Working Paper

Investor Sentiment and the (Discretionary) Accrual-return Relation

Abstract: Discretionary accruals are positively associated with stock returns at the aggregate level but negatively so in the cross section. Using Baker-Wurgler investor sentiment index, we find that a significant presence of sentiment-driven investors is important in accounting for both patterns. We document that the aggregate relation is only prominent during periods of high investor sentiment. Similarly, the cross-section relation is considerably stronger in high-sentiment periods in both economic magnitude and statistical significance. We then embed investor sentiment into a stylized model of earnings management, and illustrate that a positive (negative) relationship between stock returns and earnings management can endogenously emerge in the aggregate (cross section). Our analysis suggests that the (discretionary) accrual-return relation at both the aggregate and firm levels at least partially reflects mispricing that is related to market-wide investor sentiment.

Keywords: Investor sentiment; Uncertainty; Earnings management; Accrual anomaly;

JEL Classification: D82; D83; G12; G14;

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Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2020-09-18

Number: 1300