The Association Between Investor Sentiment and Returns of Chinese Stock Market Under Different Market States

School of Finance, Nankai University, Tianjin, 300350, China

^* Corresponding author: 2213220@mail.nankai.edu.cn

Abstract

The dynamic relationship between investor sentiment and stock returns in Chinese market is examined in this study and compared under two different market states, bull market and bear market. Applying principal component analysis, this paper extracts principal components from different market indicators to construct a composite index representing current investor sentiment, and a Vector autoregressive model is built to capture the bidirectional correlation. The result shows that investor sentiment exhibits persistence in bull markets, and lagged sentiment significantly strengthens current sentiment. In bear markets, sentiment volatility increases with prior negative sentiment exacerbating the current downtrend. However, the direct impact between investor sentiment and market return is not significant in both cases. The innovation of this paper is to incorporate market state heterogeneity into behavioral finance analysis, and help investors further understand the trading characteristics of Chinese stock market, which is still immature. The findings of this paper suggest that regulators should strengthen the tracking of market sentiment, curb overheated sentiment in a timely manner during bull market phases and adopt policy measures to mitigate panic selling during bearish phases.