries. We also document that unanticipated increase in
the rational component of US individual investor sentiment has a significant negative impact only on
the industry volatilities of US auto and finance industries.
Research limitations/implications – The results are based only on the 1999 – 2010 US industry-
specific stock return and volatility data and are confined to these industries.
Practical implications – The findings of this paper can help investors to improve their asset return
generating models by incorporating investor sentiment. The findings can also help policymakers to
design policies that stabilize sentiment and reduce volatility and uncertainty in the stock markets.
Originality/value – This paper adds to the growing literature on behavioral finance by filling a gap
and addressing the impact of investor sentiment in the various US industries.
Keywords Investor sentiment, Stock returns-volatility, VAR estimation, Investors, Stock returns
Paper type Research paper
1. Introduction
Deviations of stock prices from their fundamentals are widely documented in the financial
empirical literature (e.g. Shiller et al., 1996; Becchetti et al., 2007; Anderson et al.,
Review of Behavioral 2003). Shiller’s et al., (1996) seminal paper cemented a belief in some form of “market
Finance Vol. 5 No. 1, 2013
pp. 58-76 irrationality.” The failure of traditional financial models to explain unusual market
r Emerald Group Publishing Limited phenomena like bubbles and crashes, and their general poor performance in predicting
1940-5979
DOI 10.1108/RBF-01-2013-0006 asset returns has led to the development of an impressive array of
behavioral models to show, among other things, that investor sentiment has an impact on Investor
stock prices. The premise of behavioral finance is that traditional finance ignores how sentiment and
investors make investment decisions (De Long et al., 1990). Hence behavioral models
focus on investors’ behavior and their investment decision-making process (Barberis and stock returns
Thaler, 2003).
A partial list of these models include Kyle (1985), De Long et al. (1990), Campbell
and Kyle (1993), Hirshleifer et al. (2006), Dumas et al. (2006) and Kogan et al. (2006). 59
However, attempts to empirically validate these models have produced mixed results.
Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 18:52 03 September 2018 (PT)
Lee et al. (1991), Swaminathan (1996) and Neal and Wheatley (1998) find investor
sentiment significantly related to asset returns. Sias et al. (2001) do not find a significant
relation between proxies for individual investor sentiment and closed-end fund
discounts. Their results indicate that investors who hold closed-end funds do not earn an
additional risk premium for shouldering the noise trader risk. Sentiment, unlike rational
choice is society and culture specific. Thus, the results of behavioral models are not
necessarily applicable to different industry stock returns and volatility, each one of
which must be studied independently to determine the relevance and applicability of the
behavioral models in stock markets.
This paper examines the impact of US individual investor sentiment on stock returns
and volatility in the US auto, finance, food, oil and utility industry stock returns and
volatility. By examining the effect of investor sentiment on the desegregated components
of the market, i.e. by various industries, this paper fills a gap in the existing literature
and adds to the growing literature on behavioral finance.
The rest of the paper is organized as follows. Section 2 presents literature review, Section
3 discusses the model and methodology, Section 4 presents data, Section 5 first discusses the
impact of US market fundamentals on sentiments, and then reports the Vector Autoregression
(VAR) results, and finally, Section 6 concludes the research.
2. Literature review
In the last two decades, the effect of investor sentiment on stock markets has been
extensively examined in finance literature. Some of the notable papers in which the
theoretical foundation of investor sentiment effect on stock returns have been developed are
Black (1986), De Long et al. (1990), Shleifer and Vishny (1997), Lewellen et al. (1977),
Poterba and Summers (1988), Lee et al. (1991), Elton et al. (1998), Campbell and Shiller
(1988), D’Avolio (2002), Trueman (1988), Barberis et al. (1998), Shefrin and Statman
(1994), Shleifer and Summers (1990), and Brown and Cliff (2004, 2005). Previous studies
reveal that investor sentiment has a significant effect on stock returns, and has important
implications for portfolio allocation and asset management. The studies also reveal that
investors act not only on rational sentiment but also on irrational sentiment or noises. They
may make investment decisions acting on their beliefs even when there is no rational basis
for the belief. Because of these sensitivities, unexpected changes in the investor sentiment
can have a significant effect on stock returns (Baker and Wurgler, 2006, 2007; Barberis et al.,
1998; Black, 1986; De Long et al., 1990; Fisher and Statman, 2000; Kumar and Lee, 2006;
Trueman, 1988).
