Dependence matters! Investor sentiment and stock returns: A sliced inverse regression approach

Abstract We construct a new investor sentiment index by exploiting the information of the sentiment proxies with the sliced inverse regression approach. We show that the new index is a strong negative predictor of future aggregate stock returns in both in‐sample and out‐of‐sample tests. Further evidence indicates that the new sentiment index generates large utility gains for a mean‐variance investor who optimally allocates between equities and risk‐free assets. In addition, we show that this sentiment index exhibits the strongest return predictability for portfolios sorted on size, value, momentum, and industry.