International Sentiment Spillovers in Equity Returns

Published date01 October 2016
AuthorDirk Nitzsche,Don Bredin,Deven Bathia
DOIhttp://doi.org/10.1002/ijfe.1549
Date01 October 2016
INTERNATIONAL JOURNAL OF FINANCE AND ECONOMICS
Int. J. Fin. Econ.21: 332–359 (2016)
Published online 23 February 2016 in Wiley Online Library
(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1549
INTERNATIONAL SENTIMENT SPILLOVERS IN EQUITY RETURNS
DEVEN BATHIA1,,, DON BREDIN2and DIRK NITZSCHE3
1Queen Mary University of London, London, UK
2School of Business, University College Dublin, Dublin, Ireland
3Cass Business School, London, UK
ABSTRACT
This paper examines the extent of spilloversfrom US investor sentiment on G7 aggregate market, value and growth stock returns.
As a proxy for investor sentiment, we include individual investor survey, measured by the University of Michigan consumer
confidence index and market sentiment measured by Baker and Wurglercomposite sentiment index. Using monthly data for the
period January 1991 to December 2013, our results indicate the presence of significant spillover effects of US investorsentiment
on G7 stock returns. Our findings from generalized impulse response functions show that aggregate market and growth stocks
of all non-US G7 countries are significantly affected by the propagation of the US market sentiment. The financial crisis of 2007
has played a significant role in affecting value stock returns in these countries. Our findings further reveal that both the rational
and irrational components of the US individual investor sentiment do not play any significant role in affecting international
stock returns. Copyright © 2016 John Wiley & Sons, Ltd.
Received 21 May 2015; Revised 9 December 2015; Accepted 17 January 2016
JEL CODE: G14; G15
KEY WORDS: investor sentiment; international financial markets; vector autoregression; equity spillovers; international
stock returns
1. INTRODUCTION
Traditional tests of market efficiency haverelied heavily on asset pricing models, in particular, capital asset pricing
model (CAPM). The CAPM states that both rational investors and professional arbitrageurs play a significant role
in minimizing security mispricing, and therefore, asset prices will always reflect their true fundamental values.
Furthermore, CAPM does not place any role for behavioural factors (e.g. investor sentiment) in explaining asset
prices. However, the efficient market hypothesis is put through renewed analysis following financial crises, for
example, October 1987 stock market crash (French, 1988) and the recent financial crisis (Ball, 2009). Several
studies have attributed pricing anomalies to non-fundamental variables. For instance, Black (1986) and De Long
et al. (1990) have shown that investors trade on noise rather than fundamentals. Furthermore, the presence of
investors’ underreaction and overreaction resulting in securities mispricing is given as an explanation for pricing
anomalies (e.g. De Bondt and Thaler 1985, 1987; Barberis et al. 1998; Daniel et al. 1998). 1Recently, Brown and
Cliff (2005) highlight the role of uninformed demand shocks and limits to arbitrage as a potential explanation for
security mispricing. Baker and Wurgler (2006) show that stocks that have subjective valuations and are difficult to
arbitrage are mostly affected by investor sentiment. They find that these stocks usually tend to be small, young,
highly volatile, unprofitable, non-dividend paying, extreme growth and distressed stocks.
The vast majority of empirical studies have examined time-series relationships between investor sentiment and
stock returns. These studies were mainly centred around the US market. To our knowledge, very few studies
have determined the extent of the propagation of US investor sentiment on international stock returns. As previ-
ous studies have shown that any movement in the US stock market has a significant effect on international stock
Correspondence to: Deven Bathia, School of Business and Management, Queen Mary University of London, London E1 4NS
E-mail:d.bathia@qmul.ac.uk
Copyright © 2016 John Wiley & Sons, Ltd.
INTERNATIONAL SENTIMENT SPILLOVERS IN EQUITY RETURNS 333
markets (e.g. Masih and Masih, 2001), we expect US investor sentiment to play a significant role in affecting
international stock returns. In this study, we examine the extent of spillover effects from US investor sentiment to
non-US G7 (G6, henceforth) aggregate market returns as well as value and growth stock returns. 2The dynamic
linkages between US investor sentiment and G6 stock market returns are investigated, and in doing so, it essen-
tially asks two questions. First, to what extent do changes in the US sentiment levels affect G6 stock returns, and
second, should global investors be sensitive to changes in US investor sentiment when considering non-US G7
diversification potentials.
Is it still the case that when the USA acquires a cold, the rest of the world contracts pneumonia? On the one hand
there has been a considerable increase in the degree of global integration, measured in terms of trade. This is clearly
depicted in Figure 1, which represents an increase in trade integration by over 84% in the last 23 years. Furthermore,
the role that the USA plays in global markets, as evidenced from its contribution to world gross domestic product
(GDP), also affirms the need for studying the shocks originating from the USA and its effect on other countries
(Table 1). However, the US contribution to world GDP has considerably declined over the last decade (Figure 2).
Previous studies have already shown the significant role US sentiment plays in affecting domestic US returns (e.g.
Brown and Cliff, 2005; Baker and Wurgler, 2006, 2007). Our study examines the significance of shocks from the
US sentiment on global financial markets of non-US G7 countries. As a proxy for investor sentiment, we include
both direct and indirect measures of US sentiment. Specifically, our direct measure is individual investor survey,
measured by the University of Michigan consumer confidence (UMCC), while the indirect measure adopted is
the Baker and Wurgler (2006) (BW henceforth) composite sentiment index. We study their impact on aggregate
market, value and growth stock returns of G6 countries.
Our paper contributes to the existing literature in the following areas. This is the first study that investigates
the presence of spillover effects of US investor sentiment on international aggregate market, value and growth
stock returns. To our knowledge, only Verma and Soydemir (2006) have examined the international effects of
US investor sentiment on aggregate stock returns. Verma and Soydemir (2006) include two developed economies,
the USA and the UK, and three developing South American economies, Brazil, Mexico and Chile. Our sample
includes aggregate, value and growth stock returns of G6 countries, as they represent equity markets that are highly
developed, regulated and institutionalized. Empirical evidence indicates that if stock markets across the globe are
highly integrated, then their performance should be driven by similar factors.3As our study includes stock returns
of G6 countries whose stock markets are considered to be highly developed, then the effect of the US sentiment on
international stock returns should be pronounced.
25 30 35 40 45 50
1995 2000 2005 2010 20131991
Degree of trade integration
Figure 1. Degree of trade integration for the period January 1991 to December 2013. Figure 1 reports degree of trade integration for the period
January 1991 to December 2013. Degree of trade integration is defined as the world import volume relativeto world GDP. The data are
sourced from the International Monetary Fund and the World TradeOrganization.
Copyright © 2016 John Wiley & Sons, Ltd. Int. J. Fin. Econ.21: 332–359 (2016)
DOI: 10.1002/ijfe

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