International Review

Review of
of Finance,
Finance, 2017
17:4, 2017: pp. 617–626
DOI: 10.1111/irfi.12120
10.1111/irfi.12120

Asymmetric Relationship between

Investors’ Sentiment and Stock
Returns: Evidence from a Quantile
Non-causality Test*
HAIQI LI†,‡, YU GUO† AND SUNG Y. PARK§
†
College of Finance and Statistics, Hunan University, Changsha, China,
‡
Department of Economics, Cornell University, Ithaca, NY, USA and
§
School of Economics, Chung-Ang University, Seoul, Korea

ABSTRACT

This study investigates the causal relationship between investor sentiment

and stock returns in the USA by conducting a quantile Granger non-
causality test. Employing two proxies for investor sentiment – the sentiment
index developed by Baker and Wurgler in 2007 and the University of Michigan
Consumer Survey, a consumer confidence index – we find that the causal rela-
tionship between investor sentiment and stock returns strengthens when a
tail quantile interval is considered. This finding implies that the investor
sentiment could provide the incremental predictability for the stock returns
under the extreme market situation, which cannot be found using a
traditional Granger causality test. Interestingly, the findings can be explained
by investors’ loss aversion and herding behavior.

JEL Codes: C12; G14; G15

I. INTRODUCTION

The relationship between investor sentiment and stock returns is an important

topic in the field of behavioral finance. A growing body of research has recently
examined the role of investor sentiment in the predictability of stock returns;
however, there is no consensus on the issue in the literature. For example, Baker
and Wurgler (2006) argued that the pattern of stock return predictability of inves-
tor sentiment varied by stock characteristic (e.g., firm size, volatility, and age).
Chung et al. (2012) found that the predictive power of investor sentiment was
generally significant in the expansionary state, but non-significant in the reces-
sionary state. Kim and Kim (2014) found no evidence concerning the return
* We would like to thank the editor and an anonymous referee for many pertinent comments and
suggestions. However, we retain the responsibility for any remaining errors. This project was sup-
ported by the National Natural Science Foundation of China (NSFC) (no. 71301048) and the Natural
Science Foundation of Hunan province in China (no. 14JJ3053).

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predictability of investor sentiment measured by Internet message postings.

Despite the vast literature on the predictability of investor sentiment regarding
stock returns, few studies explore the Granger causality (causal effect) between
investor sentiment and stock returns. Three exceptions are Brown and Cliff
(2004), Schmeling (2009), and Dergiades (2012). While Brown and Cliff (2004)
found limited evidence of Granger causality from investor sentiment to stock
returns, Schmeling (2009) demonstrated bidirectional Granger causality.
Dergiades (2012), however, found unidirectional causality from investor
sentiment to stock returns using Hiemstra and Jones’s (1994) nonlinear causality
test. This study examines the Granger causality between investor sentiment and
stock returns using the quantile causality test of Chuang, Kuan, and Lin (2009).
To the best of our knowledge, no study has adopted the conditional quantile
approach to examine the relationship between investor sentiment and stock
returns.
A quantile causality test has certain advantages over the conventional linear
and nonlinear causality tests. First, almost all linear and nonlinear causality tests
reveal causal relationships in a pre-specified order of conditional moment. For ex-
ample, Granger’s (1969) test can only deal with linear Granger causality in mean,
and Hiemstra and Jones’s (1994) test focuses on nonlinear Granger causality in
mean. The quantile causality test, however, allows us to check for a causality re-
lationship in each level of conditional quantile or over a quantile interval. Impor-
tantly, it is equivalent to the Granger causality in distribution, as pioneered by
Granger (1980), given that a conditional distribution can be expressed in terms
of conditional quantiles. Because different conditional quantiles of the stock
returns reflect various stock market states – high, medium, and low levels of
quantiles correspond to expansionary, medium, and recessionary stock market
states, respectively – the quantile causality test can reveal the heterogeneity of
causal relationship in various stock market states and investor sentiments.
Second, the quantile causality test can also be applied to investigate the causal
relationship between nonlinear and non-normal time series variables. This is
an attractive property because most economic and financial time series are
known to be nonlinear and non-normal. In the empirical analysis section, we
indeed find that investor sentiment and stock return series are nonlinear and
non-normal.
By using the quantile causality test, we find that the investor sentiment could
provide the incremental predictability for the stock markets only when the mar-
kets are in a recession or normal state rather than in a flourishing state. This
asymmetric predictability can be explained by the Kahneman and Tversky’s
(1979) prospect theory. Kahneman and Tversky (1979) found that economic
agents care more about losses than gains. In a recession market state, investors
become more pessimistic or loss averse and might deleverage or close their posi-
tions, which would cause stock prices to decline. By contrast, in an expansionary
market state, investors tend to become prudent or hesitant. Thus, it is not easy
for them to make investment decisions because bigger investments would lead
to greater losses if market conditions deteriorate.

