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

73 Pages Posted: 23 Nov 2020 Last revised: 23 Mar 2022

See all articles by Stefano Cassella

Stefano Cassella

Tilburg University- School of Economics and Management

Zhaojing Chen

Renmin University of China - School of Finance

Huseyin Gulen

Purdue University - Krannert School of Management

Ralitsa Petkova

Case Western Reserve University - Department of Banking & Finance

Date Written: March 20, 2022

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

Suggested Citation

Cassella, Stefano and Chen, Zhaojing and Gulen, Huseyin and Petkova, Ralitsa, Extrapolators at the Gate: Market-wide Misvaluation and the Value Premium (March 20, 2022). Available at SSRN: https://ssrn.com/abstract=3705481 or http://dx.doi.org/10.2139/ssrn.3705481

Stefano Cassella

Tilburg University- School of Economics and Management ( email )

Professor de Moorplein 521
Tilburg, 5037
Netherlands

Zhaojing Chen

Renmin University of China - School of Finance

59 ZHONGGUANCUN STREET
BEIJING, Beijing 100872
China
15210960946 (Phone)

Huseyin Gulen (Contact Author)

Purdue University - Krannert School of Management ( email )

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

Ralitsa Petkova

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
484
Abstract Views
2,072
rank
87,473
PlumX Metrics