Investor Sentiment and Paradigm Shifts in Equity Premium Forecasting

Applying Baker and Wurgler’s investor sentiment index as a switch, we find that fundamental economic variables forecast the equity premium well only when sentiment is low. They lose their predictive power when sentiment is high, since their fundamental links with the equity premium become weakened. In contrast, non-fundamental variables predict the equity premium well only when sentiment is high but not when it is low, since their performance relies on behavioral biases that become reduced during low-sentiment periods. This sheds some light on the recent debate about the limited power of both fundamental and non-fundamental variables to forecast the equity premium. JEL classifications: C53, G02, G12, G14, G17