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 Relationship between Sentiment and Stock Returns

The remainder of this paper is organized as follows. Section II presents the

quantile causality test. Section III describes data and interprets the test results.
Section IV concludes the paper.

II. CAUSALITY TEST IN QUANTILE

To examine the heterogeneity of Granger causality across different conditional

quantiles, Chuang, Kuan, and Lin (2009) proposed the Granger non-causality
test in quantiles. A random variable Z (Z = SI or CCI) does not Granger-cause an-
other random variable R in the τ-th (∀τ ∈ [a, b] , 0 < a , b < 1) quantile if the null
hypothesis
 R   R 
HQ
0 : QRt τjIt1 ; It1 ¼ QRt τjIt1
Z
(1)
holds, where QRt ðτjIt1 Þ denotes the τ-th conditional quantile of Rt given the infor-
mation set It1 ¼ IRt1 ∪IZt1 and IRt1 and IZt1 are information setups to time t  1
generated by Rt  1 and Zt  1, respectively.
To test for the Granger non-causality in quantiles from investors’ sentiment to
stock returns, we consider the following linear conditional quantile function:
X
p X
q
QRt ðτjIt1 Þ ¼ αðτ Þ þ βi ðτ ÞRti þ γj ðτ ÞZ tj ; ∀τ∈½a; b; 0 < a; b < 1: (2)
i¼1 j¼1

Based on the conditional quantile function ((2)), the null hypothesis H Q

0 can
be further represented as follows:
H 0 : γðτ Þ ¼ 0; ∀τ∈½a; b; 0 < a; b < 1
0
where γ(τ) = [γ1(τ), … , γq(τ)] . Because the quantile level τ can take continuous
values in the quantile interval [a, b], one must check the significance of the entire
quantile process of the parameter γ(τ) for τ ∈ [a, b]. The aforementioned null
hypothesis can be tested by a sup-Wald test. To formulate the sup-Wald test,
0 P
T 0
let Xt  1 = [1, Rt  1, … , Rt  p, Zt  1, … , Zt  q] , M XX ¼ T →∞ limT 1 X t1 X t1 ,
t¼1
P
T   0
Dðτ Þ ¼ T →∞ limT 1
f t1 F 1 ðτ Þ X t1 X t1 , and Ω(τ) = D(τ)1MXXD(τ)1, where
t¼1
Ft  1 and ft  1 are the distribution and density function of Rt conditional on
It  1 and T is the sample size. Suppose that Π is the q × (1 + p + q) selection matrix,
0 0
such that Π(α(τ), β1(τ), … , βp(τ), γ(τ) ) = γ(τ). The Wald test statistic for a given fixed
τ can be written by the following:
0
 1
W T ðτ Þ ¼ T^γðτ Þ ΠΩ ^ ðτ ÞΠ0 ^γðτ Þ=½τ ð1  τ Þ

^ ðτ Þ is a consistent estimator for Ω(τ). The sup-Wald test statistic is the

where Ω
supreme of WT(τ) over the quantile interval [a, b]. Empirically, we compute the
sup-Wald test statistic by partitioning [a, b] with equal steps, that is,

