A non-linear approach for predicting stock returns and volatility with the use of investor sentiment indices

Abstract

The popular sentiment-based investor index <italic>S</italic>-super-BW introduced by Baker and Wurgler (2006, 2007) is shown to have no predictive ability for stock returns. However, Huang et al. (2015) developed a new investor sentiment index, <italic>S</italic>-super-PLS, which can predict monthly stock returns based on a linear framework. However, the linear model may lead to misspecification and lack of robustness. We provide statistical evidence that the relationship between stock returns, <italic>S</italic>-super-BW and <italic>S</italic>-super-PLS is characterized by structural instability and inherent nonlinearity. Given this, using a nonparametric causality approach, we show that neither <italic>S</italic>-super-BW nor <italic>S</italic>-super-PLS predicts stock market returns or even its volatility, as opposed to previous empirical evidence.