Sentiment and Financial Health Indicators for Value and Growth Stocks: The European Experience

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Journal Article
The European Journal of Finance, 2007, 13 (8), pp. 769 - 793
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The well-documented market underperformance of the majority of value and growth stocks over a 12-month holding period reflects that traditional valuation metrics might tell us whether a stock is potentially cheap or expensive but little about when, or even if, it will experience a market correction. Two indicators have come to the fore in recent years that provide useful insights: sentiment/momentum and accounting fundamentals/financial health.We examine their single and combined impact on value and growth stocks and find that (i) they are effective in introducing a timing element into the selection of both value and growth stocks, (ii) the sentiment indicator completely dominates the financial health indicator and, (iii) both indictors contribute to the performance of the good and bad growth stocks. The size and significance of the investment profits that potentially can be generated using the two indicators in combination questions of the efficiency of the European equity markets.We conclude that our findings are consistent with the pricing cycle for a stock proposed by Lee and Swaminathan (Lee, C. and Swaminathan, B. (2000) Price momentum and trading volume, Journal of Finance, 55, pp. 2017 2069.) and the under- and over-reaction in pricing inherent in models proposed by Barberis et al. (Barberis, N., Shleifer A., and Vishny, R. (1998) A model of investor sentiment, Journal of Financial Economics, 49, pp. 307 343.) and Hong and Stein (Hong, H. and Stein, J.C. (1999) A unified theory of underreaction, momentum trading and overreaction in asset markets, Journal of Finance, 54, pp. 2143-2184.).
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