What is market sentiment? This paper takes a new approach to this question and de- rives a formula for market sentiment as a function of the risk-free rate, the price/dividend ratio, and the conditional stock market volatility. The formula is derived from a representative agent with a prospect theory probability weighting function. We estimate the model and find that our sentiment measure correlates positively with the leading sentiment indexes. The model matches the equity premium while generating a low and stable risk-free rate with low risk aversion. We also apply the model to explain other anomalies for the aggregate stock market.
20-08 Ghazi, S. & Schneider, M. (202). An empirical study of the sentiment capital asset pricing model. ESI Working Paper 20-08. https://digitalcommons.chapman.edu/esi_working_papers/302/