Individual Investor Sentiment and Stock Returns - What Do We Learn from Warrant Traders?

In this paper, we propose a measure of individual investor sentiment that is derived from the market for bank-issued warrants. Due to a unique warrant transaction data set from a large discount broker we are able to calculate a daily sentiment measure and test whether individual investor sentiment is related to daily stock returns by using vector autoregressive models and Granger causality tests. We find that there exists a mutual influence of sentiment and stock market returns, but only in the very short-run (one and two trading days). Returns have a negative influence on sentiment, while the influence of sentiment on returns is positive for the next trading day. This result is mainly driven by experienced investors and investors with high levels of investor sophistication. Even though our sentiment measure circumvents several drawbacks of existing sentiment measures which are based on the closed-end fund discount, stock market transactions, the put-call ratio, or investor surveys, our results cast doubt on whether sentiment measures are useful to predict stock market returns over horizons of more than one day. Nevertheless, our analysis provides evidence on how individual investors trade and which determinants influence their expectations