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The Value Relevance of Sentiment

Author

Listed:
  • Dunne, Peter

    (Central Bank of Ireland)

  • Forker, John

    (University of Bath, School of Management)

  • Zholos, Andrey

    (Queen’s University Management School)

Abstract

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.

Suggested Citation

  • Dunne, Peter & Forker, John & Zholos, Andrey, 2011. "The Value Relevance of Sentiment," Research Technical Papers 5/RT/11, Central Bank of Ireland.
  • Handle: RePEc:cbi:wpaper:5/rt/11
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    More about this item

    Keywords

    Bubbles; fundamental valuation; sentiment; early warning indicators;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E66 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General Outlook and Conditions
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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