Value Bubbles

Abstract

The study reveals that the historical performance of value strategies is primarily driven
by occasional bubbles. Behavioral theories suggest the value premium should vary with
extended lagged market return or other aggregate proxies of investor sentiment—a hypothesis
supported by our cross-sectional tests. From 1926 to 2022, following two years of negative
market returns, we find that the U.S. value premium is about three times its unconditional
counterpart, whereas it appears to vanish following two years of positive market returns.
Additionally, periods of substantial losses in momentum strategies (momentum crashes)
very often coincide with substantial profits in value strategies (value bubbles). Leveraging
these insights, we develop a positively skewed, implementable dynamic investment strategy,
enhancing the Sharpe ratio of standard value and momentum strategy by over threefold and
60%, respectively. Our findings are internationally robust.

Keywords: Biases; Contrarian; Market Anomalies; Market Efficiency; Market States, Over-reaction; Value Premium

JEL Classification: G10, G11, G40, G41