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Investor Sentiment Dynamics, the Cross-Section of Stock Returns and the MAX Effect Explained

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Investor Sentiment Dynamics, the Cross-section of Stock Returns and the MAX Effect” by Muhammad A. Cheema from the University of Otago, New Zealand, and Gilbert Nartea from the University of Canterbury – College of Business and Law explores the nuanced relationship between investor sentiment and stock returns.

Existing evidence proposes that investor sentiment could counter-predict stock returns, with speculative stocks earning erratic future returns following variant sentiment states. The research extends this belief, illustrating that the mispricing of safe and speculative stocks intensifies with continuous sentiment but corrects upon sentiment transitions.

This trend aligns with the perspective that sentiment-driven mispricing governs these stocks. The study also uncovers that the MAX effect can oscillate between positive or negative, contingent upon sentiment dynamics.

The findings offer compelling insights into the influence of sentiment dynamics on cross-section stock returns, asset pricing, and maximum returns, thereby challenging prior assumptions.

Abstract Of Paper

Recent evidence shows that investor sentiment is a contrarian predictor of stock returns with speculative stocks earning lower (higher) future returns than safe stocks following high (low) sentiment states. We extend this argument by conditioning expected stock returns on sentiment dynamics and show that the mispricing of speculative and safe stocks worsens with sentiment continuations but is corrected with sentiment transitions, consistent with the view that the mispricing of these stocks is sentiment-driven. We show that the unconditional contrarian return predictability of sentiment, at least in the short-run, is due to the returns of stocks in sentiment transitions. Results show that ex post, sentiment is a momentum predictor if subsequent sentiment continues; and a contrarian predictor if subsequent sentiment transitions. We show that the MAX effect can either be positive or negative contingent on sentiment dynamics. The absence of a negative MAX effect following Low sentiment states suggested by prior studies is due to the completely offsetting negative MAX effect when sentiment continues in a Low state and the positive MAX effect when sentiment transitions from a High to a Low state.

Original paper – Download PDF

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Author

Muhammad A. Cheema
University of Otago New Zealand

Gilbert Nartea
University of Canterbury – College of Business and Law

Conclusion

In conclusion, the research paper “Investor Sentiment dynamics, the Cross-Section of Stock Returns and the MAX Effect” provides a comprehensive examination of the interplay between investor sentiment and stock returns.

Accounts of investor sentiment as a contrarian predictor of stock returns are extended, with further findings suggesting that the mispricing of speculative and safe stocks is often a consequence of sentiment dynamics. The study also brings to light that the MAX effect, hitherto assumed to lack a negative outcome following low sentiment states by previous research, is actually reliant on sentiment dynamics, establishing the potential for both positive and negative effects.

These findings enrich the understanding of the intricacies of sentiment dynamics and their influence on the cross-section of stock returns and asset pricing. Furthermore, they lay the groundwork for more nuanced strategies in arbitrage and maximum returns.

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FAQ

What does the research paper “Investor Sentiment Dynamics, the Cross-section of Stock Returns and the MAX Effect” contribute to our understanding of investor sentiment and stock returns?

The research extends the knowledge on investor sentiment as a contrarian predictor of stock returns. It emphasizes the relationship between investor sentiment and the cross-section of stock returns, particularly for speculative and safe stocks. The study reveals how the mispricing of these stocks intensifies with continuous sentiment but corrects upon sentiment transitions, challenging previous assumptions.

How does the research paper challenge conventional beliefs regarding the MAX effect following low sentiment states?

The paper challenges the common assumption that the MAX effect lacks a negative outcome following low sentiment states. It introduces the idea that the MAX effect can exhibit both positive and negative outcomes, depending on sentiment dynamics. The absence of a negative MAX effect after low sentiment states is explained by offsetting negative effects when sentiment continues in a low state and positive effects when sentiment transitions from high to low.

What practical insights do the research findings offer for investors and asset pricing strategies?

The research provides valuable insights into the impact of sentiment dynamics on cross-section stock returns, asset pricing, and maximum returns. Investors and practitioners can leverage this understanding to develop more sophisticated strategies in areas like arbitrage and maximum returns. By challenging previous assumptions, the research contributes to a deeper comprehension of sentiment dynamics in financial markets, offering practical implications for investment decision-making.

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