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Quantitative Finance
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A principal-component approach to measuring

investor sentiment
a b b
Haiqiang Chen , Terence Tai-Leung Chong & Xin Duan
a
Department of Economics , Cornell University , Ithaca, NY 14853, USA
b
Department of Economics , The Chinese University of Hong Kong , Shatin, N.T., Hong
Kong, People's Republic of China
Published online: 04 Jan 2010.

To cite this article: Haiqiang Chen , Terence Tai-Leung Chong & Xin Duan (2010) A principal-component approach to
measuring investor sentiment, Quantitative Finance, 10:4, 339-347, DOI: 10.1080/14697680903193389

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 Quantitative Finance, Vol. 10, No. 4, April 2010, 339–347
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A principal-component approach to measuring

investor sentiment
HAIQIANG CHENy, TERENCE TAI-LEUNG CHONG*z and XIN DUANz
yDepartment of Economics, Cornell University, Ithaca, NY 14853, USA
zDepartment of Economics, The Chinese University of Hong Kong, Shatin, N.T., Hong Kong,
People’s Republic of China

(Received 18 December 2007; in final form 6 July 2009)

1. Introduction based on the buy–sell imbalance and show that it has

The usefulness of the investor sentiment measure in the
stock market has received increasing attention in recent
years. Various measures of investor sentiment have been
proposed over the last two decades. Early studies, such as
Lee et al. (1991), Swaminathan (1996) and Neal and
Wheatley (1998), use closed-end fund discounts as a proxy
for market sentiment. Since both closed-end funds and
small stocks are mainly owned by individual investors, the
sentiment affects the returns of small stocks in the same
way as it influences closed-end funds. Otoo (1999) studies
the survey-based Michigan consumer confidence index
and finds a strong positive relationship between consumer
sentiment and stock prices. Kumar and Lee (2002)
construct a measure of individual investor sentiment
incremental explanatory power for small stocks, value
stocks and stocks with low institutional ownership.
Fan and Yao (2003) propose a composite index which
contains the information of various market indicators.x
Brown and Cliff (2004) use a vector autoregressive
framework to explain the mutual influence between the
sentiment measure, market returns and volatility. It is
shown that investor sentiment measures have little
explanatory power for short-term stock returns. Baker
and Wurgler (2006) construct a measure of stock market
sentiment based on the common variation of the
closed-end fund discount, NYSE share turnover, the
number of IPOs, the average first-day returns on IPOs,
equity share in new issues and dividend premium. They
show that stocks with highly subjective valuations and

*Corresponding author. Email: chong2064@cuhk.edu.hk; Homepage: http://www.cuhk.edu.hk/eco/staff/tlchong/tlchong3.htm

xOther composite measures have also been studied in the literature. For example, the El Paso index of coincident economic activity
compiled by the Federal Reserve Bank is based on non-agricultural employment, unemployment rate, inflation-adjusted wages and
inflation-adjusted retail sales. Weymark (1998) constructs an exchange market pressure index (EMP) to measure the exchange
market pressure.
Quantitative Finance
ISSN 1469–7688 print/ISSN 1469–7696 online ß 2010 Taylor & Francis
http://www.informaworld.com
DOI: 10.1080/14697680903193389
 340 Feature

13000
Index
7000
1998 1999 2000 2001 2002 2003 2004 2005 2006
Time
0.1
Return
0
−0.1

1998 1999 2000 2001 2002 2003 2004 2005 2006

Time
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Figure 1. The daily Hang Seng Index and its return series.

