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Introduction

Behavior financial theories highlight investor sentiment in influencing stock prices, despite the traditional ones positing that stock prices are the discounted future cash flows and arbitrage leaves little space for investor sentiment (Fama, 1965). De Long et al. (1990) argue that sentiment investors trading together brings systematic risk into stock markets. The risk originated from the stochastic shifts in investor sentiment imposes arbitrage limits on rational investors, impeding them from trading against noise investors. As a result, the mispricing caused by sentiment investors is persistent. Baker and Wurgler (2006) state two routes whereby investor sentiment can bring persistent impact on stock prices: (i) uninformed demand shocks, and (ii) limits on arbitrage. Uninformed demand shocks naturally persist in that irrational investors misbeliefs could be further strengthened by others joining on the bandwagon (Brown and Cliff, 2005, p. 407). Limits on arbitrage demotivate arbitrageurs from relieving the impact of investor sentiment since they are commonly subject to relatively restricted investment horizons and can hardly accurately forecast how the impact will persist. Therefore, one can observe that high levels of optimism (pessimism) would cause high (low) concurrent returns, and given the mean-reversion property, overpricing (underpricing) would be corrected and followed by low (high) subsequent returns. The theoretical analysis is supported by evidence drawn from the US market (Brown and Cliff, 2005) as well as international markets (Schmeling, 2009; Bathia and Bredin, 2013).

In line with the above-mentioned points, please prepare a report with a specific emphasis on the following seven requirements:

The question:

2. Discuss the impact of investor sentiment on stock returns conditional on economic conditions. [10 marks]

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