Investor sentiment indices based on k-step PLS algorithm: A group of powerful predictors of stock market returns |
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| Affiliation: | 1. Department of Mathematics and School of Economics and Management, University of Bologna, Bologna, Italy;2. Department of Economics, Society and Politics, University of Urbino Carlo Bo, Italy;3. Department of Economics, University of Bamberg, Germany;1. School of Finance, Renmin University of China, Beijing 100872, China;2. School of Management and Engineering, Nanjing University, Institute of Financial Innovation, Nanjing 210093, China;1. Department of Accountancy and Finance at University of Antwerp, Stadscampus Prinsstraat 13 S.B.329, 2000 Antwerpen, Belgium;2. College of Business, University of Akron, Akron, OH, USA;3. School of Accounting and Finance, University of Vaasa, Wolffintie 34, 65200 Vaasa, Finland;4. Department of Data Science, Economics and Finance at EDHEC Business School, 24 avenue Gustave Delory, 59057 Roubaix Cedex 1, France;1. Faculty of Business, City University of Macau, Macau, China;2. School of Business, Macau University of Science and Technology, Macau, China |
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| Abstract: | We construct a group of new investor sentiment indices by applying a new dimension reduction technique called k-step algorithm which adopts partial least squares method recursively. With the purpose of forecasting the aggregate stock market return, the new group of investor sentiment indices performs a greater ability in predicting the market return than existing investor sentiment indices in and out of sample by adequately using the information in residuals and eliminating a common noise component in sentiment proxies. This group of new investor sentiment indices beats five widely used economic variables and still has a strong return predictability after controlling these variables. Moreover, they could also predict cross-sectional stock returns sorted by industry, size, value, and momentum and generate considerable economic value for a mean-variance investor. We find the predictability of this group of investor sentiment indices comes from its forecasting power for discount rates and market illiquidity. |
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