high arbitrage costs exhibit low subsequent returns if the
initial investor sentiment is high. Wang et al. (2006) study
two sentiment indicators based on the surveys of the
American Association for Individual Investors and
Investors Intelligence and show that the sentiment mea-
sures are affected by the realized volatility and returns.y
In this paper, we endeavour to construct a comprehen-
sive market sentiment measure for the Hong Kong
stock market. The method is similar to Baker and
Wurgler (2006), who study the sentiment of the US
stock market using monthly data. Compared to the US
stock market, the Hong Kong stock market is much
smaller and its market sentiment is easily affected by
events occurring in China and other Asian countries. In
our paper, daily data are used in order to capture the
rapid change of sentiment. Factors under consideration
include the short-selling volume, the Hong Kong
Inter-bank Offered Rate (HIBOR), Relative Strength
Index (RSI), Money Flow Index (MFI), the performances
of the US and the Japanese equity markets, and market
turnover (Liu 2006). The stock market sentiment index is
defined as the first principal component obtained from a
Principal Component Analysis (PCA). The new measure
is applied to classify the market states of Hong Kong
using a threshold model framework. The out-of-sample
forecasting performance of our model is evaluated and a
profitable sentiment based trading rule is proposed.
The paper is organized as follows. Section 2 constructs
a new sentiment index via the principal-component
approach. A threshold model is estimated in section 3
to uncover the underlying states of the Hong Kong stock
market. Section 4 evaluates the out-of-sample forecasting
performance and the profitability of our trading rule.
Section 5 is the conclusion.
2. Stock market sentiment
2.1. Variables of interest
Observations of daily prices and turnover of the Hang
Seng Index from January 1998 to August 2006 are
obtained from DataStream. The return series, which is
defined as the log difference of the index, is plotted in
figure 1.
A new measure of market sentiment based on the
principal component of the following factors will be
developed.
2.1.1. Turnover. The market sentiment can be observed
from the turnover of the market. Ying (1966) finds that a
small turnover is typically followed by a fall in price while
a large turnover is associated with a rise in price. In
general, the turnover is high in bull markets and low in
bear markets (Karpoff 1987). Thus, the turnover infor-
mation is an important component of our sentiment
measure. We define a turnover ratio as follows:
VMA10t
Ravt ¼ 100  , ð1Þ
VMA250t
where VMA250t is the average turnover for the past 250
trading days, while VMA10t is the average turnover for
the past 10 days.z The Rav series is shown in figure 2.
2.1.2. Short selling. Figlewski (1981) studies the rela-
tionship between the level of short interest and subse-
quent stock returns. He argues that abnormal returns are
often due to temporary sentiment brought about by
short-selling activities around the event dates. Thus, we

yOther studies on market sentiment include Baker and Stein (2004), Qiu and Welch (2004), Bodurtha et al. (1995), Barberis et al.
(1998), Clarke and Statman (1998) and Cornelli et al. (2006).
zThe 10-day average is used for smoothing, while the 250-day average is usually used to differentiate between bull and bear markets.
 Feature 341

Turnover

40000
250 average line

0
1998 1999 2000 2001 2002 2003 2004 2005 2006
Time
2
Rav

1
0

1998 1999 2000 2001 2002 2003 2004 2005 2006

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Time

Figure 2. The turnover and Rav.

2.1.3. Interest rate. The Hong Kong Inter-bank Offered

0.35

Rate (HIBOR) reflects the cost of investments. When the

HIBOR is high, investors will leave the stock market. An
0.30

increase in HIBOR also increases the cost of investment

and hence lowers the profits of firms, which will eventually
0.15 0.20 0.25

be reflected in their share prices. Thus, a high HIBOR is

Short sell ratio

considered as a bearish signal. The daily HIBOR obtained

from the CEIC database is plotted in figure 4.
0.10

2.1.4. RSI and MFI. The Relative Strength Index (RSI)

is a popular market indicator showing whether the
0.05

market is oversold or overbought. An RSI of 80 implies

that the market is overbought, while an RSI of 20
0.00

implies the market is oversold. The 14-day RSI is one of

the most commonly used RSIs in the market. It is
1998 1999 2000 2001 2002 2003 2004 2005 2006 defined as follows:
Time

Figure 3. The short sell ratio. P14

also include a short-selling proxy in our sentiment
measure. We define the daily short-selling turnover ratio
as the number of shares being short sold to the total
number of shares traded.
short sell volt
SRt ¼
turnovert
The data on the short-selling volume are available from
the CEIC database. Figure 3 plots the short-selling
turnover ratio.
ðPti  Pti1 Þþ
RSIð14Þt ¼ 100  Pi¼1
14
, ð3Þ
i¼1 jPti  Pti1 j
where (Pti  Pti1)þ ¼ Pti  Pti1 if Pti  Pti140,
and ¼ 0 otherwise.
Apart from RSI, we also include the Money Flow
: ð2Þ
Index (MFI) in our sentiment measure. The money flow
index is an oscillator ranging from 0 to 100. A value of
80 indicates an equity is overbought while a value of 20
implies the equity is oversold.y The MFI contains
information of both price and turnover. A divergence
between the movements of MFI and price suggests a
possible market reversal.z To construct the MFI, we

ySee, for example, http://www.chartfilter.com/reports/c25.htm.

