Causalities Between Sentiment Indicators And Stock Market Returns Under Different Market Scenarios

This paper investigates the causal relationships between sentiment and returns under different market scenarios. In contrast to previous studies that subjectively identify the bullish and bearish markets, we apply a threshold model to detect the extreme level of investors’ sentiment econometrically. The empirical results show that most of the sentiment measures exhibit a feedback relationship with returns while ignoring different market states. However, sentiment could be a leading indicator if the higher or lower levels of sentiments were to be distinguished. Among them, the bullish/bearish indicator of ARMS, which is named after its creator, Richard Arms (1989), is a leading indicator if the market is more bearish (in the higher regime). Otherwise, the leading effect of the derivatives market sentiment indicators (the put-call trading volume and option volatility index) is discovered if the market is more bullish (in the lower regime). Our empirical findings further confirm the noise trader explanation that the causal direction would run from investors’ sentiment to market behavior.