What drives the stock market? The famous, ‘efficient market hypothesis’ (EMH) – received wisdom for decades – argues that it is driven by rational calculations. However, traders are humans, and humans are affected by emotions. Do these emotions feed through to the stock market? Studying this question is difficult, because people’s emotions are unobservable. Therefore, previous approaches took a variable that affects national sentiment and investigated its impact on stock prices.
One famous paper, co-authored by Professor Alex Edmans of London Business School and published in the Journal of Finance, studied the impact of national sporting results. It found that, when a country is knocked out of the World Cup, its stock market falls by an average of 0.5% the next day due to the negative effect on investor mood. When applied to the UK, this translates into a loss of £10 billion.
However, Professor Edmans acknowledges that this approach has limitations: “First, it only captures one variable - sports results - that drive mood, but mood may be driven by other factors. A country could have lost in Euro 2020 but maybe lockdown restrictions eased. Second, it requires you to assume that the factor actually affects mood; for example, that people care about football. Even though I do, I have to admit that not everyone does – particularly in countries where other sports are more important.”
In a new paper, 'Music Sentiment and Stock Returns Around the World', Professor Edmans, together with his co-authors Adrian Fernandez-Perez and Ivan Indriawan, both from the Auckland University of Technology, and Alexandre Garel of Audencia Business School, take a different approach. Rather than studying a variable that affects mood, they sought a measure that reflects it and thus captures how people actually feel.
As Professor Edmans explains:
“While emotions are unobservable, they do translate into observable actions. But this doesn’t seem to help us much, because most actions – such as aggressive behaviour or language – aren’t captured by any dataset. So we study the music that people listen to, which we can get data on. Spotify provides aggregated listening data across a country, and an algorithm that classifies the positivity or negativity of each song. For example, September by Earth, Wind, and Fire is the most positive song in our dataset, and Legion Inoculant by TOOL the most negative. Using these inputs, we calculate Music Sentiment, a measure of a country’s sentiment as expressed by the positivity of the songs its citizens listen to.”
This idea builds on prior research that people’s music choices reflect their mood (e.g. playing sad songs at funerals or happy songs at parties). Indeed, former Bank of England Chief Economist Andy Haldane noted that Spotify listening data predicts consumer spending at least as well as consumer confidence surveys. One concern might be that people choose music to neutralise their mood, rather than reflect it – for example, listening to upbeat music to cure a downbeat mood. Professor Edmans and his coauthors show that this is not the case. Music Sentiment is more positive during sunnier days and lengthening days, which prior research has shown to be high-mood periods, as well as when COVID restrictions become weaker.
In their main results, the authors find that a one standard deviation increase in Music Sentiment is associated with an 8.1 basis point increase in a country’s stock market during the same week (4.3% annualised). It also leads to a 7.0 basis point decrease the next week (3.7% annualised), suggesting that the initial reaction was a temporary one driven by sentiment. Stock market volatility goes up, also consistent with an emotional reaction.
One concern with an offbeat, unexpected result is that it might produce a spurious correlation, similar to the ‘Superbowl Effect’ where the identity of the Superbowl winner predicts US stock markets, even though there is no rational or behavioural reason why it should. Professor Edmans and his coauthors conduct a battery of tests to address this concern. They show the result holds across 40 countries, rather than being driven by a single country. They also study other outcomes than stock returns. Higher Music Sentiment is associated with greater purchases of equity mutual funds, but also lower returns to government bonds. This is consistent with positive animal spirits causing investors to switch out of safe bonds into risky stocks. The paper is also forthcoming in the Journal of Financial Economics, an elite academic finance journal with stringent peer review standards.
As a self-confessed sports and music fanatic, how does Professor Edmans respond to concerns that these findings might be intellectually interesting, but not as practical as his research on executive pay or responsible business?
“While these studies might seem fun, they aim to tackle a serious academic question – is the stock market driven by fundamentals or sentiment? I use sports and music as sentiment measures not because they’re my passions, but because other measures of national mood, such as unemployment, have direct economic effects. If we showed that a drop in unemployment causes the stock market to rise, this won’t prove that the market is driven by emotions, because the rise could be a rational response to the falling unemployment. The reason for thinking out-of-the-box to come up with sports and music is that they don’t have a direct economic impact, so any stock market reaction can be attributed to sentiment."
What are the main takeaways from this research? Should investors set up funds trading on football results or music sentiment?
Professor Edmans explains: “Future research indeed followed up on my football paper and showed that you can form a trading strategy based on it. And it’s not implausible that investors use music sentiment as one of many factors, given the increasing popularity of big data. But I didn’t write these papers to help hedge funds make more money. Instead, their purpose is to show that the stock market is affected by emotions, rather than fundamentals. Ultimately, my research provides evidence that your frame of mind influences your choice of investment and hence returns. This has important implications for all investors, whether you are trying to select a mutual fund for your own pension or a professional trader acting on behalf of others. There is a simple message: stop for a moment and consider if your decision is guided by analysis rather than emotions. And if you are feeling particularly happy or miserable that day, it may be wise to adjourn the decision to another time.”
Prior research has shown that sentiment affects financial decisions, as summarised by Professor Edmans’s recent Gresham College public lecture series on 'The Psychology of Finance'. This paper aims to extend the frontiers of that research.
As Professor Edmans concluded: “Our study also demonstrates the power of “big data” to reveal sentiment across a whole country at high frequency. Another limitation of national sporting events is that they only take place on a couple of days, and some countries rarely qualify for the World Cup. Music is a universal language, enjoyed throughout the world on every day of the year. It thus allows us to construct a real-time measure of national sentiment that’s available on a comparable basis across the globe.”
More information on 'Music Sentiment and Stock Returns Around the World' and 'Sports Sentiment and Stock Returns'.