A Dynamic Model of Stock Market Sentiment

We propose a dynamic measure of stock market sentiment, extending heavily the widely adopted Baker and Wurgler (2006) market sentiment index construct on the novel basis that (1) the aggregate market sentiment must cover as many views from different investors or investment activities as possible; (2) such aggregation must adapt to changes in how different sentiment indicators mutually express sentiment, i.e. their co-movements, which evolve dramatically over time; and (3) the aggregation must not be informed by future information, so that a resultant sentiment index is usable in empirical analyses without forward looking bias. We demonstrate that each basis has a substantial impact on the model value of the index. Using our new index, we find the significant impact of market sentiment on stock market anomaly portfolio returns has been largely priced in since 2000