Revisiting the role of investor sentiment in the stock market

The stock market is a critical determinant of global economic growth, and investor irrational behaviors are remarkable forces that are not only forming stock prices but also determining the stock market's performance. To examine the significant impacts of those irrationalities, various methods have been applied to generate an investor sentiment index. However, isolating the irrational judgments of investors is a challenge and the existing sentiment indices are inefficient. To overcome this shortcoming, this paper develops a new investor sentiment index. We take into account only the irrational part of people's behavior biases that lead to misvaluation in stock markets, neither behavioral biases nor misvaluation per se. We then conducted several robust tests toward stock returns' predictability using time-series data for the U.S. and Chinese markets. Various empirical methods, including OLS, TVP-VAR model, and out-of-sample test are used in this study. Our results confirm the advantages of our index to assess the predictability towards stock returns compared to two common existing measures of investor sentiment: survey-based Consumer Sentiment Index and market-based Baker & Wurgler index. To the best of our knowledge, this is the first study that presents this novel approach to capture the irrationalities of investors.