Earlier studies have mostly focussed on investor sentiment and aggregate returns in
stock markets. The major focus of these studies was to test whether the stock market as a
whole can deviate from fundamental prices.
Shiller et al. (1996) investigate why the Japanese stock market crashed and lost
considerable value between 1989 and 1992. They found Japanese expectations for future
earnings growth in Japan became less optimistic between 1989 and 1994 and
RBF they concluded that the Japanese stock market crashed due to changes in Japanese
5,1 price expectations and speculative strategies.
Brown and Cliff (2004) investigate the effect of investor sentiment on near-term
stock in the US stock market. They show that historical stock returns are an important
variable for investor sentiment.
Baker and Wurgler (2006) find that investor sentiment has significant cross-
60 sectional effect in the US stock market. For example, they document that when
investor sentiment is low, subsequent stock returns are relatively high on small stocks,
Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 18:52 03 September 2018 (PT)
The sentiment variable computed using Equation (1) are then used as independent
variables to study their impact on industry volatility by setting up the model in
Equation (5) (Calafiore, 2010):
^ ð5Þ
st ¼ a0 þ a1Sent1t k þ a2xt þ pt
RBF where st is the one-month volatility of the industry as estimated in Equation (4); a 0
is constant, a1 is the parameter to be estimated, k is the appropriate lag length, a 2 is
5,1
the coefficient of the irrational sentiment and pt is the random error term. The
parameter a1 captures the effect of rational sentiment induced volatility, while a 2
captures the effect of irrational sentiment induced volatility.
The VAR modeling approach proposed by Sims (1980) is used to examine the
62 impact of US individual investor sentiment on industry return and volatility in the
USA. The predictive performance of VAR models is better than the more complex
Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 18:52 03 September 2018 (PT)
4. Data
The sample period for this paper on the impact of US individual investor sentiment
on the various industry stock returns and volatility extends from January 1999 to
December 2010. Following previous researchers, we use the AAII as the individual
investor sentiment proxy (Brown and Cliff, 2004; Fisher and Statman, 2000, Verma
and Soydemir, 2006). Individual investors do not participate in daily trading
activities to make a living; therefore, they seem to be less sophisticated traders or
noise investors (Baker and Wurgler, 2006).
AAII has been conducting a weekly survey asking its members for the likely
direction of the stock market during the next six months since July 1987. It has
approximately 1,00,000 members. The participants are randomly chosen among
members for each week’s survey. AAII then processes the results on a weekly basis Investor
and labels them bullish, bearish, or neutral. The individual sentiment index is sentiment and
computed as the Bull-Bear spread percentage. Since this survey reflects the
expectations of individual investors on the direction of the stock market, the index is stock returns
an appropriate proxy measure for individual investor sentiment. The survey index data
are obtained from AAII’s web site.
In addition, this paper uses several macroeconomic factors that are representative 63
of the US market fundamentals. The following are the most commonly used and
Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 18:52 03 September 2018 (PT)
5. Empirical results
Descriptive statistics of the USA
Table I summarizes the descriptive statistics of the variables used in this research
paper. The mean of SENT1 is 10.53 percent. This indicates that individuals have been
optimistic during most of the sample period. On the other hand, the measure of
RBF Mean Median Maximum Minimum SD Skewness Kurtosis
5,1 SENT1 0.10531 0.10965 0.50850 0.98300 0.18646 1.23913 9.65760
sentiment has a higher standard deviation than the various industry returns and market
fundamentals, suggesting that sentiment has been highly volatile during this period.
