When Does Investor Sentiment Predict Stock Returns?

We examine the predictive effect of sentiment on the cross-section of stock returns across different economic states. The degree of mispricing and the subsequent price correction can be different between economic expansion and recession because of the limits of arbitrage and short sale constraints. The predictive ability of sentiment is asymmetric between different states ofthe economy. We implement a multivariate Markov-switching model to characterize the economic states. Conditional on the identified economic states, we use the lagged sentiment proxy to forecast the portfolio returns related to small stocks, non-earning stocks, growth stocks, and non-dividend-paying stocks. We find that only in the expansion state does sentiment performs both in-sample and out-of-sample predictive power on these categories of stocks. When an expansion state has high sentiment, these categories of stocks earn relatively low subsequent returns. The predictive ability of sentiment can not be attributed to time-variation in the market beta driven by investor sentiment