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.
