Buffett was Right About Sentiment and the VIX as Predictors of Returns

larry swedroeIn his 2004 letter to Berkshire shareholders, Warren Buffett advised investors: “If they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.” New research confirms Buffett’s admonition.

Academic research on the role of investor sentiment in stock returns, including the 2006 study, “Investor Sentiment and the Cross-Section of Stock Returns,” the 2012 studies, “Global, Local, and Contagious Investor Sentiment” and “The Short of It: Investor Sentiment and Anomalies,” the 2020 study, “Investor Sentiment: Predicting the Overvalued Stock Market,” and the September 2022 study, “A New Firm-level Investor Sentiment,” has found that investor sentiment plays a significant role in market volatility, generating predictability consistent with the correction of investor overreaction. Research also has found that total sentiment is a contrarian predictor of market returns – high investor sentiment predicts low future returns and vice versa. The effect of sentiment is greater on hard-to-arbitrage stocks (due to greater costs and greater risks) and hard-to-value stocks (small-cap, high return volatility, growth and distressed stocks) – stocks that exhibit high “sentiment beta.”

Other research, including the 1987 study, “Expected Stock Returns and Volatility,” by Kenneth French, William Schwert and Robert Stambaugh, has found that stock market returns are negatively related to the unexpected change in the volatility of stock returns. This relationship results in the tendency to produce negative equity returns in times of high volatility – greater-than-expected volatility leads to negative stock returns because investors demand a higher risk premium to compensate them for the greater risk. The result is that the discount rate used to value future cash flows increases, lowering prices. Thus, there is a negative relationship between future returns (as the equity risk premium investors demand increases) and unexpected increases in volatility.