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The Behaviour of Sentiment-Induced Share Returns: Measurement When Fundamentals Are Observable

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Portfolio Construction, Measurement, and Efficiency

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Abstract

We test the effect of sentiment on returns using a sample of upstream oil stocks where we have a good proxy for fundamental value. For this sample, the influence of sentiment is highly time-varying, appearing only after the post-2000 increased interest in oil-related assets. Contrary to the hard-to-arbitrage hypothesis, sentiment affects returns on these stocks principally through their fundamentals rather than through deviations from fundamentals. Retail investor sentiment predicts short-term momentum of fundamentals and Baker–Wurgler sentiment predicts mean reversion of fundamental factors. These effects appear in a portfolio that is long hard-to-arbitrage stocks and short easy-to-arbitrage stocks, but only because this portfolio has net exposure to fundamentals.

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Notes

  1. 1.

    Our results are robust to varying the definition of these variables. For example, using spot Brent prices or a closer futures contract does not affect our conclusions. Equally, we obtain qualitatively similar, but somewhat less strong, results using the Datastream index of US oil stocks rather than our equally weighted portfolio of upstream stocks only.

  2. 2.

    A regression of the Baker–Wurgler index on the concurrent and nine lagged values of the AAII measure gives a positive loading on each of the independent variables with a multiple correlation of .34.

  3. 3.

    We also estimated Eq. (13.7) using estimates of the innovations in the fundamental variables. These were estimated from an AR process with the optimal (i.e. not pre-specified) number of lags. The results were not sensitive to whether the fundamental variables were whitened.

  4. 4.

    Note that the regressions employ data only from 1988. The first 60 months of data are used to form the initial high- and low-variance portfolios.

  5. 5.

    It is also possible that the lower exposure of low-variance stocks to energy prices reflects hedging activity, although Haushalter (2000) suggests that hedging is more commonly used by the more risky oil and gas firms.

  6. 6.

    The period is reduced by 5 years because the first 60 months are used to estimate Eq. (13.8).

  7. 7.

    The sharp changes in cumulative flows into commodity hedge funds prompted us to examine (more in hope than expectation) the effect within the VAR of interacting the cumulative flows with the sentiment variables. There was no evidence that the impact of sentiment on returns was related to the cumulative flows into managed futures funds.

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Acknowledgements

The authors appreciate the comments of Bernell Stone, the reviewer of the manuscript.

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Authors and Affiliations

  1. London Business School, Sussex Place, Regent’s Park, London, NW1 4SA, UK

    Richard A. Brealey, Ian A. Cooper & Evi Kaplanis

Authors
  1. Richard A. Brealey
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  2. Ian A. Cooper
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  3. Evi Kaplanis
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Correspondence to Ian A. Cooper .

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  1. McKinley Capital Management, Anchorage, Alaska, USA

    John B. Guerard, Jr.

Appendix: Principal Data Sources

Appendix: Principal Data Sources

Stock samples: All common stocks with NAIC code of 211111 or SIC code of 1311 (oil production or exploration) that were listed on the NYSE or Nasdaq and whose issuers were incorporated in the USA. Returns data were taken from the CRSP monthly database. Portfolio returns were constructed from equally weighted holdings in all stocks with valid returns data for that month. Portfolio returns were then converted to continuously compounded returns.

Oil prices: Month-end spot prices for West Texas Intermediate taken from the Energy Administration website at www.eia.gov.

Natural gas prices: Monthly spot prices for Natural Gas Wellhead Price taken from Globalfindata. Prices are month averages from March 1983–December 1995 and end-of-month from January 1996–January 2011.

Contango: NYMEX futures prices are taken from Quandl at www.quandl.com. The contango is defined as the price of the contract that is sixth nearest to delivery divided by the price of the contract that is closest to delivery. The change in contango is defined as ln(contango t ) − ln(contango t − 1).

Baker–Wurgler Sentiment Index: SENT1 constructed from IPO volume, IPO first-day returns, market turnover, and the market-book ratio of high-volatility stocks relative to that of low-volatility stocks. See http://people.stern.nyu.edu/jwurgler/. The index is rescaled to have mean zero and unit standard deviation.

American Association of Individual Investors (AAII) Investor Sentiment Survey: Proportion of investors reporting they are bullish divided by the total proportion reporting that they are either bullish or bearish (i.e. not neutral). Taken from final week’s survey in each month as reported on www.aaii.com/sentimentsurvey. The index is rescaled to have mean zero and unit standard deviation. Data are available from July 1987.

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Brealey, R.A., Cooper, I.A., Kaplanis, E. (2017). The Behaviour of Sentiment-Induced Share Returns: Measurement When Fundamentals Are Observable. In: Guerard, Jr., J. (eds) Portfolio Construction, Measurement, and Efficiency. Springer, Cham. https://doi.org/10.1007/978-3-319-33976-4_13

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