This paper investigates the influence of investor sentiment on a broad set of asset pricing anomalies. We hypothesize that when investors are optimistic, mispricing is more severe since the influence of noise traders is larger and arbitrage is more difficult with short sale constraints. As a result, the magnitude of the anomalous returns (if they are driven by mispricing) should be larger during high sentiment periods.
We show that the average returns on the long-short portfolios based on financial distress, total accruals, net stock issues, composite equity issues, net operating assets, return-to-assets, and gross-profitability-to-assets are significant only during high sentiment periods.
Furthermore, we show that business cycle variables have very low predictive power for the profitabilities of these anomalies. Finally, our results are robust to risk adjustments and different measures of investor sentiment such as Michigan Consumer Sentiment Index, Consumer Confidence Index, and the market-based sentiment index developed by Baker and Wurgler (2006).
Research Interests: Theoretical and Empirical Asset Pricing, Behavioral Finance, and International Finance
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