Investor Sentiment and Stock Market Crisis: The Case of Pakistan

Abstract

The overall purpose of the study is to analyze the history of sentiments and stock market crisis in Pakistan from different perspectives. To address this purpose, the study answers a few research questions, which include: how to measure investor sentiment and crises; what are the roles of investor sentiment and macroeconomic fundamentals in influencing the occurrence and intensity of crisis; and whether stock market crises and volatility in the US, the world’s leading market, have contagion effect on crisis in Pakistan. Answer to these research questions is expected to contribute to knowledge in the context of Pakistani literature of sentiment and crises. A composite sentiment index is constructed by employing Principal Component Analysis (PCA) using direct proxy of Google Search Volume Index (GSVI) and nine indirect proxies mostly based on firm-level financial variables indicating trading pattern, liquidity, size, and profitability. However, it turns out from this construction that Pakistani investors give more importance to interest rate, mutual funds as opposed to individual stocks and turnover in formulating their sentiments. The study finds evidence of asymmetry and irrationality in the Pakistani market due to which investors tend to use gut feeling, experience, intuition and emotion or mood to influence the process of stock price formation. As a result, stock prices deviate from their fundamental values and affect stock returns. Next, CMAX methodology is employed to identify and measure stock market crises in Pakistan. The timing of crises occurrence and their various dimensions (magnitude of crisis, days to recovery, duration of crisis, depth of crisis, size of crisis, etc.), especially the two major crises of 1997-2002 and 2008-2012 are found to coincide with a number of major financial, economic and political crises in Pakistan and around the world. Moving further, a number of potential factors that may contribute to stock market crises in Pakistan are explored. The behavioral factor of investor sentiment is found to be an important factor determining the likelihood and intensity of stock market crises. All the financial ratios considered are found to have negligible role in the occurrence as well as intensity of crises except through their impacts in formation of investor sentiment. Macroeconomic variables turn out to be significant factors in the occurrence and especially the intensity of crises. In particular, high inflation rate, low term spread and slow growth in growth rate of economy-wide liquidity (money supply) are found to be leading indications of the likelihood of market crisis. The study also finds that severity of crises in Pakistan tends to be mitigated when term spread widens, money supply grows at faster rate and inflow of foreign capital and Gross Domestic Product (GDP) growth improve. Finally, the study finds significant incidence of financial contagion from the US stock market to Pakistan. When the US market crashes, it increases the likelihood of crisis incidence in Pakistan as well. Moreover, volatility of rate of return in the US stock market significantly increases the likelihood of crisis incidence as well as its intensity in the short and long-run. Based on the above observations, the study concludes that it will help financial market regulators and policy makers to be better able to predict stock market crisis on the basis of information on behavioral factor of investor sentiment along with economic xvi fundamentals and design more prudent financial policy, especially to promote financial stability. There is need to increase information disclosures to improve investors’ decision, which will consequently reduce panic trading, especially during distressed periods. Regulators may improve information flow by regularly publishing statistics on macroeconomic situation, investor sentiments, and global financial outlook. Corporate managers may improve company disclosures in order to improve investor decision by avoiding emotional trading. Since the Pakistani market is found quite vulnerable to happenings in the global financial market, regulators need to enhance the global orientation factor while making regulations and strategies of minimizing the likelihood of crises and reducing their intensity in order to minimize the detrimental effects of potential future crises in Pakistan