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Investor Sentiment and the Cryptocurrency Market

Article  in  The Empirical Economics Letters · November 2020

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Empirical Economics Letters, 19(11): (November 2020) ISSN 1681 8997

Investor Sentiment and the Cryptocurrency Market

Wei-Ying Nie
Department of International Trade
Chinese Culture University, Taiwan
Email: nwy@ulive.pccu.edu.tw

Hui-Pei Cheng＊ and Kuang-Chieh Yen**

Department of Economics, Soochow University
Taipei city, Taiwan
Abstract: By utilizing the cryptocurrency volatility and volume data and the
sentiment index for the U.S. stock market from February 2014 to December 2018,
we show that the change rate of the trading volume of Bitcoin and Ethereum will
be lower when the investors are optimistic about the U.S. stock market. In
addition, we find that the volatility of Bitcoin will be larger when the investors are
pessimistic about the U.S. stock market. Furthermore, the volatility of Bitcoin will
decrease when the investors are optimistic about the stock market associated with
the higher U.S. economic policy uncertainty.
Keywords: Sentiment, Bitcoin, Cryptocurrency, Economic Policy Uncertainty,
U.S.
JEL Classification Number: C22, G15, D81

1. Introduction
The cryptocurrency, as a novel financial means, has attracted more and more people to
invest their money on it because the cryptocurrency could be as another safe-heaven
asset.1 Because of its popularity in the financial markets, researchers have begun studying
the determinants of the cryptocurrency return. For example, the crypto-market factors such
as cryptocurrency’s technical indicators (e.g., Gerritsen et al., 2019) and the impact of the
media attention (e.g. Philippas et al., 2019) might be related to the crypto-market
performance. Moreover, macroeconomic factors such as economic policy uncertainty and
global economy activity might be associated with the performance of the cryptocurrency
as well.2

＊
Email: terrycheng@scu.edu.tw; ** Corresponding author. Email: kcyen@scu.edu.tw
The authors are grateful to the Ministry of Science and Technology of Taiwan for the financial
support (108-2410-H-034-004- and 108-2410-H-031-031-) provided for this study.
1
See for more details, Wang, Zhang, Li, Shen (2019) and Wu, Tong, Yang, and Derbali (2019).
2
See for example, Demir, et al. (2018), Cheng and Yen (2019a, 2019b), Yen and Cheng (2019).
Empirical Economics Letters, 19(11): (November 2020) 1254

Except for the above factors related to the crypto-performance, the investor sentiment
could play an important role on it. For instance, Baig, et al., (2019) show that the investor
sentiment of Bitcoin can affect its return: on the other hand, López-Cabarcos et al. (2019)
indicate that the investor sentiment of stocks can predict Bitcoin volatility. 3 The above
text-based sentiment indexes could contain more noise than the market-based sentiment
index (e.g., the investor sentiment provided by Baker and Wurgler, 2006). Thus, we adopt
the investor sentiment constructed by Baker and Wurgler (2006) to proxy the sentiment of
investors in the U.S. stock market.4More precisely, we study whether the sentiment of the
investors in the stock market could affect the trading volume and volatility of the
cryptocurrency.
The investor sentiment relates to investors’ attitude for the stock market, especially to
noise traders’ behaviour. High (low) sentiment implies investors are bullish (bearish) and
they are optimistic (pessimistic) in the future stock market performance (Baker and
Wurgler, 2006). De Long et al. (1990) indicate that higher investor sentiment also
encourages more noise trading. In addition, Kyle (1985) and Baker and Stein (2004) show
that the irrational market makers exist more in the market and thus market liquidity
increases more in higher investor sentiment period. Liu (2015) finds that the liquidity and
trading volume of stock market are positively associated with investor sentiment.
Therefore, we construct competing hypotheses to investigate the relation between investor
sentiment and volume of cryptocurrency to examine whether stock market and
cryptocurrency are competitive financial instruments (the competitive effect) or the
information can spill-over to the other market (the contagion effect).
We then investigate whether volatility of stock and cryptocurrency returns will spill-over
across two markets by the investor sentiment effect. Brown (1999) shows that the
volatility for closed-end fund returns is large in high investor sentiment period. Moreover,
the adjustments in volatility on the changes in sentiment are decreasing gradually in bull
market, while those are increasing gradually in bear market (Lee, Jiang, and Indro, 2002).
Therefore, we hypothesize that the relation between investor sentiment and volatility of
cryptocurrency should be positive if noise traders can bring their information for the other
market (the contagion effect); that should be negative if stock market and cryptocurrency
are competitive financial instruments (the competitive effect).
Our empirical findings indicate that the change rate of the trading volume of Bitcoin and
the other cryptocurrency, Ethereum, will be lower during the period when the investors are

