Investors are not all alike and neither is their sentiment. 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. There is a negative relationship between the sentiment of each of the three groups and future stock returns and that relationship is statistically significant for Wall Street strategists and individual investors.
The sentiment of investors, large and small
We study three groups of investors, small, medium and large: small individual investors, medium writers of investment newsletters and large Wall Street strategists.Newsletter writers are often described as semi-professionals, midway between amateur individual investors and professional Wall Street strategists.
We find that the sentiment of the three groups of investors does not move in lockstep. There is a positive relationship between changes in the sentiment of individual investors and that of newsletter writers but there is virtually no relationship between changes in the sentiment of Wall Street strategists and that of either individual investorsWe study three groups of investors, small, medium and large: small individual investors, medium writers of investment newsletters and large Wall Street strategists.Newsletter writers are often described as semi-professionals, midway between amateur individual investors and professional Wall Street strategists.
or newsletter writers.
The sentiment of all three groups points in the wrong direction; there is a negative relationship between sentiment and future S&P 500 Index returns. The sentiment of individual investors and Wall Street strategists are reliable contrary indicators; the negative relationship between them and future S&P Index 500 returns is statistically
significant. Newsletter writers do well relative to their sorry associates. The negative relationship between the sentiment of newsletter writers and future S&P 500 Index returns is not statistically significant.
Individual investors are wiser in their investment actions than in their sentiment.While there is a negative and statistically significant relationship between the sentiment of individual investors and future S&P 500 Index returns, there is a positive, although not statistically significant, relationship between the stock allocation in portfolios of
individual investors and future S&P 500 Index returns.
Does sentiment move in lockstep?
Individual investors grow bullish when newsletter writers grow bullish, but not inlockstep. The correlation between changes in the monthly sentiment of the two groups is 0.47, highly statistically significant but hardly perfect. The relationship between the sentiment of Wall Street strategists and the sentiment of the other two groups is notnearly as strong. Changes in the sentiments of Wall Street strategists are virtually unrelated to changes in the sentiment of individual investors or newsletter writers. Then correlation between changes in the sentiment of individual investors and Wall Street7 strategists is 0.01 and the correlation between changes in the sentiment of newsletter
writers and Wall Street strategists is 0.03.
The sentiment of Wall Street strategists, like the sentiment of individual investors, is a reliable contrary indicator for future S&P 500 Index returns. We find a negative and statistically significant relationship between the sentiment of Wall Street strategists and S&P 500 Index returns in the following month. An increase of one percentage point in
the sentiment of Wall Street strategists associated with a decrease of 0.24 percentage points in S&P 500 Index returns in the following month. There is also a negative relationship between the sentiment of Wall Street strategists and CRSP 9-10 Index returns in the following month, but that relationship is not statistically significant. The combination of the sentiment of the three groups provides a good tool for forecasting future S&P 500 Index return. A multiple regression of S&P 500 Index returns in one month on the sentiment of the three investor groups in the preceding month yields
an R2 of 0.08, a figure that is statistically significant at the 0.01 level. An R2 of 0.08 might seem low, it indicates that returns. But the 0.08 figure is properly interpreted as high. Clarke, Fitzgerald, Berent and Statman (1989) showed that information reflected in such R2 can add substantial value to a tactical asset allocation program.
What makes investors bullish?
Stock returns are prominent among factors that affect sentiment. But do investors forecast continuations of past returns or do they forecast reversals? Common investment proverbs provide no good answers because they reflect diametrically opposite perceptions of the processes underlying stock returns. For every proverb that implies one should expect reversals , there is a proverb implying that continuations are the rule
Stock returns affect individual investors as they affect newsletter writers. We find, consistent with De Bondt (1993), a positive and statistically significant relationship between S&P 500 Index returns and changes in the sentiment of individual investors. A one percentage-point increase in S&P 500 Index returns is associated with a one percentage- point increase in the sentiment of individual investors. However, stock returns have little effect on the sentiment of Wall Street strategists. While there is a positive relationship between S&P 500 Index returns and changes in the sentiment of Wall Street strategists, that relationship is not statistically significant.Individual investors do follow their sentiment with investment actions but not forcefully. There is a positive and statistically significant relationship between the monthly changes in the sentiment of individual investors and the monthly changes in the stock allocation in their portfolios but the Adjusted R2 of the regression of changes in allocation on changes in sentiment is only 0.02.
It turns out that individual investors are wiser in their investment actions than in their sentiment. While there is a negative and statistically significant relationship between the sentiment of individual investors and future S&P 500 Index returns, there is a positive, although not statistically significant relationship between actual stock
allocations and future S&P 500 Index returns.
Conclusions
Studies of the sentiment of investors are important for two reasons. First, they teach us about biases in the stock market forecasts of investors. Second, they teach us about opportunities to earn extra returns by exploiting these biases. We study the sentiment of three groups of investors, large and small: “small” individual investors, “medium” newsletter writers and “large” Wall Street strategists. Wefind that the sentiment of the three groups does not move in lockstep. The correlation between changes in the sentiment of individual investors and newsletter writers is high12 but hardly perfect and there is virtually no correlation between changes in the sentiment of Wall Street strategists and changes in the sentiment of the other two groups. The sentiment of both small investors and large ones are reliable contrary indicators for future S&P 500 Index returns. The relationship between the sentiment of individual investors and future S&P 500 Index returns is negative and statistically significant and so is the relationship between the sentiment of Wall Street strategists and future S&P 500 returns. While the relationship between the sentiment of newsletter writers and future S&P 500 Index 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 Index returns that can be used in a tactical asset allocation program.