The role of investor sentiment in the long-term correlation between US stock and bond markets

This paper investigates the influence of the composite index of investor sentiment on the time varying long-term correlation of the U.S. stock and bond markets based on the DCC-MIDAS model. We modify the model by considering structural break points of the 1997 Asian financial crisis and the 2008 global financial crisis based on the Bai and Perron (2003) test to adjust the correlation during different periods. The results show that the composite index of investor sentiment has a significantly positive influence on the long-term stock-bond correlation, and the shock of crises significantly decrease the average correlation but the effect of sentiment does not change significantly. Finally, our out-of-sample analysis presents significant improvement for the performance of portfolio allocation after involving the effect of investor sentiment on the long-term stock-bond correlation.