Sentimental Journey

Based on research by Yuhang Xing, Steven E. Sibley, Yanchu Wang and Xiaoyan Zhang

• New research builds on behavioral finance findings to explore the factors driving stock returns.
• Economic fundamentals, rather than sentiment, likely predict stock returns.
• Rational explanation, not behavior, can describe stock pricing.

How many wealth advisors and investors have stories about the disastrous “hot” tip picked up at a cocktail party? Who hasn’t listened to bar buddies crow about the winning stock that will make them rich?

Most traditional finance models ignore the exuberance or despair that often drive investors’ choices. But back in 2006, two professors interested in behavioral finance, Malcolm P. Baker of the Harvard Business School and Jeffrey Wurgler of the NYU Stern School of Business, created a model to capture those emotions. The result was the Sentiment Index, a proxy that convincingly showed that less-than-rational behavior can predict stock returns.

Now Rice Business professor Yuhang Xing and a team of colleagues have challenged this finding. Building on Baker and Wurgler’s research, Xing and her associates explored what gives the Sentiment Index its predictive power. Does it really come from investors’ feelings? Or do rational economic fundamentals predict returns?

To answer these questions, they first focused on the factors comprising the Sentiment Index. These include the unemployment rate, inflation, the interest rate, market volatility and liquidity and the Treasury Bill rate, as well as seven other macroeconomic factors. They then developed mathematical tests to look for what predicts future returns.

Now, why did they first look at the Sentiment Index’s factors?

Like a connoisseur at the bar, they wanted to know the growing conditions, the production methods and the history of the producer for the ingredients making their cocktail.

Xing’s team found that the Treasury Bill rate and market liquidity conditions alone provide a significant explanation of future returns. This gave them enough evidence to suggest that the power to predict returns actually lies with the economic fundamentals to which sentiment is related.

In other words, investor sentiment by itself does not cause capital to suddenly rush into a market or change hands.

This would not be the first time researchers found that a seemingly emotional behavior within economic markets is, in fact, rational. IPO waves and the NASDAQ “bubble” are two examples of irrational behavior that, with additional study, turned out to have rational explanations.

So the next time you hear a story about what happened when someone acted on a friend’s stock tip, think about what macroeconomic factors are at play. While investors are reacting to cocktail chatter, media reports or the flow of private capital, their feelings might not predict future returns. Instead, there is a strong chance that responding to macroeconomic trends will get you better returns on your investments. 

Yuhang Xing is an associate professor of finance at Jones Graduate School of Business at Rice University.

To learn more, please see: Sibley, S. E., Wang, Y., Xing, Y., & Zhang, X. (2016). The information content of the Sentiment Index. Journal of Banking & Finance, 62, 164-179.