We decompose the excess market return into speculation and non-speculation components. The former is negative and predicted by market sentiment. The latter is positive and not predicted by sentiment. The speculation component explains roughly 30% of the variation in the excess market return. In...

Market sentiment drives fluctuations in financial markets, but it is measured with empirical proxies lacking strong theoretical foundations. In a generalization of the Consumption CAPM where the representative agent has a prospect theory probability weighting function, we derive a formula for...