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supW T ¼ i ¼ 1; …; N supW T ðτ i Þ; a≤τ 1 < ⋯ < τ N ≤b:

Koenker and Machado (1999) and Chuang, Kuan, and Lin (2009) showed that

B q ðτ Þ
τ∈½a; b supW T ðτ Þ→d τ∈½a; b sup∥ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi ∥2
τ ð1  τ Þ
where Bq(τ) is a vector of q-independent Brownian bridges. The critical values for
the asymptotic distribution of the sup-Wald test can be obtained by simulating
the standard Brownian motion (Andrews 1993). Note that the critical values vary
by quantile interval and lag truncation order.

III. EMPIRICAL ANALYSIS

A. Data description
Shefrin (2008) defines investor sentiment as excess optimism or pessimism re-
garding stock performance, and it reflects the misperception noise investors have
regarding future prices. Given the lack of a direct measure for investor sentiment,
we employ two proxies: First is the monthly market-based sentiment series by Ba-
ker and Wurgler (2007; hereafter BW), and second is the consumer sentiment sur-
vey by the University of Michigan. The BW sentiment index can be downloaded
from Jeffrey Wurgler’s website.1 Data are available for 1965:7–2010:12. The index
is defined by the first principal component of residuals from a regression in
which six proxies for investor sentiment are regressed on a set of macroeconomic
variables to eliminate the effects of macroeconomic information. Drawing on
Dergiades (2012), we adopt SIt, denoting a monthly change in investor sentiment
series. The University of Michigan Consumer Sentiment Survey was first con-
ducted in 1947 on a quarterly basis for months 2, 5, 8, and 11. The monthly data
are available from 1978:1 to 2014:8 on the Survey of Consumer, University of
Michigan, website.2 For more details, see Lemmon and Portniaguina (2006). Sim-
ilar to Kadilli (2014), the consumer confidence index in this study is standardized
by subtracting the long-run mean and then dividing it by the standard deviation;
we use its monthly change denoted by CCIt. The US stock prices index
(2010 = 100) is taken from OECD’s Main Economic Indicators database.3 Stock
returns Rt are obtained as a logarithmic difference in the stock prices pt, that is,
Rt = log (pt)  log (pt  1). We chose two samples for US stock returns (Rt) to match
different samples for the sentiment (SIt) and consumer confidence (CCIt) indexes.
Table 1 summarizes the descriptive statistics for three series: Rt, SIt, and CCIt. In
light of skewness and kurtosis, three series are all skewed and highly leptokurtic.
The p-values for the normality test statistics by Jarque and Bera (1982) are all

1 http://people.stern.nyu.edu/jwurgler
2 http://data.sca.isr.umich.edu/
3 http://www.oecd-ilibrary.org/statistics

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Table 1 Summary statistics

R SI CCI
Mean 0.0051 0.000006 0.0002
Standard deviation 0.0379 0.9999 0.3064
Skewness 1.0799 0.2762 0.0476
Kurtosis 7.8209 5.1984 4.1133
Minimum 0.2547 3.6160 0.9772
Maximum 0.1193 5.4160 1.3311
Jarque-Bera 633.7036*** (0.0000) 118.6323*** (0.0000) 23.61*** (0.0000)
BDS (2, σ) 4.3770*** (0.0000) 4.3770*** (0.0000) 0.7117 (0.4767)

Notes: Jarque-Bera denotes Jarque and Bera’s (1982) normality test. BDS (m, l) is the statistics for the
linearity test of Brock et al. (1996), where m is the embedding dimension and l is the distance pa-
rameter. σ is the standard error in the series. The numbers in the parentheses are p-values for the
corresponding test statistics.***denotes significance at the 1% level.

