Can Investor Sentiment Help Explain Stock Market Crises

Traditional financial theory, assuming rationality and stock market prices justified by fundamentals, has failed to explain the occurrence of several large stock market crises. Theories in behavioral finance suggest stock market overvaluation, eventually leading to stock market crises, partly occur due to noise trading. In this thesis, noise is captured through investor sentiment with the purpose of investigating the relationship between stock market crises and investor sentiment. Individual investor sentiment is the general optimism or pessimism towards the present and future economy among individual investors. To proxy the individual investor sentiment Consumer Confidence Indices have been used. Results, from logit and OLS models, show that an increase in investor sentiment optimism seems to increase the probability of stock market crises occurring on four major stock markets. Further, the effect of investor sentiment explaining stock market returns seems to have been larger during the subprime mortgage crisis than during the dot-com bubble.