Sentiment cycles created by institutional investors

Investor sentiment changes all the time and moves in sometimes mysterious ways. There are several proxies for how this investor sentiment can be measured and we are understanding more and more how investors change their portfolios as sentiment changes. But in the spirit of markets being reflexive, these behavioural changes by investors in turn change market sentiment and create these sentiment cycles.

To see how this works, one can look at the sentiment index designed by Malcolm Baker and Jeffrey Wurgler in 2006. They analysed the common component of several market-based sentiment indicators like the discount/premium paid on closed-end funds, the number and returns of IPOs, the issuance of equity in the secondary market or the premium paid on companies that pay no dividend vs. dividend payers. The chart below shows the latest available sentiment data to August 2022 from Jeffrey Wurgler’s website.

Baker-Wurgler investor sentiment index

Source: Baker and Wurgler (2006)

The swings in sentiment are clearly visible. If you want to know what creates these sentiment swings you have to look at institutional and professional investors. Most of the time, we think of retail and other less sophisticated investors as ‘sentiment traders’ that follow swings in market sentiment up and down. But this study has shown that institutional investors react to sentiment swings as well and they arguably move share prices much more than retail investors can.

What the above-mentioned study shows is that when sentiment improves, institutional investors increase their investments in riskier stocks and lottery-like stocks while they reduce these investments when sentiment deteriorates. This may be a recipe for underperformance since we know that periods of high sentiment are followed by low equity returns and vice versa. So, increasing investment risk as sentiment improves means increasing investment risk as equities face deteriorating return prospects.

But not so fast. This study investigated the behaviour of institutional investors not as a function of the change in sentiment but as a function of the level of sentiment at the beginning of a pe. And it found that institutional investors increase portfolio risk when sentiment is low at the beginning of the period and reduce risk when sentiment is high.

Put these two studies together and you get a picture where institutional investors create the very sentiment swings they are trying to exploit. When sentiment is low, institutional investors increase risk in their portfolios. As they do that, they push share prices higher, particularly for the riskier and more speculative stocks in the market. This creates an increase in sentiment indicators. Once sentiment is too positive, institutional investors start reducing risk in their portfolios and drive down the prices of the risker shares in the market. This in turn creates deteriorating sentiment until sentiment becomes so low that institutional investors see buying opportunities. And so the cycle begins again. It’s like a perpetuum mobile, really.