Extrapolation Bias and the Predictability of Stock Returns by Price-Scaled Variables

73 Pages Posted: 22 Oct 2015 Last revised: 5 Sep 2017

See all articles by Stefano Cassella

Stefano Cassella

Tilburg University- School of Economics and Management

Huseyin Gulen

Purdue University - Krannert School of Management

Date Written: September 5, 2017

Abstract

Using survey data on expectations of future stock returns, we recursively estimate the degree of extrapolative weighting in investors' beliefs (DOX). In an extrapolation framework, DOX determines the relative weight investors place on recent-versus-distant past returns. DOX varies considerably over time, and the ability of price-scaled variables to predict the year-ahead equity premium is contingent on DOX. High price-scaled variables are followed by lower returns only when the DOX is high. Our findings support extrapolation-based theories of the aggregate stock market and the interpretation of price-scaled variables as proxies for mispricing. Our results help answer a critical question: when will an overvalued asset experience a correction?

JEL Classification: G02, G12, G14

Suggested Citation

Cassella, Stefano and Gulen, Huseyin, Extrapolation Bias and the Predictability of Stock Returns by Price-Scaled Variables (September 5, 2017). Available at SSRN: https://ssrn.com/abstract=2676860 or http://dx.doi.org/10.2139/ssrn.2676860

Stefano Cassella

Tilburg University- School of Economics and Management ( email )

Professor de Moorplein 521
Tilburg, 5037
Netherlands

Huseyin Gulen (Contact Author)

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States

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