Download This PaperTime Variation in Extrapolation and Anomalies
64 Pages Posted: 23 Apr 2020 Last revised: 25 Jul 2025
Date Written: September 15, 2023
Abstract
We find that the degree of extrapolative weighting in investors' belief (DOX) proposed by Cassella and Gulen (2018) has strong predictive power for a broad set of overreaction-related anomalies in the stock market. The average return spread of these anomalies is about 0.86% per month following high DOX periods and -0.31% per month following low DOX periods. In sharp contrast, DOX has opposite, but weaker, predictive power for underreaction-related anomalies. In addition, the predictive power of DOX is robust after controlling for a broad set of economic forces. Moreover, most of the DOX effect on long-short anomaly returns derives from the short legs of these overreaction-related anomalies, suggesting that time variation in DOX leads to more time variation in overpricing than in underpricing, probably because of short-sale impediments.
Keywords: Extrapolation, Overreaction, Underreaction, Mispricing, Factor
JEL Classification: G12
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