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

79 Pages Posted: 23 Nov 2020

See all articles by Stefano Cassella

Stefano Cassella

Tilburg University- School of Economics and Management

Zhaojing Chen

Purdue University - Krannert School of Management

Huseyin Gulen

Purdue University - Krannert School of Management

Ralitsa Petkova

Case Western Reserve University - Department of Banking & Finance

Date Written: October 5, 2020

Abstract

We develop a model of financial markets based on the idea that when extrapolators move capital in and out of the equity market, they disproportionately buy growth stocks in good times and sell value stocks in bad times. The model predicts that the cross-sectional value premium should be stronger following states of large market-wide over- or undervaluation due to extrapolative expectations. We test this prediction empirically and find strong support for it. The value premium is 3.42% per month following market-wide undervaluation and 1.70% per month following market overvaluation. In the remainder 60% to 80% of the sample, when the market is neither significantly over or under-valued, there is no significant value premium in a monthly horizon and the value premium is only 0.54% per month in an annual horizon. We provide extensive evidence that our results are driven by extrapolative expectations. Overall, this paper sheds new light on the source of the value premium and offers new support for extrapolation-based asset-pricing theories.

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 (October 5, 2020). 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

Purdue University - Krannert School of Management ( email )

610 Purdue Mall
West Lafayette, IN 47907
United States

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

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