The main purpose of this paper is to investigate the effect (if any) of investor sentiment on asset prices. To calibrate the ability of various market sentiment variables in forecasting stock returns, we followed the recursive regression methodology by Pesaran and Timmermann (1995,2000), taking into account the influences of regime switches on trading decisions of investors in real time. Our results suggest that stock returns may be difficult to predict when stock market is relatively unstable and investors are unsure of which forecasting model to be employed for trading strategies. This finding is not consistent with the empirical results of Pesran and Timmermann (1995). We also find that net buy (sell) of investment trusts and security dealers become in a close relation with stock returns after 1998, implying that institutional investors seem to reasonably capture the sentiment of the market and their trading strategies may reflect information asymmetries between managers and investors.

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