Investor sentiment and the cross-section of stock returns: new theory and evidence

Abstract

We extend the noise trader risk model of Delong et al. (J Polit Econ 98:703–738, 1990) to a model with multiple risky assets to demonstrate the effect of investor sentiment on the cross-section of stock returns. Our model formally demonstrates that market-wide sentiment leads to relatively higher contemporaneous returns and lower subsequent returns for stocks that are more prone to sentiment and difficult to arbitrage. Our extended model is consistent with the existing empirical evidence on the relationship between sentiment and cross-sectional stock returns. Guided by the extended model, wen also decompose investor sentiment into long- and short-run components and predict that long-run sentiment negatively associates with the cross-sectional return and short-run sentiment positively varies with the cross-sectional return. Consistent with these predictions, we find a negative relationship between the long-run sentiment component and subsequent stock returns and positive association between the short-run sentiment component and contemporaneous stock returns.