zFor instance, if the price of a stock makes a new rally high but the MFI high is less than its previous high, it indicates that the
market trend is likely to reverse.
 342 Feature

0.2
HIBOR
0.1
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0.0

1998 1999 2000 2001 2002 2003 2004 2005 2006

Time

Figure 4. The HIBOR.

first define MFI

Positive Money Flow
high þ low þ close ¼ 100  :
Typical Price ¼ : Positive Money Flow þ Negative Money Flow
3 ð6Þ
The daily typical price is the simple average of daily
2.1.5. The performance of the US and Japanese equity
high, low and close prices. The money flow is
defined as markets. To examine how the performance of the
world’s two largest stock markets affect the Hong Kong
Money Flow ¼ Typical Price  Turnover: market, the returns of the S&P 500 index and the
NIKKEI 225 (as shown in figure 6) are included in our
If the typical price today is higher than that of sentiment measure.
yesterday, then today’s money flow is considered as After taking the time-zone difference into consider-
positive money. The total money flow over N days is ation, we define the rate of return of the two markets at
computed. In this paper, we set N ¼ 30, and the sum of all time t as follows:
positive money in the previous 30 days is defined as the
SPt ¼ ln S&Pt1  ln S&Pt2 ,
positive money flow. Define
JAPt ¼ ln NIKt  ln NIKt1 :
Positive Money Flow 2.2. Estimation results
Money Ratio ¼ : ð4Þ
Negative Money Flow
The descriptive statistics of our factors of interest are
The money flow index is calculated as follows: reported in table 1.
For each t, we let SMSt be the stock market sentiment
100 index, which is defined as the first principal component of
MFI ¼ 100  : ð5Þ the aforementioned factors. The principal component is
1 þ Money Ratio
estimated by using the Hmisc package of the R statistical
It can also be expressed as program. Our result shows thaty

yThe estimates reported in equation (7) are obtained by converting the original estimates from the standardized model, which is
estimated by applying the PCA to the standardized variables subject to the constraint that the vector of the estimates is of unit
length.
 Feature 343

80
RSI

40
0
1998 1999 2000 2001 2002 2003 2004 2005 2006
80 Time
MFI30

40
0

1998 1999 2000 2001 2002 2003 2004 2005 2006

Time
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Figure 5. RSI and MFI.

0.05
NIKKEI 225 return
−0.05

1998 1999 2000 2001 2002 2003 2004 2005 2006

Time
0.05
S&P 500 return
−0.05

1998 1999 2000 2001 2002 2003 2004 2005 2006

Time

Figure 6. Market index return series of Japan and US.

Table 1. Descriptive statistics of factors. Note that the turnover variable is positively related to
market sentiment. Both the RSI and MFI positively affect
Mean Median SD
the sentiment index. The HIBOR is negatively associated
Rav 1.118 1.006 0.368 with the sentiment index. An increase in the short-selling
RSI 52.51 52.39 18.26 activities will lower the market sentiment. The perfor-
MFI 53.44 54.17 11.17
HIBOR 0.030 0.031 0.021
mance of the US and Japanese markets has a positive
SR 0.037 0.033 0.021 relationship with the Hong Kong stock market sentiment.
SP 0.0001 0.000 0.012 The sentiment index is plotted in figure 7.
JAP 0.0002 0.000 0.014

3. Threshold classifications of the Hong Kong

stock market
SMSt ¼ 4:90 þ 1:23Ravt þ 0:03RSIt þ 0:05MFIt
 1:03HIBORt  16:79SRt þ 18:74SPt Our sentiment measure can be used to define stock
þ 14:77JAPt : ð7Þ market states. It has long been a common practice to
classify a stock market into bull and bear states.
 344 Feature

3
2
1
0
SMS
−1
−2
−3
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−4

1999 2000 2001 2002 2003 2004 2005 2006

Time

Figure 7. The market sentiment index from 1999 to 2006.

