Investor Sentiment and Stock Returns: A Cultural and International View Tilburg University School of Economics and Management Faculty of Economics and Business Administration Department of Finance Master Thesis Finance Author: Job Andreas Eduardus Sinke ANR: 566377 Supervisor: Dr. J.C. Rodriguez Chairman: Prof. Dr. S.R.G. Ongena Date of graduation: 4 December, 2012 Investor Sentiment and Stock Returns: A Cultural and International View Job Sinke Master Thesis December 2012 Abstract: This paper examines if consumer confidence (a proxy for investor sentiment) affects expected returns internationally in 12 developed countries, looking at culture to be a possible determinant of cross-country differences. In line with earlier evidence I find that sentiment negatively forecasts aggregate stock market returns on average across countries. When investors are optimistic (pessimistic) future stock returns tend to be lower (higher). This relation holds for value stocks, growth stocks, small, mid and large cap stocks and for different forecasting horizons. Individual country results vary finding cross-country differences that can be explained by culture. This cross- sectional perspective provides evidence that the impact of sentiment on stock returns is more pronounced in countries scoring high on uncertainty avoidance, masculinity, long-term orientation and for countries that score low on individualism and indulgence, the effect of power distance is ambiguous. Keywords: consumer confidence; investor sentiment; style/size differences; cultural dimensions; predictive regressions -2- Contents 1. Introduction ......................................................................................................................................... 5 2. Theory and Hypothesis Development ................................................................................................. 7 2.1. The sentiment-return relation ..................................................................................................... 7 2.2. Cross sectional differences between different styles or sizes of stocks ...................................... 9 2.3. Culture and the sentiment-return relation ................................................................................ 10 3. Data and Descriptive Statistics .......................................................................................................... 15 3.1. General data considerations ...................................................................................................... 15 3.2. Descriptive statistics ................................................................................................................... 18 3.3. Preliminary tests ......................................................................................................................... 19 4. Predictive Regressions of Stock Returns on Consumer Confidence .................................................. 21 4.1. Methodology .............................................................................................................................. 21 4.2. Results for panel regressions ..................................................................................................... 22 4.3. Results for individual countries .................................................................................................. 24 4.4. Cross-sectional analysis .............................................................................................................. 26 4.5. Relation of results to earlier studies .......................................................................................... 27 4.6. Discussion ................................................................................................................................... 30 5. Conclusion ......................................................................................................................................... 31 6. References ......................................................................................................................................... 32 7. Appendices ........................................................................................................................................ 39 7.1. Appendix I. Different proxies for investor sentiment ................................................................ 39 7.2. Appendix II. Details on consumer confidence surveys ............................................................... 41 7.3. Appendix III. MSCI indices construction methodology............................................................... 42 7.4. Appendix IV. Discussion of Hofstede’s his dimensions .............................................................. 43 7.5. Appendix V. Tables ..................................................................................................................... 44 -3- Tables Table 1. Countries used in the study ..................................................................................................... 44 Table 3. Descriptive statistics ................................................................................................................ 46 Table 4. Descriptive statistics ................................................................................................................ 47 Table 5. Correlations between cultural dimensions.............................................................................. 48 Table 6. Panel unit-root tests ................................................................................................................ 48 Table 7. Granger-causality tests ............................................................................................................ 48 Table 8. Consumer confidence correlations .......................................................................................... 49 Table 9. Sentiment coefficient in long-horizon regressions .................................................................. 49 Table 10. Sentiment significance in long-horizon regressions .............................................................. 50 Table 11. Economic magnitude of the sentiment effect ....................................................................... 51 Table 12. R-squares of sentiment regressions ...................................................................................... 52 Table 13. Return predictability for individual countries across horizons .............................................. 53 Table 14. “Crisis” joint significance ....................................................................................................... 55 Table 15. Sentiment coefficient in long-horizon regressions: behavioral panels ................................. 56 Table 16. Sentiment significance in long-horizon regressions: behavioral panels ................................ 57 Table 17. Cultural joint significance ...................................................................................................... 58 -4- 1. Introduction The global stock market crash of 2007 and 2008 was an exceptional event. The MSCI World index of developed markets fell approximately 50 percent in dollar terms. Emerging markets fell even further. Individual country indices displayed falling returns, but with varying percentages. Such an event is often hard to explain by classical theories even ex post. The classical theories try to rationalize investor behavior, but in times of crisis this turns out to be difficult if not impossible. Behavioral finance rejects this neoclassical “economic” man or “rational” investor and recognizes investors to be “normal”. In this field the unbounded rationality is replaced by the observation of empirically established rationality defects. Or in other words behavioral finance is no longer based on the rationality of investors but accepts people, investors to behave different, normal, or irrational at times. Behavioral finance assumes this “bounded rationality” to be valid for most countries (Levinson and Peng, 2007). However, as seen in the MSCI World Individual country indices countries vary, cultures vary and cultural finance supports the diverging relevance of certain behavioral patterns between countries. Statman (2008) finds rationality to defect but in various magnitudes across countries. A stock market crash can therefore be explained by the behavioral approach. This field of research has recently attracted much interest, given the realization that investors might not behave “rational” after all. While the behavioral approach becomes more common, little attention has been paid to culture affecting finance. Guizo, Sapienza and Zingales (2006) document that culture may significantly affect economic outcome. One might wonder if finance is affected as well. More recently a field called “cultural finance” has established itself, which was named by Breuer and Quinten (2009). Existing economical and financial literature were reluctant to include cultural influences on financial questions for a long time. Values have been taken as given and culture is treated as a “black box” (Williamson, 2000). This reluctance to include culture comes from its definition and from methodological challenges when trying to operationalize culture. The absence of sufficient theoretical foundation can also explain the scarcity of research in this area. Recently culture is starting to gain interest of academics leading to papers with culture as the main