close to 0, which further confirms that the three series are non-normally distrib-
uted. The BDS test developed by Brock et al. (1996) rejects the null hypothesis of
linearity for Rt and SIt. Therefore, two pairs of relationship all contain series that
are nonlinear and follow non-normal distributions, which necessitates nonlinear
analytical instruments.
To check whether the series are stationary, we perform three unit root tests: the
ADF test by Dickey and Fuller (1979, 1981), the PP test by Phillips and Perron
(1988), and the KPSS test by Kwiatkowski et al. (1992). The null hypothesis for
the ADF and PP is that the series have a unit root, whereas that for KPSS considers
the series are stationary. For ADF, the Akaike information criterion with a maxi-
mum lag length of 12 is used to choose the optimal lag orders. For the PP and
KPSS tests, [4  (T/100)1/4] provides us with an automatic bandwidth value needed
to compute long-run variance, where [] denotes the integer of a real number and
T is the sample size. The results for unit root tests are reported in Table 2. Clearly,
the ADF and PP tests reject the null hypothesis for three series at the 1%

Table 2 Unit root test results

ADF PP KPSS
R 14.237*** (Andrews 1993) 15.241*** 0.147
SI 7.2369*** (Andrews 1993) 22.008*** 0.097
CCI 19.903*** (5ex]3em.5pt 2007) 40.513*** 0.031

Critical values
1% level 3.44 3.44 0.7390
5% level 2.87 2.87 0.4630
10% level 2.57 2.57 0.3470

Notes: ADF and PP are the tests proposed by Dickey and Fuller (1979, 1981) and Phillips and Perron
(1988) for the null hypothesis of a unit root. KPSS is a stationarity test developed by Kwiatkowski
et al. (1992). [ ] denotes the optimal lag order by using Akaike information criterion.***Significant
at the 1% significance level.

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significance level but that of stationarity of the KPSS test cannot be rejected at the
10% significance level. Thus, the three series – Rt, SIt, and CCIt – are regarded as
stationary series.

B. Empirical results
We first study the causal relationship using the Granger (1969) test. In general,
the usual linear Granger causality test is based on the following linear
regressions:
X
p X
q
Rt ¼ α0 þ αi Rti þ γj Z tj þ εR;t (3)
i¼1 j¼1

X
p X
q
Z t ¼ β0 þ βi Z ti þ φj Rtj þ εZ;t (4)
i¼1 j¼1

where Zt = SIt or CCIt. We select the lag truncation orders p and q using the Akaike
information criterion. If the null hypothesis H m10 : γ1 ¼ ⋯ ¼ γq ¼ 0 is rejected, {Zt}
is said to Granger-cause {Rt}. If the null hypothesis H m2 0 : φ1 ¼ ⋯ ¼ φq ¼ 0 is
rejected, {Rt} is said to Granger-cause {Zt}.
Table 3 presents the test results for linear Granger causality test. When treating
the BW sentiment index (SIt) as a proxy for investor sentiment, the null hypoth-
esis of non-causality from investor sentiment to stock returns is rejected at the
5% significance level. However, in terms of consumer confidence index (CCIt),
the same null hypothesis cannot be rejected even at the 10% significance level.
In the opposite direction, the null hypothesis of non-causality from stock returns
to investor sentiment cannot be rejected at the 10% significance level, regardless
of whether the BW sentiment (SIt) or consumer confidence (CCIt) index is taken
as the proxy for investor sentiment. It is well known that the linear Granger cau-
sality test can miss the important nonlinear causal relationship. Therefore, the
lack of or weak evidence for the causal relationship can be attributed to the low
power of the linear Granger causality test when analyzing the nonlinear or
non-normal time series.
Next, we examine the causal relationship between investor sentiment and
stock returns by testing the Granger causality in quantiles. Similar to the test

Table 3 Linear Granger causality

Null hypothesis Statistic p-value
SIR 2.4345** 0.0249
RSI 0.9114 0.4862
CCIR 0.9940 0.4288
RCCI 1.0319 0.4038

