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Reversions from Stock Market Valuation Extremes Drive the Value Premium?

December 15, 2020 • Posted in Equity Premium, Value Premium

Do extreme equity market valuations represent opportunities in value stocks? In their October 2020 paper entitled “Extrapolators at the Gate: Market-wide Misvaluation and the Value Premium”, Stefano Cassella, Zhaojing Chen, Huseyin Gulen and Ralitsa Petkova test the hypothesis that extrapolating (momentum) investors bid up growth stocks in good times and bid down value stocks in bad times, such that the value premium concentrates during reversion from these conditions. Their principal measure of market valuation is average book value-to-market capitalization ratio (B/M) of all firms, excluding financial stocks, utility stocks and stocks priced ice less than $1. When monthly B/M is in the top (bottom) 10% of monthly values for the past 10 years, they deem the market overvalued (undervalued). For robustness, they consider other percentage cutoffs and an alternative metric that quantifies the distance between the current-month distribution of firm B/Ms and the distributions of over the past 10 years based on the Mann-Whitney U test. They further tie findings to investor expectations based on a long times series constructed from Gallup, American Association of Individual Investors and Investor Intelligence surveys of investors. Using monthly returns and accounting data for U.S. common stocks and the specified survey data during January 1962 through December 2018, they find that:


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