Foundations of Professional Knowledge Skills Essay

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MN7240 Foundations of Professional Knowledge & Skills Assignment Submission 2014/15
Dandan Shang
October 23, 2014

Investor Sentiment in the Stock Market

Abstract
The main purpose of this report is to explain irrational phenomena in stock market.
It analyse the relationship between investor sentiment and stock market. The report develops many theoretical predictions, specifically and widely. It indicates how the sentiment be measured explicitly, and how to use these sentiment’s variance to predict the changes of stock market.
Introduction
Standard financial model depends on a serious financial index such as dividend price ration, earning price ratio and book-to-market to set the price of stock. However, it is not entirely true. There exists some excess volatility that companies’ fundamentals cannot explain. Recent research shows that price fluctuation caused by investors’ sentiment on stock. Some irrational investor cannot recognize the correct future value of stock due to information asymmetry and limited knowledge of stock. Irrational traders will disrupt stock value, especially to some low capitalization, younger, unprofitable, high volatility stocks.
Content
1. The concept of investor sentiment
Baker and Wurgler (2006) claimed that investor sentiment is a belief bout future cash flows and investment risks that not justified by the facts at hand. Brown and Cliff (2004) linked sentiment to the stock market mispricing. They found a significant positive relationship between emotional variables and market returns, which means during periods of market optimism, its value will tend to be overestimate.
2. Potential sentiment proxies
Lee, Shleifer, and Thaler (1991) first time considered individual investors as irrational investors, and use the closed-end funds (CEFD) as a proxy for negative emotions. This is because individual investors hold different proportions of closed-end funds. Baker and Stein (2004) studied investor sentiment from liquidity indicators. Mobility performance in bid-ask spread, trading volume and turnover terms. Irrational investor lack of order flow information so that they cannot react stock market correctly. It will be expressed in terms of mobility changes. Excessive liquidity reflects that market dominated by irrational investors, so the stock value will be overestimated, which also manifested in terms of the private placement of company. Baker and Wurgler (2006) put forward six more complete proxy variable investors sentiment: NYSE turnover; the dividend premium; the closed-end fund discount; the number and first-day returns on IPOs; and the equity share in new issues. In addition, Baker and Wurgler (2007) proposed an indicator of investor sentiment survey may also include emotional variables (Mood Proxies), the retail investor trading, mutual fund flows, trading volume, closed-end fund discount, options implied volatility and insider transactions.
3. Theoretical Effects of Investor Sentiment on Stocks
(1) two kinds of investors
De Long et al. (1990) divided investors in two types: rational arbitrageurs who are sentiment-free and irrational traders prone to exogenous sentiment. Rational arbitrageurs won’t influenced by sentiment but limited by short selling or transaction fees. Thus, prices are not always at their fundamental values.
(2) The relationship between sentiment and stocks
Figure one shows that changes in trading volume per unit of time for individual stocks as a measure of investor sentiment, between trading volume and stock future earnings trend, whatever in the short term or the long term, a significant negative can be seen a cross-sectional relationship.
Figure 1. Cross-sectional effects of investor sentiment4.4
4. Six proxy variable to reflect sentiment
(1) the closed-end fund discount
Lee, Shleifer, and Thaler (1991) considered the closed-end fund discount price affected by investor sentiment as other securities. When small stocks performed better, the closed-end fund discount
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