Investor sentiment and stock prices in the subprime mortgage crisis

Abstract

As evidence from existing literature contradicts classical finance suggesting that there is room for investor sentiment in stock prices, and there is evidence that indicates a possible change in this relationship in the subprime mortgage crisis (since 2007), this article uses several methods to measure investor sentiment for both individual and institutional investors in the US, and then frees it from macroeconomic trends. The Granger-causality test is used to ensure that it is investor sentiment causing stock market price changes, and not vice versa. Changes in stock market prices are then regressed on changes in the investor sentiment data freed of macroeconomic trends. The resulting regression coefficients from before and during the crisis are compared to determine the impact the subprime mortgage crisis has had on the relationship between investor sentiment and stock market prices. Out of the five investor sentiment indexes used, only two exhibit significant causality in the desired direction (the Individual One-Year Confidence Index and the Individual Valuation Confidence Index, both from Yale). For the Individual One-Year Confidence Index, strong statistical evidence is found that the predictive power of investor sentiment over stock market prices has increased in the subprime mortgage crisis.