3
Baig, et al., (2019) use the sentiment index based on the database of Google Trend while López-
Cabarcos, et al. (2019) construct the sentiment measure by message from the Stocktwits website.
4
The investor sentiment is defined as the linear combination among the closed-end fund discount,
NYSE share turnover, the number and average first-day returns on IPOs, the equity share in new
issues, and the dividend premium in the stock market.
Empirical Economics Letters, 19(11): (November 2020) 1255

optimistic about the U.S. stock market. Regarding the volatility analysis, the results show
that relative to the volatility of the Bitcoin during the neutral sentimental period, the
volatility of the Bitcoin will be larger when the investors are pessimistic about the U.S.
stock market. Moreover, by incorporating the economic policy uncertainty (EPU) index of
the U.S. in the analysis, we find that the volatility of Bitcoin will decline when the
investors are optimistic about the stock market during the high economic policy
uncertainty period.
The findings from the trading volume analysis may imply that the investors consider the
cryptocurrency and the stock are substitute assets. They may thus long (short) more
crypto-assets when they are pessimistic (optimistic) about the stock market situations. As
for findings from crypto-volatility exercise, the crypto-volatility may fall when the
investors invest more in the crypto-market when they are worried about the stock market
conditions. However, the volatility may increase during the pessimistic period if the
investors believe that the stock market performance is a prominent indicator of the
economy and thus, they would like to keep their money in the bank for the liquidity
reason.
Our paper speaks to the current literature regarding the relevant factors related to the
crypto-market. Moreover, this paper is also related to the literature about how the
sentiments are related to the investors’ behaviours in the stock market. Our paper
contributes to the literature by linking the stock market sentiments to the crypto-market.
The rest of this paper is structured as follows. Section 2 discusses the data, hypotheses,
and empirical methodology, while Section 3 discusses the estimation results. Section 4
concludes.

2. Data, Hypotheses and Empirical Approach

2.1. Data
We obtain the cryptocurrencies data including Bitcoin (BTC), Ethereum (ETH), Ripple
(XRP), and Litecoin (LTC) from the coinmarketcap website. 5 The monthly return is
𝐶 −𝐶
calculated as 𝑟𝑡 = 𝑡 𝑡−1 , where 𝐶𝑡 is the price of the cryptocurrency in the last trading
𝐶𝑡−1
day of the month 𝑡.The monthly sentiment index is constructed by Baker and Wurgler
(2006).In general, our sample period runs from February 2014 to December 2018 while
Ethereum starts from September 2015 to December 2018.
2.2. Hypotheses
The sentiment index reflects investors’ attitude for the U.S. stock market and, thus, high
(low) sentiment index means investors are bullish (bearish) or optimistic (pessimistic) in

5
See for more detail in the website (https://coinmarketcap.com/)
Empirical Economics Letters, 19(11): (November 2020) 1256

the future stock market performance (Baker and Wurgler, 2006). De Long et al. (1990)
and Baker and Stein (2004) show that the higher the investor sentiment, the larger the
noise trading and the more the irrational market makers in the market, which results to
increase market liquidity (Kyle, 1985). In addition, Liu (2015) finds that the stock market
is more liquid and trading volume is greater when sentiment index is higher.
For cryptocurrency is an emerging investment to attract the money from the traditional
financial market, two possible competing hypotheses are presented in the following. First,
the cryptocurrency is considered as a hedged tool against the U.S. stock market, therefore,
the crypto-trading volume could decline during the period of the high sentiment. On the
other hand, if investors suggest that the property of the cryptocurrency is similar to U.S.
stock, the crypto-trading volume would arise during the period of the high sentiment. If
the contagion effect is supported, the effect of the sentiment index for the volatility of the
cryptocurrency returns should be similar with that for stocks. If the competitive effect is
supported, these two markets are substitute. Hence, two hypotheses are as follows:

Hypothesis 1a: Competitive Effect Hypothesis –the trading volume of the specific
cryptocurrency would decline when the sentiment index is high.
Hypothesis 1b: Contagion Effect Hypothesis –the trading volume of the specific
cryptocurrency would increase when the sentiment index is high.