**Significant at the 5% significance level.

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for linear causality, the quantile causality test is based on the following condi-
tional quantile functions:
X
q X
q
QRt ðτjIt1 Þ ¼ α0 ðτ Þ þ αi ðτ ÞRti þ γj ðτ ÞZ tj (5)
i¼1 j¼1

X
q X
q
QZ t ðτjIt1 Þ ¼ β0 ðτ Þ þ βi ðτ ÞZ ti þ φj ðτ ÞRtj (6)
i¼1 j¼1

where Zt = SIt or CCIt and τ ∈ [a, b] (0 < a < b < 1). If the null hypothesis H Q1 0 :
γ1 ðτ Þ ¼ ⋯ ¼ γq ðτ Þ ¼ 0 (τ ∈ [a, b]) is rejected, {Zt} is said to Granger-cause {Rt} in
quantile interval [a, b]. If the null hypothesis H Q2 0 : φ1 ðτ Þ ¼ ⋯ ¼ φq ðuÞ ¼ 0
(τ ∈ [a, b]) is rejected, {Rt} is said to Granger-cause {Zt} in quantile interval [a, b].
Similar to Chuang et al. (2009), for simplicity, the same lag order q for both Rt
and Zt is used. The lag order q is chosen using the sup-Wald test results. For exam-
ple, if the null hypothesis γq = 0 for τ ∈ [a, b] is not rejected under the lag-q model,
but the null hypothesis γq ≠ 0 for τ ∈ [a, b] is rejected for the lag-(q  1) model,
then we set the desired lag order q* = q  1. In addition, the null hypothesis of
H Q1 Q2
0 and H 0 can be tested using the sup-Wald test, as discussed in Section II.
Tables 4 and 5 report the quantile causality test results for the causal relation-
ship between the BW sentiment index (SIt) and stock returns (Rt) and that between
the consumer confidence index (CCIt) and stock returns. First, for causality from
the sentiment index to stock returns, the quantile causality test for the quantile
interval [0.05, 0.95] is significant at the 5% significance level. The following test
results in the sub-intervals further identify the quantile interval from which the
causality arises. In particular, the quantile causality test is significant for quantile
intervals [0.05, 0.5] and [0.05, 0.2] at the 1% significance level, but significant
for quantile intervals [0.5, 0.95] and [0.4, 0.6] only at the 10% significance level.
In particular, it is non-significant for higher quantile intervals [0.6, 0.8] and [0.8,
0.95]. It is generally believed that varying conditional quantiles of stock returns re-
flects different stock states; for example, high, medium, and low levels of quantiles

Table 4 Quantile causality test: stock returns and sentiment index

Quantile SIR RSI
interval
Lag order Statistic Lag order Statistic
[0.05, 0.95] 1 15.87** 1 4.99
[0.05, 0.5] 1 15.87*** 1 4.99
[0.5, 0.95] 3 9.95* 1 3.45
[0.05, 0.2] 1 16.05*** 2 0.99
[0.2, 0.4] 1 5.88* 1 4.99
[0.4, 0.6] 1 7.73** 1 3.62
[0.6, 0.8] 3 3.95 1 2.72
[0.8, 0.95] 2 7.45 1 3.20

*Significant at 10% significance level.**Significant at 5% significance level.***Significant at 1%

significance level.

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Table 5 Quantile causality test: stock returns and CCI

Quantile CCIR RCCI
interval
Lag order Statistic Lag order Statistic
[0.05, 0.95] 2 26.53*** 1 18.13***
[0.05, 0.5] 2 12.49** 1 12.17**
[0.5, 0.95] 2 27.28*** 1 18.70***
[0.05, 0.2] 2 12.66** 1 12.24**
[0.2, 0.4] 1 5.88* 1 6.51*
[0.4, 0.6] 1 1.80 1 5.49*
[0.6, 0.8] 1 2.86 1 8.62**
[0.8, 0.95] 2 27.28*** 1 20.89***

*Significant at 10% significance level.**Significant at 5% significance level.***Significant at 1%

significance level.

