“Uncertainty is the only certainty.” The maxim is most commonly applied to stock markets. As Indian markets have demonstrated in recent times, volatility makes stock markets extremely difficult to predict. A new National Bureau of Economic Research paper by Samuel P. Fraiberger of World Bank, and others, however, suggests that there may be one important cue: News sentiment.
Using a data set of more than 4.5 million Reuters articles published across the globe between 1991 and 2015, the authors show that media sentiment is an important predictor of daily stock returns in both emerging and advanced markets. The authors construct a daily news-based sentiment index for 25 advanced and emerging countries, which uses the fraction of positive and negative words in media reports, to capture the sentiment of news.
They then analyse the response of equity prices to sentiment shocks.
They find that an increase in optimism in local news predicts a short-run increase in local stock returns while more pessimistic news is associated with a temporary decrease in local returns. To isolate the effect of local news from that of global news, the authors recompute the sentiment index for each country after excluding articles that mention other countries. They find that changes in global news sentiment have a more robust and permanent impact on equity returns around the world.
More optimistic global news increases stock returns and vice-versa.
According to the authors, these effects on stock returns occur mainly through foreign investors rather than local investors.
They also find that the global news sentiment index explains more of the variance in global equity returns than other measures of volatility such as the Volatility Index, VIX, which captures market expectations of fluctuations in the stock market.
The authors find that local news and their tone mainly influences foreign investor sentiment, with more positive news increasing local returns in the short run.
Over the long term, optimistic global news attracts permanent inflows and has a stronger impact on returns. Interestingly, the impact of global news sentiment is found to be four times stronger in global “bear” markets than in global “bull” markets, suggesting that investors are more sensitive to the news tone during global market downturns.
They also find that media coverage varies significantly with the direction of the global news sentiment index. When the global news sentiment index is strongly positive, it is because the media focuses more on positive financial and corporate news in advanced economies, especially in the US. By contrast, when the index is negative, this is more a result of media reports of economic and political news in emerging markets.