Extrapolators at the Gate: Market-wide Misvaluation and the Value Premium

Abstract

We show that the magnitude of the value premium over 1968-2018 is conditional on aggregate market-wide misvaluation. The value premium is 3.42% per month following market-wide undervaluation, 1.70% per month following market-wide overvaluation, and close to being nonexistent following periods in which the aggregate market is neither significantly over- or undervalued. Going from normal valuation states to market-wide overvaluation (undervaluation), the increase in the value premium is due primarily to the poor (good) performance of growth (value) stocks. We show theoretically that these facts can be reconciled in a model in which some investors overextrapolate the past performance of stocks. In our model, extrapolators’ demand for value and growth stocks depends not only on the relative performance of these stocks but also on the overall performance of the stock market, which causes investors with extrapolative beliefs to move capital in and out of the equity market. This extrapolative asset-class switching behavior helps explain both the conditionality of the value premium and the drivers of the premium in different market-wide misvaluation states.

Keywords: Value premium, extrapolation, extrapolative expectations, style investing, predictability

JEL Classification: G02, G11, G12, G14