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Investor Sentiment and the Cross-Section of Stock Returns

THE JOURNAL OF FINANCE VOL. LXI, NO. 4 AUGUST 2006 Investor Sentiment and the cross -Sectionof Stock ReturnsMALCOLM BAKER and JEFFREY WURGLER ABSTRACTWe study how Investor Sentiment affects the Cross-Section of Stock Returns . We pre-dict that a wave of Investor Sentiment has larger effects on securities whose valua-tions are highly subjective and difficult to arbitrage. Consistent with this prediction,we find that when beginning-of-period proxies for Sentiment are low, subsequent re-turns are relatively high for small stocks, young stocks, high volatility stocks, un-profitable stocks, non-dividend-paying stocks, extreme growth stocks, and distressedstocks. When Sentiment is high, on the other hand, these categories of Stock earnrelatively low subsequent FINANCE THEORY LEAVES NO ROLE FOR Investor Sentiment . Rather, thistheory argues that competition among rational investors, who diversify to opti-mize the statistical properties of their portfolios, will lead to an equilibrium inwhich prices equal the rationally discounted value of expected cash f lows, andin which the Cross-Section of expected Returns depends only on the cross -sectionof systematic if some investors are irrational, classical theory ar-gues, their demands are offset by arbitrageurs and thus have no significantimpact on this paper, we present evidence that Investor Sentiment may have signifi-cant effects on the cross -s

in rational, market-wide risk premia or time variation in the cross-sectional pattern of risk, that is, beta loadings. Further tests cast doubt on these hy-potheses. We test the second possibility directly and find no link between the patterns in predictability and patterns in betas with market returns or con-sumption growth.

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  Cross, Sectional, Sentiment, Predictability, Sentiment and the cross

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