Full name : La Ode Sabaruddin Student ID Number : 139040727 Program : Accounting and Finance MSc Module : Foundations of Knowledge

and Professional Skills Assignment Questions : Step 1: Find and read the following article: Baker, M., and Wurgler, J. (2007), Investor Sentiment in the Stock Market, Journal of Economic Perspectives, Vol. 21, No. 2, pp. 129-151 Step 2: Prepare a short (1,000 words) REVIEW of the article that: Summarizes the aims, scope and main arguments of the article Critically analyses the article from a methodological perspective

Review of the article: Baker, M. and Wurgler, J. 2007. Investor Sentiment in Stock Market. Journal of Economic Perspectives, 21 (2), pp. 129-151. In this review I respectfully refer to Baker and Wurgler (2007) as BW.

Abstract BW article provides an empirical framework to understand the co-movement between sentiment and stock returns using a top down approach. It shows that sentiment works on both firms and market, and stocks that cannot be arbitraged or difficult to value are most affected by sentiment. I provide a review in two parts (i) theoretical framework and arguments of the article (ii) methodological issues of the article in particular relating to the fact that sentiment cannot be measured straightforwardly.

Introduction Issues relating to investor sentiment in stock market have been the subject matter of discussion in behavioral finance as there is evidence of prolonged price anomalies in stock market empirically1. It is to explain the demand for securities or the volatility of stock returns that is not justified by fundamentals. Many studies have tried to measure investor sentiment and link its effects to stock returns2. BW article is one of these studies, which contributes through develop a top down approach which measures sentiment at aggregate level.
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See Subrahmanyam (2007) for detailed theoretical literature and anomalous evidence on stock returns 2 See Schmeling (2009), Bathia and Bredin (2012), Baker et al (2012), and Chen et al. (2013) for some recent empirical studies, and Subrahmanyam (2007) for the prior studies

Aims of the Article BW article tries to analyze the stock market movements relating to investor sentiment. Specifically, the article aims to: First, identifies the empirical approach to measure investor sentiment. Second, find the links between the waves of investor sentiment to stock returns and investigate which stocks are more affected by investor sentiment. Third, test whether changes in investor sentiment can predict the future stock returns Scope of the Article BW article investigates the investor sentiment in US stock market from January 1966 to December 2005 focuses on mutual fund flows of eight stock categories vary from speculative funds to safer funds. The article works on two underlying assumption that investors are prone to sentiment and betting against sentimental investors is risky and costly, and therefore creates the limits to arbitrage3. Regarding data availability, the article only considers six proxies to measure sentiment, namely, the close-end fund discount, trading volume, number of IPOs, first-day return on IPOs, dividend premium, and equity share in new issues. Stock returns are measured according to their levels of volatility, which result in two categories, speculative and difficult to arbitrage stocks and bond-like stocks. In regard to analysis, the article proposes a theoretical prediction that different sentiment levels affect average returns of different types of stocks asymmetrically. Main Argument of the Article BW article demonstrates some important points: First, the article highlights an empirical approach to measure sentiment. BW notices the existence of imperfect sentiment proxies, and therefore suggests the combination
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see Delong et al (1990) and Shleifer and Vishny (1997) for detailed explanation about these assumption

of these imperfect measures. Having said that, BW only employs six proxies to measure sentiment as mentioned before. BW develops a sentiment-levels index and a sentiment-changes index based on these six proxies using principal component analysis. To capture fluctuations in sentiment, BW employs eyeball test and correlates the indexes to mutual fund flows which produce two possibilities channels how sentiment affects stock returns, generic and speculative demands. Second, investor sentiment creates mispricing and works on both firms and market. Speculative stocks that cannot be arbitraged or difficult to value are most affected by sentiment. BW regress the index of sentiment changes to returns of ten volatility portfolios on generic and speculative demands of mutual fund flow changes. The results show that high volatility stocks of both general and speculative demands have higher sentiment betas than bond-like stocks and increase as stocks become more speculative and harder to arbitrage. These results are consistent with the prior theoretical predictions proposed by BW. Third, sentiment changes can predict future stock returns both on individual firms and stock market as a whole. BW justifies this finding by developing an empirical version of the prior theoretical prediction using the levels of volatility to characterize stock returns and split the periods according to the grades of sentiment, high-sentiment and low-sentiment periods. The results show that the speculative stocks always have average higher future returns when sentiment is low and lower returns when sentiment is high. In aggregate view, future market returns are lower in the following periods when the high-sentiment periods end. In other words, investor sentiment has negative relationship to future stock returns.

