How market sentiment and fundamental factors interact in driving stock-return expectations

Difficulty in connecting monthly movements in aggregate stock prices to changes in dividends and interest rates has been widely documented. In contrast, attempts to examine the high frequency effect of earnings announcement surprise in micro-level data has found more success. In this paper, we find clear effects from simple measures of monthly dividend and interest rate news on the S&P 500. However, this is only the case when interacting the fundamental news with measures of market sentiment. The market sentiment is measured through a textual analysis from the Wall Street Journal. More specifically, we find significant increases in stock returns when "good" fundamental news coincides with optimistic sentiment, and when adverse fundamental news coincides with pessimism. We define optimism or pessimism as whether sentiment exceeds or falls below certain thresholds. The results are robust with thresholds of the 15^th, 25^th, 40^th, and 50^th percentile. We measure interest rate news as the change in interest rates, and dividend news as whether dividend growth is above or below (the sample) average. For robustness, we also use a step indicator saturation procedure to allow for a changing average (expected) dividend growth rate across sub-samples. The results are robust to measuring news relative to this changing mean. The interactions between sentiment and fundamentals are significant when examining both ex post returns and survey forecasts of returns from Investors Intelligence. We estimate the model with interactions using ordinary least squares (OLS) with Newey-West standard errors. Survey data on investors' forecasts allows one to circumvent some of the "joint hypothesis" challenges inherent in testing financial theories. The significant interaction supports the idea that it is important to account for the "narratives" in the market, but in a particularly unique way here. Further, these interactions may account for some of the structural change documented in other asset pricing studies.