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Using VIX and Investor Sentiment to Explain Stock Market Returns

July 10, 2023 • Posted in Sentiment Indicators, Volatility Effects

Do stock market return volatility (as a measure of risk) and aggregate investor sentiment (as a measure of risk tolerance) work well jointly to explain stock market returns? In their June 2023 paper entitled “Time-varying Equity Premia with a High-VIX Threshold and Sentiment”, Naresh Bansal and Chris Stivers investigate the in-sample power an optimal CBOE Volatility Index (VIX) threshold rule and a linear Baker-Wurgler investor sentiment relationship to explain future variation in U.S. stock market excess return (relative to U.S. Treasury bill yield). They skip one month between VIX/sentiment measurements and stock market returns to accommodate investor digestion of new information. They consider return horizons of 1, 3, 6 and 12 months. They also extend this 2-factor model to include the lagged Treasury implied-volatility index (ICE BofAML MOVE Index) as a third explanatory variable. Using monthly excess stock market return and VIX during January 1990 through December 2022, monthly¬† investor sentiment during January 1990 through June 2022 and monthly MOVE index during October 1997 through December 2022, they find that:


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