Extrapolative Market Participation

Abstract

This paper proposes a simple dynamic asset pricing model featuring extrapolative market participation by retail investors, that is, increased market participation following high returns in the stock market and high new participation growth (NPG). The model implies that extrapolative market participation induces asset bubbles and large trading volume and produces momentum and value effects simultaneously. More important, the model also implies that NPG positively predicts momentum strategy returns and negatively predicts value strategy returns. Using a composite measure for NPG, we find empirical support for these predictions. The momentum effect is 1.96% per month following high NPG and only 0.51% following low NPG, whereas the value effect is -0.10% per month following high NPG and 0.68% following low NPG. A similar, albeit weaker, pattern also holds for the time-series momentum and value effect.