However, there is no definitive method in the literature where yt is defined as 100 ln(Pt/Pt1), and SMSt1 is the
on how to obtain the market cycles. Fabozzi and threshold variable. For forecasting purposes, SMSt1 is
Francis (1977) and Kim and Zumwalt (1979) define a constructed from the past data at time t. fi()
bull market as a period when returns in any given are well-defined functions such that fi() 6¼ fj () for i 6¼ j,
month exceed a certain threshold value. Recently, the i’s are finite-dimensional parameters, it denotes
Pagan and Sossounov (2003) define the bull and bear noise terms and  1, . . . ,  n are threshold values. According
states based on cumulative price changes. Lunde and to the results in the previous section, the SMS varies
Timmermann (2004) obtain the bull and bear states via approximately from 4 to 4. Two threshold values are
a filter that tracks the movements between local peaks detected in this range using the method of Tsay (1998).
and troughs. In this paper, we use our new sentiment Thus, the model can be written as follows:
8
measure to define the stock market cycle of Hong >
> a0 þ a1 yt1 þ a2 yt2
Kong. The following multivariate threshold model >
>
>
> þ    þ ap1 ytp1 þ 1t if SMSt1  1
>
>
(Tsay 1998, Bai et al. 2007) using the stock market >
< þ  y þ  y
sentiment index as the threshold variable will be 0 1 t1 2 t2
yt ¼
estimated to capture the nonlinear movement of the > þ    þ p2 ytp2 þ 2t if 1 5 SMSt1  2
>
>
>
stock index.y >
> 0 þ 1 yt1 þ 2 yt2
>
>
8 >
:
> f1 ðyt1 ,yt2 ,.. .; 1t j1 Þ, if SMSt1  1 þ    þ p3 ytp3 þ 3t if 2 5 SMSt1 :
>
>
< f ðy ,y ,.. .;  j Þ, if  5SMS   ð9Þ
2 t1 t2 2t 2 1 t1 2
yt ¼ ð8Þ
>
> ... We apply the model to the daily Hang Seng Index. The
>
:
fn ðyt1 ,yt2 ,.. .; nt jn Þ, if n 5SMSt1 : sample period is from 26 January 1998 to 21 August 2006.z

yA growing body of studies has examined the nonlinearity of stock prices. For example, Tong (1983) applies the STAR model to the
movement of the IBM stock price. Li and Lam (1995) investigate the asymmetric behaviour of stock prices in bear and bull markets
by using a threshold type ARCH model. Recently, Shively (2003) employs a three-regime threshold random-walk model to explain
the movements of stock market indices.
zThe first 250 observations are used to construct the moving average, while the last 200 observations are for the out-of-sample
forecast evaluation. The number of observations for estimation is 1666.
 Feature 345

19
17
15
13
11
9
7 HSI
Index

SMS
3
1
−1
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−3
−5
−7
−10

1999 2000 2001 2002 2003 2004 2005 2006

Time

Figure 8. Hang Seng Index and market sentiment Index from 1999 to 2006.

Table 2. The threshold test result. Both threshold values are significant at the 5% level
Threshold value 0.92 1.47 since the observed test values are larger than their
Observed test value 16.47 27.01 bootstrap critical values. Based on the estimation results,
Bootstrap critical value 9.94 16.58 the stock market is classified into three regimes. A com-
**significant at the 5% level. parison of our sentiment index and the Hang Seng Index
is shown in figure 8. The two extreme market states
determined by the threshold values are shaded. It can be
The estimation result is as follows: seen from figure 8 that when the Hang Seng Index is rising
yt (falling), the value of the sentiment index is generally high
8 (low).
>
> 0:13  0:094yt1
>
>
>
>  0:037yt2
>
>
>
> þ 0:09yt3 þ 1t if SMSt1  0:92
>
>
>
> 0:05 þ 0:1yt1 4. Predictive ability
>
>
>
>
> þ 0:0005yt2
>
>
< þ 0:067y The significance of our results is demonstrated via the out-
t3
¼ of-sample forecasting performance of the threshold model
>
> þ 0:02yt4
>
> and the profitability of a sentiment-based trading rule.
>
> 0:053yt5 þ 0:05yt6
>
>
>
> þ 2t if  0:925 SMSt1  1:47
>
> 4.1. Forecasting evaluation criteria
>
>
>
> 0:17 þ 0:05yt1
>
> Consider a sample size of T ¼ m þ n. We use a rolling
>
>  0:18yt2
>
: sample {ytmþ1, . . . , yt} of size m to estimate model param-
 0:12yt3 þ 3t if 1:475SMSt1 :
eters, and then generate a sequence of one-step-ahead
ð10Þ ytþ1 gT1
forecasts fb t¼m . We compare the out-of-sample fore-
To test whether there are threshold effects, the likelihood casts of our model with the martingale model, AR model,
ratio test of Hansen (2000) is performed. The test results and the multivariate threshold AutoRegressive (TAR)
are reported in table 2. model of Tsay (1998) in terms of the Mean Squared
 346 Feature
Table 3. The forecasting results.
indices: the Hang Seng HK Largecap Index and the Hang
Models MSFE MAFE Seng HK Smallcap Index. The former is constructed from
the top 15 stocks based on market capitalization, while
Martingale 0.98 0.68
the latter is compiled from companies ranked 51st or
AR model 0.93 0.69
Tsay’s TAR 1.55 0.68 below. Table 4 reports the MFTR of our sentiment-based
TAR_SMS 0.26 0.68 trading rule.
Note that our trading strategy achieves a higher profit
than the buy-and-hold strategy. Recall that yt is defined
Table 4. Trading-rule profits.
as 100 ln(Pt/Pt1), so the result implies that the daily
Trading strategy MFTR profit of our trading rule is 0.135%, as compared to
0.085% of the buy-and-hold strategy. Note also that
SMS based trading rule (HSI) 0.135
SMS based trading rule (Largecap) 0.090
small stocks are more sensitive to market sentiment than
SMS based trading rule (Smallcap) 0.139 large stocks. The corresponding MFTR for the Hang
Buy-and-hold 0.085 Seng HK Smallcap Index is 0.139%, while that for the
Largecap Index it is only 0.09%.

