Investor Sentiment, Disagreement and Return Predictability of Ownership Breadth

We extend theories and empirics in Chen, Hong and Stein (2002) by allowing investors subject to market sentiment to hold a biased belief in aggregate. With a dynamic multiple-asset model, we show that the ownership breadth-return relationship can be either positive or negative depending on the relative strength of two offsetting forces: (1) variation in disagreement and (2) variation in sentiment. Using sentiment index developed in Baker and Wurgler (2006, 2007), we find evidence consistent with our predictions. The stocks in the highest decile of change in breadth underperform those in the lowest decile when market sentiment variation is large. This effect is stronger among stocks that have larger exposure to market sentiment. Our unified framework can reconcile a few seemingly inconsistent empirical studies in this literature.