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

Abstract

We show that the magnitude of the value premium is conditional on aggregate market-wide misvaluation. The monthly value premium is 2.69% following market-wide undervaluation, 1.29%
following market-wide overvaluation, and -0.69% following periods in which the market is neither
significantly over- or undervalued. Going from periods of normal valuation to market-wide overvaluation (undervaluation), the value premium is driven primarily by the poor (good) performance of growth (value) stocks. We show theoretically that these facts can be reconciled in a model in which extrapolation bias drives both the cross-sectional demand for stocks and asset-allocation decisions.

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

JEL Classification: G02, G11, G12, G14