Predictability of stock returns of financial companies and the role of investor sentiment: A multi-country analysis

• We examine the predictability power of investor sentiment on financial stock returns.
• We focus on a large panel of 20 developed countries.
• We use panel regime-switching models to take into account business-cycle variations.
• The impact of sentiment is negative in normal times and positive in crisis times.
• The sensitivity of returns to investor sentiment seems to depend on the stock type.

We investigate the role of investor sentiment in predicting annual stock returns of financial companies at the aggregate level and for a large panel of developed countries within two panel regime-switching models, with threshold and with smooth transition between regimes. We find a negative, but insignificant effect of sentiment on future returns during normal times, and a surprisingly positive and strongly significant effect during crisis times. This result could be explained by a differentiated impact of investor sentiment on specific types of stocks, as opposed to a wide horizon of stocks. We find less evidence of predictability for shorter-term financial stock returns. To the best of our knowledge, this study is the first to examine the predictability of financial stock returns within a panel regime-switching framework.