Brown (1999) shows that the level of sentiment is positively related to volatility for
closed-end fund returns. In addition, Lee, Jiang, and Indro (2002) suggest that the
adjustments in volatility on the changes in sentiment are decreasing gradually in bull
market, while those are increasing gradually in bear market. We then investigate whether
the effects of the sentiment index for the volatility of the cryptocurrency returns exists or
not. To explore this question is to investigate whether these two markets, stock and
cryptocurrency market, are competitive for noise traders or not. If these two markets are
competitive for noise traders, the competitive effect holds. If noise traders can bring their
information for the other market, the contagion effect holds. Therefore, we argue two
hypotheses:
Hypothesis 2a:Competitive Effect Hypothesis –the volatility of the specific
cryptocurrency would decline when the sentiment index is high.
Hypothesis 2b:Contagion Effect Hypothesis –the volatility of the specific
cryptocurrency would increase when the sentiment index is high.
2.3. Empirical Approach
To evaluate how the sentiments are linked to the crypto market performance, this paper
adopts the sentimental data regarding the United States (U.S.) stock market and the
Empirical Economics Letters, 19(11): (November 2020) 1257

cryptocurrency data in the analysis. In practice, we classify the sentimental data into three
groups: the pessimistic group, the neutral group and the optimistic group. The pessimistic
group indicates the period when the sentimental index is below the 10 th percentile value;
the optimistic indicates the period when the index is above the 90 th percentile value; the
neutral group means the period when the index is in between the percentiles. We then link
these re-constructed sentimental variables to the cryptocurrency’s trading volume and
volatility in the analysis.
To investigate the relationship between the investor’s sentiment and the volatility (volume)
of the cryptocurrency, we use two regression models as follows: 6
3
Δ𝑉𝑜𝑙𝑢𝑚𝑒𝑡 = 𝛼 + 𝑖=1 𝛽𝑖 Δ𝑉𝑜𝑙𝑢𝑚𝑒𝑡−𝑖 + 𝛾1 𝐼𝑆𝐻𝑡 + 𝛾2 𝐼𝑆𝐿𝑡 + 𝛾3 𝑃𝑜𝑠𝑡 + 𝜃𝑋 + 𝑣𝑡 (1)
3
𝑉𝑜𝑙𝑡 = 𝛼 + 𝑖=1 𝛽𝑖 𝑉𝑜𝑙𝑡−𝑖 + 𝛾1 𝐼𝑆𝐻𝑡 + 𝛾2 𝐼𝑆𝐿𝑡 + 𝛾3 𝑃𝑜𝑠𝑡 + 𝜃𝑋 + 𝜖𝑡 (2)

where Δ𝑉𝑜𝑙𝑢𝑚𝑒𝑡 represents the change rate of cryptocurrency’s trading volume at time
𝑡; 𝑉𝑜𝑙𝑡 represents the cryptocurrency’s volatility at time 𝑡;𝐼𝑆𝐻𝑡 means the dummy for the
period of high sentiment (optimistic on the U.S stock market); 𝐼𝑆𝐿𝑡 means the dummy for
the period of low sentiment(pessimistic on the U.S stock market); 𝑃𝑜𝑠𝑡 indicates the
period of China’s regulation on cryptocurrency; 𝑋 is the vector of year and quarter
dummies; and 𝜖𝑡 and 𝑣𝑡 are the innovations at time t. Moreover, we adopt the Newey-West
standard errors to eliminate the potential heterogeneity and autocorrelation problems
(Newey and West, 1987).
3. Empirical Results
3.1. The Effects of the Sentiment Index for Bitcoin Volume and Volatility
In this subsection, we would like to investigate whether sentiment index regarding to U.S.
stock market affects the Bitcoin return volatility and trading volume. Thus, we run the
regression models which the dependent variable is the change rate of the trading volume
of Bitcoin and the volatility of Bitcoin returns in the Eq. (1) and (2), respectively.
In Table 1, the coefficients of 𝛾1 are negative in Model (1) and (2), revealing that trading
volume declines during the optimistic period of the U.S. stock market. One possible
explanation is that the high sentiment might attract more investors into the stock market as
well as crowd out investors for the cryptocurrency market. On the other hand, we observe
that the coefficients of 𝛾2 are positivein Model (3) and (4), implying that there exists higher
volatility during the pessimistic period of the U.S. stock market. It also suggests that
investors pessimistic on the U.S. stock market would disturb investors’ expectation for the
Bitcoin future price to lead the higher volatility. Overall, the higher sentiment index
related d trading volume of the Bitcoin.

