Trevor Young

Sentiment and Uncertainty (with Justin Birru)

Journal of Financial Economics, 146 (3), 1148-1169, 2022 

Abstract: Sentiment should exhibit its strongest effects on asset prices at times when valuations are most subjective. Accordingly, we show that a one-standard-deviation increase in aggregate uncertainty amplifies the predictive ability of sentiment for market returns by two to four times relative to when uncertainty is at its mean. For the cross-section of returns, the predictive ability of sentiment for assets expected to be most sensitive to sentiment, including existing measures of both risk and mispricing, is substantially larger in times of higher uncertainty. The results hold for both daily and monthly proxies for sentiment and for various proxies for uncertainty.

The Information Content of Aggregate Mutual Fund Alpha

Revise and Resubmit, Journal of Finance

Abstract: Recent evidence shows that mutual funds collectively buy overvalued stocks. I hypothesize that aggregate mutual fund alpha partly arises from such stocks becoming even more overvalued and thus is a measure of market overvaluation. A one-standard-deviation increase in aggregate alpha corresponds to a 0.63 percentage-point decrease in the following month’s market return, and aggregate alpha yields a monthly out-of-sample R2 of 2.79%. The predictability indeed stems from funds tilting toward overvalued stocks and small-cap or growth styles. Further consistent with overvaluation, higher aggregate alpha predicts higher anomaly returns and lower earnings surprises. The evidence is difficult to reconcile with rational explanations based on benchmarking, flow, or catering. My findings highlight a novel common component of time-varying fund performance and a new empirical fact about the usefulness of abnormal fund returns for understanding expected stock returns.

Disentangling Anomalies: Risk versus Mispricing (with Justin Birru and Hannes Mohrschladt)

Abstract: Systematic mispricing primarily affects speculative stocks and tends to take the form of overpricing, predicting lower average returns. Because speculative stocks are typically deemed risky by rational models, failing to control for exposure to systematic mispricing can bias tests of risk-return tradeoffs. Controlling for the effects of systematic mispricing, we recover robust positive risk-return relations for a large number of cross-sectional risk proxies, including many low-risk and distress anomalies. We also recover robust positive illiquidity-return relations. We provide a unifying framework to explain a number of puzzles arising from the empirical failure of standard asset-pricing models and show that risk-return relations supporting rational models can be recovered from the data by accounting for the existence of time-varying common mispricing.

The Real Effects of Sentiment and Uncertainty (with Justin Birru)

Abstract: The effects of sentiment should be strongest during times of heightened valuation uncertainty. As such, we document a significant amplifying role for market uncertainty in the relation between sentiment and aggregate investment. A one-standard-deviation increase in uncertainty more than doubles the effect of sentiment on investment. Moreover, allowing uncertainty-dependent sentiment effects substantially increases explanatory power (i.e., R2). Our results are robust to many sentiment, uncertainty, and investment measures. We also document similar effects for aggregate equity issuance. Consistent with theory, we find even stronger results in the cross-section of valuation uncertainty. The evidence suggests that the importance of sentiment for corporate decisions varies over time and depends crucially on the underlying level of market uncertainty.

Returns to Speculativeness

Abstract: Motivated by evidence that investor sentiment influences demand for speculative and non-speculative stocks, this paper examines the relation between speculativeness and expected stock returns. Measuring speculativeness as a firm’s return sensitivity to shifts in sentiment, I show that the relation between speculativeness and future returns is significantly negative. Returns differ by more than −8% per year between the average 95th and 5th percentiles of speculativeness. My findings provide support for theories in which investors tend to push the prices of speculative stocks too high and thus these stocks exhibit lower average returns. In contrast, the results suggest a lesser role for systematic sentiment risk, which implies that speculative stocks should offer higher average returns.