The Value Relevance of Sentiment

It is generally accepted that excessive exuberance or gloom in investor sentiment contributes to booms and crashes in share prices. However, views differ on the merits of active policy intervention due to gaps in our understanding of the transmission mechanism. To fill this gap we apply a fully ex ante valuation model in which an index of investor sentiment is included along with earnings and growth fundamentals to explain value. The outcome is a precise indication of the value relevance of sentiment. We employ the investor sentiment indicator proposed by Baker and Wurgler (2007). Valuation, and implied permanent growth, based on the inclusion of standard fundamentals is compared with that obtained when sentiment is added. The resulting ratio produces an index of ’the valuation effects of sentiment’ that can be assessed with statistical significance. Out-of-sample fit is also examined. For the Dow index the valuation effects of sentiment are significant and as large as 40% of market value at the peak of the ’dot-com’ bubble. The index we propose identifies conditions, detectable in advance and under the control of policy makers, that are conducive to the creation of asset bubbles. It is easy to construct, timely, robust and can be used improve our understanding of what leads to bubbles and crashes and to inform policy.