Does investor sentiment predict future stock returns, and does the release of new investor sentiment data therefore cause an immediate market reaction? In the February 2009 version of their paper entitled “Not so Dumb Money: The Prognostic Power of Investor Sentiment over Time”, Jördis Hengelbrock, Erik Theissen and Christian Westheide measure the predictive power of German and U.S. investor sentiment indicators and test whether the market responds immediately to the release of new sentiment data. For the German market, they define investor sentiment using the Sentix value index (percent bullish minus percent bearish), derived from a weekly survey of institutional and individual investors regarding their outlook for German equities over the next six months and published on weekends. For the U.S. market, they define investor sentiment using an American Association of Individual Investors (AAII) value index (percent bullish minus percent bearish), derived from a weekly survey of individual investors regarding their outlook for U.S. equities over the next six months and published before the market open on Thursdays. Using AAII survey results for July 1987 to June 2008 and Sentix survey results for February 2001 to June 2008, along with contemporaneous stock index levels, they conclude that:
- The Sentix index, as calculated from individual investor respondents only, relates positively to one-week to 13-week future DAX 30 returns. In other words, a high (low) sentiment level predicts high (low) future stock returns.
- Over the entire 1987-2008 sample period, AAII investor sentiment relates negatively to 13-week and 26-week future S&P 500 index returns. This negative relationship is very pronounced for a 1987-1994 subsample and smaller in magnitude for a 1994-2001 subsample. It reverses to positive but generally insignificant in a most recent 2001-2008 subsample. In other words, the predictive power of U.S. investor sentiment disappears in recent years.
- The market return the day after release of new Sentix index results relates positively to sentiment changes. Market participants tend to buy (sell) after a rise (fall) in the sentiment indicator.
- Over the entire 1987-2008 sample period, there is no significant announcement day reaction to new AAII sentiment data. There is a moderately significant negative response for the 1987-1994 subsample but no significant effects in the two later subsamples.
In summary, German investor sentiment correctly anticipates equity market moves over the next few months to some degree. U.S. investor sentiment used to to be a contrarian indicator for equity market moves over coming months, but its predictive power has disappeared.
The different results for U.S. and German investor sentiments, and the disappearance of predictive power for U.S. sentiment, undermine belief in sentiment as a pervasive (derived from basic human nature) contrarian indicator of pending reversion.
Frequently Asked Questions
What is an investor sentiment indicator like the Sentix or AAII index?
An investor sentiment indicator such as the Sentix or AAII value index is calculated as the percent of survey respondents who are bullish minus the percent who are bearish. Sentix surveys institutional and individual investors about German equities, while AAII surveys individual investors about U.S. equities. Both ask for an outlook over the next six months and are conducted weekly.
Does investor sentiment predict future stock returns?
Investor sentiment predicts future stock returns in Germany but no longer does so in the U.S. The Sentix index, based on individual investor respondents, relates positively to one-week to 13-week future DAX 30 returns (February 2001 to June 2008). AAII sentiment related negatively to 13-week and 26-week S&P 500 returns over 1987-2008, but this reversed to positive and generally insignificant in the 2001-2008 subsample.
How is the market reaction to new investor sentiment data tested?
The market reaction to new investor sentiment data is tested by relating market returns around the release of weekly survey results to changes in the sentiment indicator. Sentix results are published on weekends, so the test uses the next-day market return, while AAII results are published before the market open on Thursdays. The study uses AAII data from July 1987 to June 2008 and Sentix data from February 2001 to June 2008, with AAII also split into 1987-1994, 1994-2001 and 2001-2008 subsamples.
Is investor sentiment a contrarian indicator for stock markets?
Investor sentiment is not a reliably contrarian indicator, because German and U.S. results differ. German Sentix sentiment is positively related to future DAX returns, which is the opposite of contrarian. U.S. AAII sentiment acted as a contrarian indicator in 1987-1994 and to a lesser degree in 1994-2001, but that predictive power disappeared in 2001-2008. These differences undermine the belief that sentiment is a pervasive contrarian indicator of pending reversion.
What are the limitations of using investor sentiment surveys to forecast stock returns?
Investor sentiment surveys have limited forecasting reliability because their predictive power varies across markets and over time. AAII sentiment's negative relationship with future S&P 500 returns was strong in 1987-1994, weaker in 1994-2001, and gone in 2001-2008. The German Sentix result rests on a short sample (February 2001 to June 2008), and the study found no significant announcement-day reaction to AAII data over the full 1987-2008 period.