Extrapolative Market Participation

Abstract

This paper proposes an asset pricing model featuring extrapolative market participation by retail investors, who increase participation following high market returns and high new participation growth (NPG). The extrapolative market participation induces momentum, value effects, and asset bubbles. More important, the model suggests that NPG positively (negatively) predicts momentum (value) strategy returns. Using a composite measure for NPG, we empirically confirm these predictions. Following periods of high (low) NPG, the momentum effect is 1.87% (0.55%) per month, while the value effect is -0.08% (0.68%) per month. A similar yet weaker pattern also holds for the time-series momentum and value effects.

Keywords: Extrapolation, Momentum, Participation, Sentiment

JEL Classification: G12, G40, G41