The Impact of Market Sentiment Index on Stock Returns: An Empirical Investigation on Kuala Lumpur Stock Exchange

TLDR: In this article, the role of investor sentiment in asset pricing mechanism by focusing on Malaysian stock market and using data from January 2000 to December 2010 was investigated by using the technique of principal component analysis (PCA) to construct the investor sentiment index.

Abstract: Modern finance theory documents that investor sentiment should not be priced. This is due to an element of mispricing where sentiments can be removed when rational investing and arbitrage occurs. Nevertheless, in research during the decades, it shows that sentiment induces uniformed demand of stock and cost of arbitrage is high, hence investor sentiment cannot be ignored. Prior studies provide conflicting evidences on the impact of sentiment on the financial markets. This study continues the investigation of the role of investor sentiment in the asset pricing mechanism by focusing on Malaysian stock market and using data from January 2000 to December 2010. This research also examines whether the influence of investor sentiment index on stock returns varies according to some characteristics of the firm. The technique of Principal Component Analysis (PCA) is used on market data to construct the investor sentiment index for Malaysian stock market. It is shown that Malaysian investor sentiment index could be measured by an equation of seven market variables. Using regression analysis and controlling for firm size, market-to-book ratio, financial leverage and growth opportunity, this index is shown to be able to predict Kuala Lumpur Composite Index (KLCI) returns in general. Further analyses which are based on portfolios of stocks formed based on size, risk and age show that the influence of the investor sentiment index on stock returns varies according to age and risk, but not size. However, after classifying the period of studies into before and after crisis periods, it is then shown that the significant relationship between the investor sentiment index and stock returns only takes place before the crisis period but not after the crisis period. The relationship between the index and stock returns is shown to differ according to firm age and risk after the crisis period but not before the crisis period. As a whole, the market sentiment is able to predict stock return in Malaysian equity market. The results imply that investor sentiment could be one of the major factors that should be accounted for in recent.