6
We follow the regression model setting of Cheng and Yen (2019b).
Empirical Economics Letters, 19(11): (November 2020) 1258

Table 1: Investor Sentiment Effects on Bitcoin Volatility and Volume

(1) (2) (3) (4)
Coefficients Volume Volume Volatility Volatility
γ1 -0.318* -0.403** -0.009 -0.009
γ2 -0.469 -0.323 0.014* 0.015**
Constant -0.092 0.010 0.051*** 0.049***
Adj 𝑅2 0.190 0.160 0.304 0.318
Year FE YES YES YES YES
Quarter FE YES YES YES YES
Lagged Term NO YES NO YES
Observations 59 56 59 56
Note: *, ** and *** denote the significance at 10%, 5%, and 1% level respectively.

3.2. Other Main Cryptocurrencies

In this subsection, we further investigate whether other main cryptocurrencies can be
affected by sentiment index. We run the regression models which the dependent variable
is the change rate of the trading volume of Ethereum and the volatility of Ethereum returns
in the Eq. (1) and (2), respectively.
Table 2: Investor Sentiment Effects on Ethereum Volatility and Volume
(1) (2) (3) (4)
Coefficients Volume Volume Volatility Volatility
γ1 -2.128** -2.140** -0.005 -0.005
γ2 0.144 0.411 0.025* 0.044**
Constant 2.557*** 2.568** 0.111*** 0.129**
Adj 𝑅2 0.204 0.133 0.133 0.187
Year FE YES YES YES YES
Quarter FE YES YES YES YES
Lagged Term NO YES NO YES
Observations 40 37 40 37
Note: *, ** and *** denote the significance at 10%, 5%, and 1% level respectively.
In Table 2, we observe that the coefficient (𝛾1 ) of high sentiment dummy is significantly
negative in Model (1) and (2), while the coefficient (𝛾2 ) of low sentiment dummy is
significantly positive. It implies that the stock market can attract investors’ position from
Ethereum when the investors’ sentiment is high, on the other hand, the investors’ attitude
for Ethereum future price could be more volatile when investors’ sentiment is low. Overall,
the results based on Ethereum’s trading volume and volatility is consistent with the case of
Bitcoin.
Empirical Economics Letters, 19(11): (November 2020) 1259

Next, we focus on the effects of the stock investors’ sentiment on the Ripple trading
volume and volatility. Thus, we run the regression of Eq. (1) and (2) based on the case of
Ripple.
Table 3: Investor Sentiment Effects on Ripple Volatility and Volume
(1) (2) (3) (4)
Coefficients Volume Volume Volatility Volatility
γ1 0.102 0.417 -0.002 0.001
γ2 0.124 0.251 0.012 0.012
Constant -0.371** -0.444* 0.053*** 0.048**
Adj 𝑅2 0.141 0.138 0.194 0.174
Year FE YES YES YES YES
Quarter FE YES YES YES YES
Lagged Term NO YES NO YES
Observations 59 56 59 56
Note: *, ** and *** denote the significance at 10%, 5%, and 1% level respectively.

In Table 3, we observe that the coefficient (𝛾1 ) in Model (1) and (2) andcoefficient (γ2 ) in
Model (3) and (4) are insignificant. It is inconsistent with the above results, implying that
the investor sentiment in the stock market cannot affect the trading volume and volatility
of Ripple. Finally, we investigate whether the investor sentiment affects the Litecoin
trading volume and volatility. We run the regression model of Eq. (1) and (2).
Table 4: Investor Sentiment Effects on Litecoin Volatility and Volume
(1) (2) (3) (4)
Coefficients Volume Volume Volatility Volatility
γ1 -0.203 0.444 0.002 0.026
γ2 -1.231 -0.640 0.025 0.074
Constant 0.309 0.455 0.056*** 0.076***
Adj 𝑅2 0.077 0.043 0.170 0.347
Year FE YES YES YES YES
Quarter FE YES YES YES YES
Lagged Term NO YES NO YES
Observations 59 56 59 56
Note: *, ** and *** denote the significance at 10%, 5%, and 1% level respectively.

