Corporate executives, by their nature, are glass-is-half-full kind of people. “Onward and upward” and “can do” are their mottos and they tend to put a positive spin even on bad news.
But too much optimism from CEOs, CFOs and other top managers can be a warning sign for investors, according to research by Poets&Quants’ Professor of the Week, Xiumin Martin of the Olin Business School of Washington University in St. Louis.
Her paper, “Manager Sentiment and Stock Returns,” which she co-wrote with Olin colleague Guofu Zhou, Fuwei Jiang of Central University of Finance and Economics in Beijing, China, and Joshua Lee of the University of Georgia, is slated for publication in the Journal of Financial Economics.
THE NEGATIVE RELATIONSHIP BETWEEN SENTIMENT & FUTURE STOCK PRICES
“We ﬁnd a negative predictive relationship between manager sentiment and subsequent future stock returns at both the aggregate level and at the ﬁrm level over longer horizons,” Martin and her co-authors write.
To track and quantify managers’ sentiment, the authors pored through 113,000 transcripts of conference calls from almost 6,000 firms from January 2003 through December 2014. They also sifted through 264,335 10K annual reports and 10Q quarterly reports filed by more than 10,000 firms with the Securities and Exchange Commission (SEC) over the same time period.
The researchers calculated the “tone” of these calls and statements by subtracting negative from positive terms and then compiled a monthly index based on the average ‘tone” of both the conference calls and the SEC filings. They tracked what happened to stocks in the period that followed each index reading to measure the subsequent impact of managers’ statements on share prices.
MANAGERS TEND TO BE OVERLY OPTIMISTIC
“We find that periods with high manager sentiment are accompanied by high aggregate investment growth in the short run-up to three quarters, but low subsequent aggregate investment growth in the long run-up to two years,” the researchers write. “Our findings indicate that high manager sentiment captures managers’ overly optimistic beliefs about future returns to investment which leads to overinvestment.”
In addition, Martin and her co-authors found that periods of high optimism among corporate managers—such as during the dot.com boom or the mid-2000s housing bubble—are often followed by pendulum swings in the other direction. Similarly, periods in which managers are more cautious or pessimistic (such as during the financial crisis a decade ago) usually precede stock market rallies.
“Manager sentiment, similar to investor sentiment, peaks (troughs) in advance of weak (strong) stock market performance,” Martin and colleagues write. Or, as Warren Buffett put it, “Be greedy when others are fearful and fearful when others are greedy.”
THE PREDICTIVE POWER ON AN INDEX
Reviewing the historical performance of their index, the researchers found that “its predictive power is far greater than commonly-used macroeconomic variables, and it outperforms existing investor sentiment measures.”
As an investing tool, the monthly manager sentiment index would have a Sharpe ratio (a measure of risk-adjusted return) of 0.17, the authors calculated. That’s higher than the market’s Sharpe ratio of -0.02, they wrote, suggesting that at least in the past, using this manager sentiment index consistently (and in a contrarian manner) would have produced higher risk-adjusted returns than buying an index fund.
Martin, 47, is a professor of accounting and chair of the accounting department at Olin. Her research focuses on disclosure issues, financial accounting, and how accounting affects asset valuation. She teaches classes in Accounting Policy and Research for both doctoral and master’s degree students.
Having earned her bachelor’s degree from Nanjing University in China and her master’s from Hong Kong Baptist University, Martin got her Ph.D. from the University of Missouri in Columbia, Mo. She has taught at Olin since 2011. Before entering the Ph.D. program at Missouri, she worked as an auditor for three years at Deloitte Touch Tohmatsu in Shanghai.