Skip to main content

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

Journal of Asset Management volume 10, pages 305–317 (2009)Cite this article

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.

This is a preview of subscription content, access via your institution.

Access options

Buy single article

Instant access to the full article PDF.

USD 39.95

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Figure 1
Figure 2
Figure 3

Notes

  1. Ten year long-term government bond return is used as LIR instead of short-term interest rate because first, short-term interest rate is found to be integrated in different order as other variables; second, LIR is found to be better than short-term interest rate in response to the nominal risk-free component of the discount rate in stock valuation models in the US market (Mukherjee and Naka, 1995).

  2. Ibbotson Association does not have seasonal adjusted data for IP and MS. In this case, we obtain data for IP and MS from DataStream.

  3. The full details of the tests are suppressed here but available upon request.

  4. SIC is used rather than Akaike information criterion because SIC is proved to have best result when choosing correct lag length. See Kerry Patterson (2000).

  5. I also test other lag lengthens with restriction that r does not have full rank. The coefficient results are similar to the cases k=6 and k=7.

  6. The critical value of two-side t-test at 5 per cent significant level is from −1.96 to 1.96.

  7. Capital adjustment cost measures the flexibility of the firm to adjust capital. The higher the adjustment cost the firm faces, the less flexibility it has to adjust their capital, and the riskier its return will be.

  8. As a robustness check, the Johansen procedure was re-estimated excluding CPI given its insignificance; however, results for the remaining series were qualitatively unaffected. The full results are available upon request.

References

  • Black, A. (2002) The Value Premium and Macroeconomic Activity. Working paper. University of Aberdeen, Department of Accountancy and Finance.

  • Black, A., Fraser, P. and McMillan, D.G. (2005) Are international value premium driven by the same set of fundamentals? International Review of Economics and Finance 16: 113–129.

    Article  Google Scholar 

  • Black, F. (1993) Beta and return. Journal of Portfolio Management 20: 8–18.

    Article  Google Scholar 

  • Brown, S.J., Goetzmann, W.N. and Ross, S.A. (1995) Survival. Journal of Finance 50: 853–873.

    Article  Google Scholar 

  • Bulmash, S. and Trivoli, G. (1991) Time-lagged interactions between stock prices and selected economic variables. Journal of portfolio management 17 (Summer): 61–67.

    Article  Google Scholar 

  • Chen, N., Roll, R. and Ross, S.A. (1986) Economic forces and the stock market. Journal of Business 59: 383–403.

    Article  Google Scholar 

  • Cochrane, J.H. (1991) Production-based asset pricing and the link between stock returns and economic fluctuations. Journal of Finance 46: 209–238.

    Article  Google Scholar 

  • Daniel, K. and Titman, S. (1997) Evidence on the characteristics of cross sectional variation in stock returns. Journal of Finance 53: 1–33.

    Article  Google Scholar 

  • Engle, R.F. and Granger, C.W.J. (1987) Co-integration and error correction: Representation, estimation and testing. Econometrica 55: 251–276.

    Article  Google Scholar 

  • Fama, E.F. (1990) Stock return, expected returns, and real activity. Journal of Finance 45: 1089–1108.

    Article  Google Scholar 

  • Fama, E.F. and French, K.R. (1992) The cross-section of expected stock returns. Journal of Finance 47: 427–465.

    Article  Google Scholar 

  • Fama, E.F. and French, K.R. (1993) Common risk factors in the returns on stocks and bonds. Journal of Financial Economics 33: 3–56.

    Article  Google Scholar 

  • Fama, E.F. and French, K.R. (1995) Size and book-to-market factors in earnings and returns. Journal of Finance 50: 131–155.

    Article  Google Scholar 

  • Fama, E.F. and French, K.R. (1996) Multifactor explanations of asset pricing anomalies. Journal of Finance 51: 55–84.

    Article  Google Scholar 

  • Fama, E.F. and French, K.R. (1998) Value versus growth: The international evidence. Journal of Finance 53: 1975–1999.

    Article  Google Scholar 

  • Fama, E.F. and Schwert, W. (1977) Asset returns and inflation. Journal of Financial Economics 5: 115–146.

    Article  Google Scholar 

  • Johansen, S. (1991) Estimation and hypothesis testing of cointegration vectors in Gaussian vector autoregressive models. Econometrica 59: 1551–1580.

    Article  Google Scholar 

  • Johansen, S. (1995) Likelihood-based Inference in Cointegrated Vector Autoregressive Models. Oxford: Oxford University Press.

    Book  Google Scholar 

  • Johansen, S. and Juselius, K. (1990) Maximum likelihood estimation and inference on cointegration – With applications to the demand for money. Oxford Bulletin of Economic and Statistics 52: 169–210.

    Article  Google Scholar 

  • Lakonishok, J., Shleifer, A. and Vishny, R.W. (1994) Contrarian investment, extrapolation, and risk. Journal of Finance 49: 1541–1578.

    Article  Google Scholar 

  • Liew, J. and Vassalou, M. (2000) Can book-to-market, size and momentum be risk factors that predict economic growth. Journal of Financial Economics 57: 221–245.

    Article  Google Scholar 

  • Lo, A.W. and MacKinlay, C. (1990) Data-snooping biases in tests of asset pricing models. Review of Financial Studies 3: 434–467.

    Google Scholar 

  • Maysami, R.C. and Koh, T.S. (2000) A vector error correction model of the Singapore stock market. International Review of Economics and Finance 9: 79–96.

    Article  Google Scholar 

  • Merton, R.C. (1987) On the current state of the stock market rationality hypothesis. In: R. Dornbusch, S. Fischer, J. Bossons (eds.) Macroeconomics and Finance: Essays in Honor of Franco Modigliani. Cambridge, MA: MIT Press, pp. 93–124.

    Google Scholar 

  • Mukherjee, T.K. and Naka, A. (1995) Dynamic relations between macroeconomic variables and the Japanese stock market: An application of a vector error-correction model. Journal of Financial Research 18: 223–237.

    Article  Google Scholar 

  • Osterwald-Lenum, M. (1992) A note with quantiles of the asymptotic distribution of the maximum likelihood cointegration rank test statistic. Oxford Bulletin of Economics and Statistics 54: 461–472.

    Article  Google Scholar 

  • Patterson, K. (2000) An Introduction to Applied Econometrics. London, Palgrave Macmillan.

    Google Scholar 

  • Vassalou, M. (2003) News related to future GDP growth as a risk factor in equity returns. Journal of Financial Economics 68: 47–73.

    Article  Google Scholar 

  • Zhang, L. (2005) The value premium. Journal of Finance 60: 67–103.

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations

  1. School of Management, University of St Andrews, The Gateway, North Haugh, St Andrews, KY16 9SS, UK

    David G McMillan

Authors
  1. Angela J Black
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Bin Mao
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. David G McMillan
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to David G McMillan.

Additional information

2recently completed her PhD examining the three-factor model at the University of Aberdeen.

Rights and permissions

Reprints and Permissions

About this article

Cite this article

Black, A., Mao, B. & McMillan, D. The value premium and economic activity: Long-run evidence from the United States. J Asset Manag 10, 305–317 (2009). https://doi.org/10.1057/jam.2009.15

Download citation

  • Received:

  • Revised:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1057/jam.2009.15

Keywords

  • value premium
  • economic activity
  • cointegration