Fundamental strength strategy: The role of investor sentiment versus limits to arbitrage

Zhaobo Zhu, Licheng Sun and Kenneth Yung

International Review of Financial Analysis, 2020, vol. 71, issue C

Abstract: This paper evaluates the return predictability of fundamental strength in a two-dimensional framework that considers both investor sentiment and limits to arbitrage simultaneously. Sentiment and limits to arbitrage have independent and overlapping explanatory power on the return predictability of fundamental strength. The return predictability of fundamental strength is more pronounced among stocks with high arbitrage costs following high sentiment. Among stocks with low arbitrage costs, the fundamental strength strategy is profitable only following high sentiment. However, among stocks with high arbitrage costs, the same strategy can earn economically and statistically significant profits even following low sentiment. Consistent with Miller (1977), we emphasize the interaction of sentiment and limits to arbitrage on stock valuation.

Keywords: Investor sentiment; Limits to arbitrage; Fundamental strength; Mispricing (search for similar items in EconPapers)
JEL-codes: G11 G12 G14 (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:71:y:2020:i:c:s1057521919304284

DOI: 10.1016/j.irfa.2020.101452

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