The relationship between investor sentiment and stock returns: A comparative analysis on G7 and emerging countries

Conventional financial theories assert that investors are rational and financial markets are efficient. However, there are plenty of research showing that the models presented by conventional financial theories do not reflect the reality. This phenomenon has led to the start of a new era in financial literature which was called "Behavioral Finance" at the beginning of 1980s. Empirical findings revealed that the movements of prices in financial markets can be explained by investors' beliefs and attitudes, perceptions and sentiments; and made "investor behavior" one of the mostly studied and discussed subjects in this area. This dissertation mainly aims to explore the relationship between investor sentiment and stock market index returns in G7 and E7 countries. In this respect, the effect of investor sentiment on stock market returns are investigated in 14 countries, namely, Germany, United States of America, France, United Kingdom, Italy, Japan (G7), Brazil, China, Indonesia, India, Mexico, Russia and Turkey (E7) between the period of January 2004 – August 2016. Monthly and daily data are used and both time series and panel data methods are employed in the research. Consumer confidence index, stock market turnover ratio and VIX fear index are considered as investor sentiment proxies. In the first part of the research, the model representing the relationship between investor sentiment and stock market returns is analyzed by using monthly data and employing ordinary least squares and ARCH (1) methodologies. In the second part, the same model is predicted for G7 and E7 countries by employing Driscoll-Kraay fixed effect panel data regression method. In the third and fourth parts, the same analyses are made by using daily data. Findings of the research indicate that the model representing the relationship between investor sentiment and stock market returns is statistically significant at 95% confidence level. The results obtained both in time series and panel data analyses assert that investor sentiment has a considerable and statistically significant impact on stock returns in global financial markets. Keywords: Behavioral finance, investor behavior, investor sentiment, stock market index return, developed (G7) and emerging (E7) countries, time series analysis, panel data analysis.