The mean average return for the oil, auto, and the utility industries are 1.27,
0.0617, and 0.618 percent, respectively, indicating that overall these industries have
provided a higher return than the finance and the food industries with 0.00269 and
0.00575 percent mean average returns, respectively. However, the auto, finance and
oil industries show higher volatilities than the utility and the food industries. Most of
the market fundamental variables have provided less volatility compared to the US
individual investor sentiment and the industry stock return.
The variance inflation factor (VIF) is calculated for assessing multicollinearity for
each independent variable in Equation (1). Table II shows VIF values for each
independent variable in the model. The VIF values in Table II are less than 5 which
indicates that each variable represents a distinctive characteristics of US
macroeconomic factors and that multicollinearity will not bias the results.
Table III reports the cross-correlations between US market fundamentals.
Estimation results
We first performed the Augmented Dickey-Fuller (ADF) Test (Dickey and Fuller,
1979, 1981) to check for the existence of a unit root in the time series of each
variable. The ADF Test suggests that the null hypothesis of non-stationarity is rejected
for the first difference of the time series for each variable, i.e. the series are stationary
after first differencing[1].
The study first examines the effect of market fundamental variables on US Investor
individual investor sentiment based on Equation (1). Table IV reports that the US sentiment and
individual investor sentiment is negatively related to US business condition
(BUSCON) and the excess return on the market (RM). However, the low value of stock returns
Durbin-Watson statistic (1.4018) in the regression indicates a high degree of positive
first-order correlation. In addition, the Jarqua-Bera histogram-normality test indicates
a violation of the normality condition, possibly caused by outliers[2]. 65
To remove the serial correlation in error term and to achieve normality in residuals,
Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 18:52 03 September 2018 (PT)
an AR(1) process is included in Equation (1). The result shows that there is no serial
correlation problem with the revised model and the lagged residual is insignificant.
The Jarqua-Bera histogram-normality test shows that normality is also achieved after
the AR(1) process is included. (See footnote 2)
The results are reported in Table V. The Durbin-Watson statistic improves from
1.4081 to 1.9898, showing that there is no first-order serial correlation in error terms.
The findings in Table V reveal that US individual investor sentiment is significantly
negatively related to US business conditions (BUSCON) and the excess return on the
market (RM) but significantly positively related to US future economic conditions
(FUTEC), the premium on a portfolio of high-book/market stocks relative
The equation to calculate VIF scalar VIF independent variable ¼ 1/ ð1 Equation ð1Þ at R2Þ
BUSCON EXCRATE FUTEC HML IIP INF INT MOM RM SML
VIF 1.95 1.14 1.86 3.39 1.59 2.15 1.63 3.25 1.53 1.27
Notes: Variables are variance inflation factor (VIF), US economic growth (IIP), US business
conditions (BUSCON), US future economic conditions (FUTEC), the premium on a portfolio of high Table II.
book/market stocks relative to low book/market stocks (HML), the premium on a portfolio of small The variance inflation
stocks relative to large stocks (SMB), inflation (INF), short-term interest rates (INT), momentum factor of US market
factors (MOM), currency fluctuations (EXCRATE), and excess return on the market portfolio (RM) fundamentals
BUSCON 1.00
relative to large stocks (SMB), and short-term interest rates (INT). In other words, the
relationships between the independent variables (i.e. BUSCON and RM) and the
dependent variable (SENT1) are significantly negative suggesting that an increase in
perceptions on these variables (i.e. BUSCON and RM) have a negative impact on US
2
individual investor sentiment. The R -value (0.3205) suggests that US market
fundamentals in the equation can explain about one-third of the variation in the US
individual investor sentiment. Overall, these findings provide evidence consistent
with previous literature that market fundamentals have an impact on investor
sentiment (Brown and Cliff, 2004, 2005; Qiu and Welch, 2006; Verma and Soydemir,
2006; Calafiore, 2010).
