Market Sentiment and Paradigm Shifts

The equity premium forecasting literature provides ample evidence of predictability for both fundamental economic variables and non-fundamental variables, such as time-series momentum. In this paper, we study the role of investor setiment in equity premium predictability. Consistent with the theory of investor sentiment, we find that although economic variables can have strong predicting power when investor sentiment is low, their predictability tends to become insignificant when investor sentiment is high and the fundamental link between economic variables and equity premium is weakened. In contrast, the predictability of non-fundamental variables can be strong in high sentiment periods while tends to vanish away when sentiment is low and behavioural actions boosting the predictability of non-fundamental variables are moderated. Moreover, about 80% (20%) times can be classified as low (high) sentiment periods in our framework, which idicates that economic variables could be a more prevalent force than non-fundamental variables in terms of predicting equity premium