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Sentiment, Convergence of Opinion, and Market Crash

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  • Qingwei Wang

    ()
    (Bangor University)

Abstract

I introduce a novel proxy of investor sentiment and differences of opinion among trendchasing investors to forecast skewness in daily aggregate stock market returns. The new proxy is an easy-to-construct, real time measure available at different frequencies for more than a century. Empirically I find that negative skewness is most pronounced when investors have experienced high sentiment. The role of differences of opinion depends on the states of average investor sentiment: it positively forecasts market skewness in an optimistic state, but negatively forecasts it in a pessimistic state. Conceptually, I provide an explanation for the role of differences of opinion based on the theory of Abreu and Brunnermeier (2003). I argue that convergence of opinion in an optimistic state indicates that the price run-up is unlikely to be sustained since fewer investors can remain net buyers in the future. Therefore rational arbitrageurs coordinate their attack on the bubble, leading to a market crash. Vice versa, the convergence of opinion in a pessimistic state promotes coordinated purchases among rational arbitrageurs, leading to a strong recovery.

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Bibliographic Info

Paper provided by Bangor Business School, Prifysgol Bangor University (Cymru / Wales) in its series Working Papers with number 10012.

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Length: 41 pages
Date of creation: May 2010
Date of revision:
Handle: RePEc:bng:wpaper:10012

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Related research

Keywords: investor sentiment; differences of opinion; technical trading; skewness; stock market crash;

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References

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  1. Malcolm Baker & Jeffrey Wurgler, 2007. "Investor Sentiment in the Stock Market," NBER Working Papers 13189, National Bureau of Economic Research, Inc.
  2. Ernan Haruvy & Yaron Lahav & Charles N. Noussair, 2007. "Traders' Expectations in Asset Markets: Experimental Evidence," American Economic Review, American Economic Association, vol. 97(5), pages 1901-1920, December.
  3. Cars Hommes & Joep Sonnemans & Jan Tuinstra & Henk van de Velden, 2004. "Coordination of Expectations in Asset Pricing Experiments," DNB Staff Reports (discontinued) 119, Netherlands Central Bank.
  4. Charles Lee & Andrei Shleifer & Richard Thaler, 1990. "Investor Sentiment and the Closed-End Fund Puzzle," NBER Working Papers 3465, National Bureau of Economic Research, Inc.
  5. Gregory W. Brown & Michael T. Cliff, 2005. "Investor Sentiment and Asset Valuation," The Journal of Business, University of Chicago Press, vol. 78(2), pages 405-440, March.
  6. Chen, Joseph & Hong, Harrison & Stein, Jeremy C., 2001. "Forecasting crashes: trading volume, past returns, and conditional skewness in stock prices," Journal of Financial Economics, Elsevier, vol. 61(3), pages 345-381, September.
  7. Sullivan, Ryan & Timmermann, Allan G & White, Halbert, 1998. "Data-Snooping, Technical Trading Rule Performance and the Bootstrap," CEPR Discussion Papers 1976, C.E.P.R. Discussion Papers.
  8. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
  9. Dilip Abreu & Markus K. Brunnermeier, 2003. "Bubbles and Crashes," Econometrica, Econometric Society, vol. 71(1), pages 173-204, January.
  10. Hueng, C. James & McDonald, James B., 2005. "Forecasting asymmetries in aggregate stock market returns: Evidence from conditional skewness," Journal of Empirical Finance, Elsevier, vol. 12(5), pages 666-685, December.
  11. Jianguo Xu, 2007. "Price Convexity and Skewness," Journal of Finance, American Finance Association, vol. 62(5), pages 2521-2552, October.
  12. Andrews, Donald W K, 1991. "Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation," Econometrica, Econometric Society, vol. 59(3), pages 817-58, May.
  13. Taylor, Mark P. & Allen, Helen, 1992. "The use of technical analysis in the foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 11(3), pages 304-314, June.
  14. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2009. "Carry Trades and Currency Crashes," NBER Chapters, in: NBER Macroeconomics Annual 2008, Volume 23, pages 313-347 National Bureau of Economic Research, Inc.
  15. Po-Hsuan Hsu & Chung-Ming Kuan, 2005. "Reexamining the Profitability of Technical Analysis with Data Snooping Checks," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 3(4), pages 606-628.
  16. Hentschel, Ludger & Campbell, John, 1992. "No News is Good News: An Asymmetric Model of Changing Volatility in Stock Returns," Scholarly Articles 3220232, Harvard University Department of Economics.
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