correspond to expansionary, medium, and recessionary stock market states, re-

spectively. Therefore, the results imply that the sentiment index Granger-causes
stock returns in a recessionary market state rather than an expansionary state. In
the recessionary market state, investors become more pessimistic or loss averse
and might deleverage or close their positions, which would cause stock prices to
decline. By contrast, in an expansionary market state, investors become prudent
or hesitant, and it is not easy for them to make investment decisions, because a
higher investment would lead to greater losses if market conditions deteriorate.
These results are consistent with Kahneman and Tversky’s (1979) prospect theory,
which argues that people care more about losses than gains.
As shown in the left panel of Table 5, when considering the causality from the
consumer confidence index to stock returns, the quantile causality test results
show no major difference for all but the quantile intervals [0.4, 0.6] and [0.8,
0.95]. The sup-Wald test for the quantile interval [0.4, 0.6] is non-significant at
the 5% significance level, but significant for the quantile interval [0.8, 0.95] at
the 1% significance level. This means that the consumer confidence index
Granger-causes stock returns in an extreme boom market state. In this state, in-
vestors may become over-confident, and their additional investment might cause
a sharp rise of stock prices within a short time period or even push up the market
to a bubble state.
In the opposite direction, that is, from stock returns to the sentiment index,
the quantile causal relationships are non-significant for all quantile intervals,
which is consistent with Dergiades’s (2012) findings. However, the results differ
when considering the consumer confidence index, as shown in the right panel of
Table 5. The quantile causal relationships for all quantile intervals from stock
returns to the consumer confidence index are all significant at different signifi-
cance levels. This can also be explained by investors’ loss aversion and herding
behavior. Because the dependent variable in the current quantile regression is
the consumer confidence index, the various quantile levels reflect different states
of the index. In the high quantile levels of the consumer confidence index, that
is, when investors are optimistic, increasing stock prices will give investors more

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confidence. By contrast, when investors are pessimistic, declining stock prices

will make them more pessimistic.
Our test results reveal the heterogeneity of the causality relationship under dif-
ferent stock markets states and investor sentiments. It is well known that the
presence of the causality relationship provides an incremental predictability
from one economic variable to another. Our results indicate that the stock market
returns could be predictable by using the investor sentiment only when the mar-
kets are in a recession state rather than in an expansion state and therefore reveal
the asymmetry in the predictability. This implies that the government should
pay more attention to the investor sentiment in a recession and perform the pos-
itive induction. In the literature, Chung et al. (2012) also investigated the asym-
metry in the predictive power of investor sentiment in the cross section of stock
returns across economic expansion and recession states. However, Chung et al.
(2012) adopted the NBER’s classification and separated the states of the economy
into recession and expansion regimes, which might be restrictive in practice.
This paper divides the states of the economy into several regimes automatically
by using the conditional quantile approach and avoids the artificial classification
as in Chung et al. (2012).

IV. CONCLUSIONS

In this study, we examine the causal relationship between investor sentiment and
stock returns by conducting a quantile non-causality test (Chuang, Kuan, and Lin
2009). The results depend on whether BW sentiment index or the University of
Michigan’s consumer confidence index is used as an investor sentiment proxy.
When applying the BW sentiment index, the causal relationship from investor
sentiment to stock returns exists only in the lower quantiles, whereas no causal re-
lationship exists from stock returns to investor sentiment. However, when we
adopt the consumer confidence index as a proxy, the causal relationship from
the stock return to investor sentiment becomes significant and stronger when
considering very low and high quantile levels. Because different conditional
quantiles correspond to different states of dependent variables, our test results re-
veal the heterogeneity of the causal relationship under different stock markets
states and investor sentiments. Interestingly, the heterogeneity can be explained
by investors’ loss aversion and herding behavior in behavioral finance theory.

Sung Y. Park
School of Economics
Chung-Ang University
84 Heukseok-Ro
Dongjak-Gu, Seoul
Korea
sungpark@cau.ac.kr

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