Investor Sentiment and Stock Returns

Investors are not all alike, and neither are their sentiments. We show that the sentiment of Wall Street strategists is unrelated to the sentiment of individual investors or that of newsletter writers, although the sentiment of the last two groups is closely related. Sentiment can be useful for tactical asset allocation. We found a negative relationship between the sentiment of each of these three groups and future stock returns, and the relationship is statistically significant for Wall Street strategists and individual investors. Is the sentiment of small, individual investors different from the sentiment of large investors? Does the sentiment of investors—large, medium, or small—predict stock returns? Do high returns turn investors into exuberant bulls? Do individual investors follow their sentiment in investment actions? These are the questions we answer in this article. We studied three groups of investors—small (individual investors), medium (writers of investment newsletters), and large (Wall Street strategists). Newsletter writers are often described as semiprofessionals, midway between amateur individual investors and professional Wall Street strategists. We found that the sentiments of the three groups of investors do not move in lockstep. A significant positive relationship exists between changes in the sentiment of individual investors and that of newsletter writers, but virtually no relationship exists between changes in the sentiment of Wall Street strategists and those of either individual investors or newsletter writers. We also found that the sentiments of both small and large investors are reliable contrary indicators for future S&P 500 Index returns. The relationship between the sentiment of individual investors and future S&P 500 returns is negative and statistically significant, as is the relationship between the sentiment of Wall Street strategists and future S&P 500 returns. Although the relationship between the sentiment of newsletter writers and future S&P 500 returns is also negative, that relationship is not statistically significant. A combination of the sentiment of the three groups provides forecasts of future S&P 500 returns that can be used in a tactical asset allocation program. Individual investors and newsletter writers form their sentiments as if they expect continuations of short-term returns. High S&P 500 returns during a month make them bullish. The sentiment of Wall Street strategists, however, is little affected by stock returns. We found no statistically significant relationship between S&P 500 returns and changes in the sentiment of Wall Street strategists. We found no support for the claim that the sentiment of small investors is influenced mostly by the returns of small-cap stocks and the sentiment of large investors is influenced mostly by the returns of large-cap stocks. Indeed, the correlation of changes in the sentiment of Wall Street strategists with the returns of small-cap stocks is higher than the correlation of changes in the strategists' sentiment with the returns of large-cap stocks. Similarly, the correlation of changes in the sentiment of individual investors with the returns of large-cap stocks is higher than the correlation of their sentiment with the returns of small-cap stocks. Individual investors are wiser in their investment actions than in their sentiment. Although we found a negative and statistically significant relationship between the sentiment of individual investors and future S&P 500 returns, we found a positive, although not statistically significant, relationship between the actual stock allocations in the portfolios of individual investors and future S&P 500 returns.