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The value premium and economic activity: Long-run evidence from the United States

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Abstract:

This article tests for the existence of a long-run relationship between the US value premium price index (VPPI) and economic activity. Although it is largely accepted that there exists a value premium in returns, there has been little investigation into the wealth index associated with a strategy that is long in value and short in growth stocks. Evidence of such a relationship would provide support that the premium results from the presence of non-diversifiable risk inherent in value stock. Our results support cointegration between the VPPI and industrial production (IP), inflation, money supply (MS) and interest rates. Further examination of the long-run relationship reveals a significant negative relationship between the value premium and both IP and MS, and a significant positive relationship with long-run interest rate. A negative but insignificant relationship is found between the value premium and inflation. Overall, these results suggest that value stocks are more sensitive to bad economic news, whereas growth stocks are more sensitive to good economic conditions. This can be rationalised by the view that value stocks are typically purchased by institutional investors who value the income (dividend) payments. In contrast, growth stocks, in which the return is largely generated from future growth opportunities, are purchased by individuals who may be adopting short-term strategies and ‘trend-chasing’, hence not adopting fully rational strategies, and whose actions may depend on the level of economic well-being and confidence.

Document Type: Research Article

DOI: http://dx.doi.org/10.1057/jam.2009.15

Publication date: December 1, 2009

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