In Table 4, we observe that the coefficients 𝛾1 and 𝛾2 are both insignificant in all Models.
However, we observe that the coefficient 𝛾2 is still positive, consistent with our hypothesis.
Overall, we conclude that the investor sentiment in the stock market can predict
Empirical Economics Letters, 19(11): (November 2020) 1260

significantly the trading volume and volatility of Bitcoin and Ethereum, rather Ripple and
Litecoin.
3.3. Further Discussions
Until now, we have discussed the effects of the investor sentiment in the stock market on
these major cryptocurrencies. Because prior literature indicates that the economic policy
uncertainty can affect the cryptocurrency trading volume and volatility. Therefore, we go a
further step to include the effects of economic policy uncertainty in our model and run the
following regression based on the case of Bitcoin,
Δ𝑉𝑜𝑙𝑢𝑚𝑒𝑡 = 𝛼 + 𝛾1 𝐼𝑆𝐻𝑡 + 𝛾2 𝐼𝑆𝐿𝑡 + 𝛾3 𝐷𝑡 + 𝛿1 𝐼𝑆𝐻𝑡 ∗ 𝐷𝑡 + 𝛿2 𝐼𝑆𝐿𝑡 ∗ 𝐷𝑡
+ 3𝑖=1 𝛽𝑖 Δ𝑉𝑜𝑙𝑢𝑚𝑒𝑡−𝑖 + 𝜃𝑋 + 𝑣𝑡 (3)
𝑉𝑜𝑙𝑡 = 𝛼 + 𝛾1 𝐼𝑆𝐻𝑡 + 𝛾2 𝐼𝑆𝐿𝑡 + 𝛾3 𝐷𝑡 + 𝛿1 𝐼𝑆𝐻𝑡 ∗ 𝐷𝑡 + 𝛿2 𝐼𝑆𝐿𝑡 ∗ 𝐷𝑡
+ 3𝑖=1 𝛽𝑖 𝑉𝑜𝑙𝑡−𝑖 + 𝜃𝑋 + 𝜖𝑡 (4)
where Δ𝑉𝑜𝑙𝑢𝑚𝑒𝑡 represents the change rate of Bitcoin trading volume at time
𝑡;𝑉𝑜𝑙𝑡 represents the Litecoin volatility at time 𝑡; 𝐼𝑆𝐻𝑡 means the dummy for the period of
high sentiment; 𝐼𝑆𝐿𝑡 means the dummy for the period of low sentiment; 𝐷𝑡 is the dummy
for the period of high economic policy uncertainty; 𝑋 is the vector of year dummy, quarter
dummy and the time dummy for China’s regulation on cryptocurrency trading; 𝜖𝑡 and 𝑣𝑡
are the innovations at time t.

Table 5: Effects of Economic Policy Uncertainty on Bitcoin

(1) (2) (3) (4)
Coefficients Volume Volume Volatility Volatility
γ1 -0.405** -0.613*** -0.009 0.009
δ1 0.300 -0.027***
γ2 -0.272 0.311 0.014** 0.021**
δ2 -0.679** -0.010
Constant 0.062 0.145 0.046*** 0.045***
Adj 𝑅2 0.148 0.136 0.307 0.334
Year FE YES YES YES YES
Quarter FE YES YES YES YES
Lagged Term NO YES NO YES
Observations 56 56 56 56
Note: *, ** and *** denotes the significance at 10%, 5%, and 1% level respectively.
In Table 5, we observe that the coefficients 𝛾1 is negative in Model (1) and (2) and 𝛾2 are
positive in Model (3) and (4), furthermore, they are both significant. It is consistent with
Empirical Economics Letters, 19(11): (November 2020) 1261

the above results. Eventually, we find that the effects of investors sentiment on Bitcoin
exists apparently.
4. Conclusion
This paper investigates whether the investor sentiment can affect the trading volume and
volatility of major cryptocurrencies. In general, we find that a high investor sentiment
leads to an increase in the trading volume of Bitcoin and Ethereum. On the other hand, a
low investor sentiment leads to a lower volatility of Bitcoin and Ethereum. Moreover, we
find that the investor sentiment cannot affect the Ripple and Litecoin. Controlling for the
economic policy uncertainty, these effects on trading volume and volatility of Bitcoin
remain significant. Overall, we conclude that the investor sentiment in the stock market
can affect the investor behaviour in the cryptocurrency market.

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