0.04
0.04 0.02
68
0.00
Malik Ibrahim, UIN Maliki At 18:52 03 September 2018 (PT)
0.00
–0.02
–0.04 –0.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Response of the US food to Response of the US oil to
0.04
0.02
0.02
0.00 0.00
–0.02 –0.02
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
0.04
0.02
0.00
–0.02
Figure 1. 12 3 4 5 6 7 8 9 10
Response of the US auto,
finance, food, oil and Note: The dashed lines on each graph represent the upper and lower 95 percent confidence
utility industry returns to band. When the upper and lower bands carry the same sign, the response becomes
US rational individual
investor sentiment statistically significant. On each graph, percentage returns are plotted on the vertical axis,
and time on the horizontal axis
Figure 2 presents the impulse response of the US auto, finance, food, oil and utility
industry return volatility to a one-standard deviation increase in the US rational individual
investor sentiment. The impulse response in Figure 2 a and b plots the time path of US
auto and finance industries’ volatility to a one-standard deviation increase in the rational
component of the US individual investor sentiment and shows the significant negative
relationship between investor sentiment and stock return volatility. For example, the first
period impulse response in Figure 2 a and b show that
Response of the US auto to Response of the US finance to
Investor
the US individual investors the US individual investors
6 0.08 sentiment and
0.06 stock returns
4
0.04
2 0.02
69
0 0.00
September 2018 (PT)
–0.02
–2 –0.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
0.02 0.04
0.00 0.00
–0.02 –0.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
0.08
0.04
0.00
–0.04
Figure 2.
1 2 3 4 5 6 7 8 9 10
Response of the US auto,
Note: The dashed lines on each graph represent the upper and lower 95 percent finance, food, oil and
utility industry volatility
confidence band. When the upper and lower bands carry the same sign, the response to US rational individual
becomes statistically significant. On each graph, percentage returns are plotted on the investor sentiment
vertical axis, and time on the horizontal axis
0.04
0.04 0.02
0.00 0.00
–0.02
–0.04 –0.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
0.02 0.04
0.02
0.00 0.00
–0.02 –0.02
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
0.04
0.02
0.00
–0.02
Figure 3.
1 2 3 4 5 6 7 8 9 10
Response of the US auto,
finance, food, oil and Note: The dashed lines on each graph represent the upper and lower 95 percent confidence
utility industry returns to
band. When the upper and lower bands carry the same sign, the response becomes
US irrational individual
investor sentiment statistically significant. On each graph, percentage returns are plotted on the vertical axis,
and time on the horizontal axis
0.20
Response of the US auto to
the US individual investors
Response of the US finance to
the US individual investors
Investor
0.08 sentiment and
0.15 0.06 stock returns
0.10 0.04
0.05 0.02
0.00 0.00 71
Malik Ibrahim, UIN Maliki At 18:52 03 September 2018 (PT)
–0.05 –0.02
–0.10 –0.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Response of the US food to Response of the US oil to
0.04 0.15
0.10
0.02
0.05
0.00 0.00
–0.02 –0.05
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
0.15
0.10
0.05
0.00
–0.05
–0.10
1 2 3 4 5 6 7 8 9 10
Figure 4.
Response of the US auto,
Note: The dashed lines on each graph represent the upper and lower 95 percent finance, food, oil and
confidence band. When the upper and lower bands carry the same sign, the response utility industry volatility
to US irrational individual
becomes statistically significant. On each graph, percentage returns are plotted on the investor sentiment
vertical axis, and time on the horizontal axis
trading.
The empirical results of the generalized impulse functions generated from VAR
reveal that there is a significant positive impact of US rational individual investor
sentiment on the US auto, finance, food, oil and utility industry stock returns. The
responses are significant in the first period on the US finance and utility industry stock
returns, though significance quickly disappears during the remaining periods. For
example, the first period impulse response indicates that one-standard deviation shock
to the US investor sentiment results in approximately a 1.8 percent increase in the US
finance industry stock returns. In addition, the impulse response shows that a one-
standard deviation increase in the rational component of the US individual investor
sentiment has a negative significant effect on the US auto and finance industries’
volatility. For example, the first period impulse responses indicate that a one-standard
deviation shock to the US investor sentiment results in approximately a 1 and a 0.2
percent decrease in the auto and finance industries’ volatility, respectively. Consistent
with existing literature, a one-standard deviation increase in the US rational individual
investor sentiment reduces the US auto and finance industry volatility (Brown and
Cliff, 2004; Verma and Soydemir, 2006; Calafiore, 2010).
