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Investor sentiment and the cross-section of stock returns

Classical finance theory gives no role to investor sentiment. Investors are rational and diversify to optimize the statistical properties of their portfolios. Competition among them leads to an equilibrium in which prices equal the rationally discounted value of expected cash flows, and in which the cross-section of expected returns depends on the cross-section of systematic risks. Even if some investors are irrational, classical theory argues, their demands will be offset by arbitrageurs and similar conclusions for prices will obtain.

In this paper, we present evidence that investor sentiment actually has strong effects on the cross section of stock prices. We start with simple theoretical predictions. Given that a mispricing is the result of an uninformed demand shock in the presence of a binding arbitrage constraint, a broad-based wave of sentiment is predicted to have cross-sectional effects, as opposed to raise or lower all prices equally, when either sentiment-based demands very across stocks or arbitrage constraints vary across stocks.

In practice, these two channels lead to quite similar predictions, because stocks that are likely to be most sensitive to speculative demand those with highly subjective valuations also tend to be the riskiest and costliest to arbitrage. Concretely, then, theory suggests two separate channels through which the stocks of newer, smaller, highly volatile firms, firms in distress or with extreme growth potential, firms without dividends, and firms with like characteristics, would be expected to be relatively more affected by investor sentiment.

To investigate this prediction empirically, and to get a more tangible sense of the intrinsically elusive concept of investor sentiment, we begin with a brief summary of rises and falls in U.S. market sentiment from 1961 through the recent Internet bubble. This summary is based on anecdotal accounts and thus is only suggestive, but it appears broadly consistent with our theoretical predictions, and suggests more formal empirical tests are warranted.

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Investor sentiment and the cross-section of stock returns