The information content of the sentiment index

The widely-used Baker and Wurgler (2006) sentiment index is strongly correlated with business cycle variables, especially the short interest rate and Lee (2011) liquidity risk factor. The power of the sentiment index to predict cross-sectional stock returns is mainly driven by its information content related to these business cycle variables. About 63% percent of the total variation in the investor sentiment index can be explained by well-known, contemporaneous risk/business cycle variables. We decompose the widely used investor sentiment index into two components: one related to standard risk/business cycle variables and the other unrelated to those variables. We show that the power of the sentiment index to predict cross-sectional stock returns is mainly driven by the risk/business cycle component, while the residual component has little significance in predicting cross-sectional stock returns.