These results are important in that they show the US individual investor
sentiment is driven by both rational and irrational impulses. They also show the
AAII is a good proxy for investor sentiment.
6. Conclusion
This paper investigates the effect of both rational and irrational components of US
individual investor sentiment on the US auto, finance, food, oil and utility
industries stock returns and volatility. The existing literature has revealed that
market fundamentals significantly affect investor sentiment. Likewise, this paper
provides evidence that the US market fundamentals have an impact on the US
individual investor sentiment. The results reveal that individual investor sentiment
is significantly negatively related to the US business condition (BUSCON) and the
excess return on the market (RM) but significantly positively related to US future
economic conditions (FUTEC), the premium on a portfolio of high-book/market
stocks relative to low-book/market stocks (HML), the premium on a portfolio of
small stocks relative to large stocks (SMB), and short-term interest rates (INT). In
other words, the relationships between the independent variables (i.e. BUSCON
and RM) and the dependent variable (SENT1) are significantly negative suggesting
that an increase in perceptions on those variables (i.e. BUSCON and RM) have a
2
negative impact on the US individual investor sentiment. The R -value (0.3205)
suggests that US market fundamentals in the equation can explain about one-third
of the variation in the US individual investor sentiment. Overall, these findings
provide evidence consistent with previous literature that market fundamentals have
an impact on investor sentiment (Brown and Cliff, 2004, 2005; Qiu and Welch,
2006; Verma and Soydemir, 2006; Calafiore, 2010).
Consistent with the findings of previous studies (Brown and Cliff, 2004; Calafiore, Investor
2010; Verma and Soydemir, 2006), this paper shows that a one-standard deviation sentiment and
increase in the US rational and irrational investor sentiment has a significant positive
impact on the US auto, finance, food, oil and utility industry returns. This suggests stock returns
that a positive investor sentiment tends to increase the US industry returns.
The paper also documents that a one-standard deviation increase in the rational
component of US investor sentiment has a negative significant effect only on the US 73
auto and finance industry volatility. In other words, an unexpected increase in rational
Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 18:52 03 September 2018 (PT)
sentiment reduces the volatility of US auto and finance industry. This might indicate
that investors have optimistic expectations of the economy overall with respect to
market fundamentals. Consistent with existing literature, this optimism can result in
creating positive expectations, reducing uncertainty, and reducing the volatility of
stock market returns (Brown and Cliff, 2004; Calafiore, 2010; Verma and Soydemir,
2006). Overall, the paper reveals that individual investor sentiment has an impact on
the stock returns and volatility making it systemic to financial market movements.
The statistical significance of US individual investor sentiment on the stock market
return and volatility found in this paper can help investors to improve their asset
valuation models by incorporating an investor sentiment variable into the return
generating process. Besides, the financial markets have always been a good indicator
of the economy overall. This research provides support for the impact of investor
sentiment on the return and volatility of various US industries and will therefore help
policymakers to design policies that stabilize sentiment and reduce volatility and
uncertainty in the stock markets.
An interesting extension of this research would be to study the impact of business
cycle stages on investor sentiment and to see how this translates into changes in stock
return and volatility for different industries. Prima facie one would expect that
investor sentiment changes brought on by different phases of the business cycle will
differentially impact the various industries with a more significant effect on industries
dealing with capital goods and luxuries, e.g. autos as compared to industries dealing
with necessities, e.g. food. This question, though intriguing, is left for future research.
Notes
1. The results of unit root tests are available from the authors upon request.
2. Results of the the Jarqua-Bera histogram normality test are available from the authors upon
request.
3. The results of the VAR estimates are available from the authors upon request.
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Corresponding author
Mustafa Sayim can be contacted at: msayim2@alliant.edu
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