5. Conclusions
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Forecast Error (MFSE) and the Mean Absolute Forecast

Error (MAFE),y which are defined as follows:
1 X T
MSFE ¼ yt Þ 2 ,
ð yt  b ð11Þ
n t¼mþ1
1 X T
MAFE ¼ j yt  b
yt j: ð12Þ
n t¼mþ1
4.2. Forecasting performance
Table 3 reports the forecasting performance of the four
models, with m ¼ 1666 and n ¼ 200. The first model is the
martingale model, with yt ¼  þ "t, where "t Pis a zero-mean
martingale sequence. The forecast is b yt ¼ m1 t1
i¼tm yt : The
second model is the simple AR( p) model, where p is the
order chosen using AIC. The third model is the multi-
variate TAR model of Tsay (1998) with the past return as
the threshold variable. The fourth model is the TAR model
with SMS as the threshold variable.
Observe from table 3 that our threshold model has the
smallest MSFE and MAFE, implying that it has
the smallest forecast error among the four models. Since
the primary objective of investors is to maximize trading
returns rather than to minimize the forecast errors, we also
evaluate the model via the mean forecast trading return
(MFTR), which is a measure of trading profits. Our trading
rule is to buy the Hang Seng Index when the sentiment
measure is smaller than 1.47 and sell if it exceeds 1.47.
The mean forecast trading return is defined as follows:
1 X T
MFTR ¼ signð1:47  SMSt Þ yt :
n t¼mþ1
For the buy-and-hold strategy, the mean forecast
trading return is defined as
1 X T
MFTR ¼ yt :
n t¼mþ1
To see whether our sentiment index has different
implications for stocks with different market capitaliza-
tions, we apply the trading rule to two different market
This paper develops a comprehensive index to measure
the sentiment of the Hong Kong stock market. The index
is a linear combination of six proxies whose weights
are obtained via the principal component method.
The proxies under consideration are the short-selling
volume, the Hong Kong Inter-bank Offered Rate, the
RSI, the MFI, turnover and the stock market perfor-
mance of the US and Japan. Our sentiment index is
positively associated with market turnover, RSI, MFI and
the performance of the US and the Japanese markets, but
is negatively related to the short-selling volume and the
interbank interest rate. A threshold model using the
sentiment index as a threshold variable is estimated to
identify the unobserved states of the Hong Kong stock
market for the period 1998–2006. In contrast to the
conventional bull–bear cycles, we show that the Hong
Kong stock market can be divided into three regimes. Our
model is shown to have high predictive power as
compared to existing models. A sentiment-based trading
rule is developed and is shown to be profitable. The
results in this paper provide useful information for
investors and business-cycle researchers. Finally, it
should be mentioned that this paper uses daily data to
construct the sentiment measure. A shortcoming of using
high-frequency data is that the sentiment measure may be
too volatile and contains too much noise. Future research
along these lines may use data of lower frequency to
construct a similar index.
Acknowledgements
The authors would like to thank Julan Du, Kam C.
Chan, Jun Zhang and two anonymous referees for
helpful comments. They would also like to thank
Mansfield Wong, Chi-man Wong, Xiaolei Wang and
Jenny Siu for able research assistance. All remaining
errors are ours.

ySee also Hong and Lee (2003).

 Feature
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