Investor Sentiment and the Consumption Capital Asset Pricing Model

Although there are a number of empirical risk factors reported in literature, researchers still try to understand the economic risks behind these factors. In response, this paper tries to empirically verify the consumption capital asset pricing model (CCAPM) as its reputation of the theoretical completeness remains well preserved. In order to overcome empirical shortcomings of CCAPM, I examine if investor sentiment can be the conditioning information of consumption-based asset pricing model. While Lettau and Ludvigson (2001)’s conditioning variable, “cay”, no longer works on the expanded sample period, I find that investor sentiment (IS) is the conditioning variable that enables consumption capital asset pricing model (CCAPM) to explain the substantial variation of cross-section of stock returns. In addition, the conditional version of CCAPM with investor sentiment as a conditioning variable (IS CCAPM) explains better the cross-section of stock returns than Fama-French three-factor model and Fama-French five-factor model over the new set of test assets. Asset’s riskiness is determined by the correlation with consumption growth conditional on the investor sentiment.