We propose a novel approach to testing non-linear stochastic discount factor (SDF) specifications that arise in rational representative investor models. Our approach does not require overly-restrictive assumptions about the shape of investors’ preferences, typically imposed by the extant literature, and is based instead on restrictions that rule out “good deals”, i.e., arbitrage opportunities as well as unduly large Sharpe ratios. We apply this framework to test the empirical admissibility of 3 and 4-moment versions of the CAPM. We find that, while coskewness and cokurtosis risk help price a number of stock strategies and portfolios, including static strategies based on a fine industry-level diversification, momentum strategies and portfolios managed on the basis of available information, the CAPM and its 3 and 4-moment versions cannot provide an exhaustive account of observed asset returns.

Earlier research finds correlation between sentiment and future economic growth, but disagrees on the channel that explains this result. We shed new light on this issue by exploiting cross-sectional variation in country size and market efficiency. We find that sentiment shocks in the largest advanced economies increase economic activity, but only temporarily and without affecting productivity. Conversely, sentiment shocks in smaller or less advanced economies predict prolonged economic growth and a corresponding increase in productivity. The results support the view that sentiment can create economic booms, although only in economies where sentiment and fundamentals are harder to disentangle.