We examine the predictive effect of sentiment on the cross-section of stock returns across different economic states. The regime-switching feature on stock returns may cause a problem in identifying the source of the return predictability. In addition, the investors’ uncertainty about the state of the economy predicts the presence of asymmetries in the predictive ability of sentiment over different economic states. We implement a multivariate Markov-switching model to characterize the economic states. Conditional on the identified economic states, we use the lagged sentiment proxy to forecast the portfolio returns related to small stocks, non-earning stocks, growth stocks, and non-dividend-paying stocks. We find that sentiment performs both in-sample and out-of-sample predictive power on these categories of stocks only in the expansion state. When a expansion state has high (low) sentiment, these categories of stocks earn relatively low (high) subsequent returns. The predictive ability of sentiment can not be attributed to time-variation in the market beta driven by investor sentiment. The investors ’ uncertainty about the economy can explain the time-variations on the cross-section of stock return in the recession state.

This paper examines optimal international portfolio choice when equity market linkages increase during periods of distress and investors are averse to disappointing outcomes. I propose a model that captures the joint effect of these two phenomena and show that it leads to a first-order effect on the optimal portfolios. Even during correlated downturns, international diversification is still highly valuable in utility terms. However, including return predictability significantly increases the attractiveness of US stocks and can create substantial home bias in more favorable states of the economy. Furthermore, the model can help rationalize the empirically documented use of “returnchasing” strategies and creates significant intertemporal hedging demands even in the absence of return predictability. An expected utility model cannot replicate the results merely by increasing curvature because the effective degree of risk aversion is strongly regime dependent. Keywords: International asset allocation, Markov-switching, risk preference, stock market

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Financial markets often change their behavior abruptly. While some changes may be transitory (“jumps”), often the changed behavior of asset prices persists for many periods. For example, the mean, volatility, and correlation patterns in stock returns changed dramatically at the start of, and persisted through, the global financial crisis of 2008-2009. Similar regime changes, some of which can be recurring (recessions