Relative Sentiment and Stock Returns

The sentiment of retail investors relative to that of institutional investors was measured by comparing their respective portfolio allocations to equity versus cash and fixed-income securities. The results suggest that fluctuations in retail sentiment are a primary driver of equity valuations for reasons unrelated to fundamentals. In the study reported, we measured the sentiment of retail investors versus the sentiment of institutional investors by comparing their respective portfolio allocations to equity versus cash and fixed-income securities. And we considered whether fluctuation in relative sentiment is associated with variation in expected stock market returns. Whereas several other studies used indirect proxies for aggregate investor sentiment, we used actual asset allocation decisions of investors as direct evidence of their sentiment. We could thus focus on the essential meaning of sentiment: a time-varying propensity to invest in risky assets that is unrelated to fundamentals. The cost of our approach, however, is that asset allocations can reveal only the sentiment of one group of investors relative to the sentiment of another group. We found that relative sentiment is uncorrelated with indicators of absolute investor sentiment and appears to have considerable value as a (contrarian) market-timing tool at a quarterly frequency. High levels of relative retail sentiment are associated with significantly lower future excess equity returns, and the change in relative sentiment is strongly positively related to concurrent market returns. This pattern is consistent with the hypothesis that retail sentiment is more variable than institutional sentiment and retail investors move prices as they update their asset allocations to reflect their shifting sentiment rather than for reasons related to fundamentals. The relationships between relative sentiment and stock returns that we documented are economically as well as statistically significant. For example, sorting on values of our index of relative sentiment yielded an annualized average market return in the following quarter equal to 25.6 percent when relative sentiment was low (in the lower quartile of the distribution) and only 4.5 percent when relative sentiment was high (in the upper quartile). Although we follow convention in labeling shifts in retail demand for equities independent of fundamentals as “sentiment driven,” our results are fully consistent with a rational interpretation of retail-side behavior. Shifts in retail risk tolerance lead to precisely the same pattern as shifts in the optimism of cash flow forecasts (relative to fundamentals). Increases in risk tolerance will induce contemporaneous increases in both prices and retail equity allocations as the retail sector bids up shares from the institutional side and will be followed by lower future expected returns. Increases in risk aversion will work similarly. In our framework, sentiment should be interpreted broadly—and not necessarily pejoratively—as also encompassing variation in risk tolerance. Our results are consistent with a smart money/dumb money view of the world in which all investors use the same risk-adjusted discount rate but one group (institutions) is better at forecasting future prospects. The key distinction between this view and a rational interpretation (that the difference in behavior comes from time-varying risk tolerance) lies with investors’ expectations. In the smart money/dumb money interpretation, if retail investors knew the conditional expected returns that we have documented, they would alter their behavior. In the rational interpretation, they would not. Unfortunately, these two interpretations are not readily distinguished by empirical analysis.