Critical Analysis of the Article: Methodological Perspective The methodological concern in BW article comes from the theoretical issue that investor sentiment cannot be observed straightforwardly. As BW relies on indirect measures and employs principal component analysis, there may be a problem concerning potential omitted variable bias in the model, which to some degree might invalidate the coefficients (Wooldridge, 2009)4. Despite robustness claim pointed by BW, indirect measures are likely to produce inferior results compared to the composite index using both direct and indirect measures5. In addition, the aggregate measures ignore the unique variance in parameters. On one side this approach makes statistical inference more robust as it preserves degree of freedom. In other side, however, regarding central limit theorem it may influence the links between investor sentiment and stock returns (Keller, 2008)6. Hence, BW article could be potentially more complete by considering other direct behavioral biases relate to sentiment7. Another methodological concern of BW article is the linear approach to predict future stock returns. In light of financial theory, real-world financial time series are likely to have both linear and nonlinear patterns, and therefore an approach, which combines linear-nonlinear method will produce a more precise result8. Looking forward, BW article is possible to be extended using this approach.

Beer and Zouaui (2011) question the indirect measures in terms of validity as the proxies are endogenous to market and economic activity, and therefore difficult if not impossible to isolate 5 Some articles such as Qiu and Welch (2006), Feldman (2010), Beer and Zouaui (2011) claim the better predictive ability of using both direct and indirect measures 6 see also Maddala (1971) for variance component models, and Yu and Yuan (2011) for the influence of investor sentiment on the market's meanvariance tradeoff 7 for example, the Michigan Consumer Confidence Index and the UBS/GALLUP Index of Investor Optimism. 8 Wang et al. (2013) develop a sentiment-based linear-nonlinear model, and find that this model has better forecasting performance on stock returns. See also Pai and Lin (2005) for other linear-nonlinear model to predict stock prices.

Conclusion A key finding of BW article is sentiment works on both firms and market. Different grades of sentiment affect different types of stocks asymmetrically where the speculative stocks that are difficult to arbitrage and to value are most affected by sentiment. This conclusion, however, may not interpret in a strict sense, as some methodological issues remain exist to capture the notion of how sentiment affects stock returns, and therefore need to be addressed in future empirical research. References Baker, M. and Wurgler, J., 2007. Investor Sentiment in Stock Market. Journal of Economic Perspectives, 21 (2), pp. 129-151. Baker, M., Wurgler, J. and Yuan, Yu, 2012. Global, local, and contagious investor sentiment. Journal of Financial Economics, 104 (2), pp. 272-287. Bathia, D. and Bredin, D., 2012. in press. An examination of investor sentiment effect on G7 stock market returns. European Journal of Finance. Beer, F. and Zouaoui, M., 2011. Measuring Investor Sentiment in the Stock Market. Available at SSRN: http://ssrn.com/abstract=1939527 or http://dx.doi.org/10.2139/ssrn.1939527 [Accessed 16 October 2013] Chen, M. P., Chen, P.F. and Lee, C.C., 2013. Asymmetric effects of investor sentiment on industry stock returns: Panel data evidence. Emerging Markets Review 14 (2013), pp. 3554. Feldman, T., 2010. A more predictive index of market sentiment. Journal of Behavioral Finance, 11 (4), pp. 211-223. Keller, G, 2008. Statistics for Management and Economics. 8th ed. Ohio: SouthWestern Pub. Maddala, G. S., 1971. The Use of Variance Components Models in Pooling Cross Section and Time Series Data. Econometrica, 39, pp. 341-358. Qiu, L. and Welch, I., 2006. Investor Sentiment Measures. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=589641 [Accessed 16 October 2013] Schmeling, M., 2009. Investor sentiment and stock returns: some international evidence. Journal of Empirical Finance, 16 (3), pp.394-408. Subrahmanyam, A., 2007. Behavioral Finance: A Review and Synthesis. European Financial Management, 14, pp.12-29. Wang, T., Gong, Q., Ren, W., Wang, Y., Luo, X. and Li, Q., 2013. A Sentimentbased Hybrid Model for Stock Return Forecasting. PACIS 2013 Proceedings. Paper 5. Available at http://aisel.aisnet.org/pacis2013/5 [Accessed 16 October 2013] Wooldridge, Jeffrey M, 2009. Introductory Econometrics: A Modern Approach. Ohio: Cengage Learning. Yu, J. and Yuan, Y., 2011. Investor sentiment and the mean-variance relation. Journal of Financial Economics, 100 (2), pp.367-381.