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

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.