Swedroe: Explaining The Value Premium

December 15, 2014

Inverse Relationship

Therefore, there is a negative relationship between the value premium and industrial production. This certainly was the case during our most recent recession, which lasted from December 2007 through June 2009, when the value premium was -0.44 percent per month.

Second, a similar relationship exists between the value premium and the money supply. Following an increase in the money supply, stock prices increase. The price of value stocks tends to increase more than growth stocks, so the value premium shrinks. When the money supply decreases, stock prices also decrease.

Value stocks decrease more than growth stocks, however, and the value premium increases. The result is a negative relationship between the money supply and the value premium.

Interest-Rate Relationship

Third, there is a positive relationship between the value premium and interest rates. As long-run interest rates rise, stocks become less attractive than bonds. Stock prices decrease, with the price of value stocks declining faster than the price of growth stocks. That leads to an increasing value premium. Conversely, when interest rates fall, the price of value stocks increases faster than the price of growth stocks.

This leads to a decreasing value premium. Thus, there is a positive relationship between interest rates and the value premium.

Inflation Connection

Fourth, there isn’t a significant relationship between the value premium and inflation.

Overall, the authors found that value stocks are more sensitive to bad economic news, whereas growth stocks are more sensitive to positive economic conditions.

They concluded that the value premium is largely based on fundamental risk factors within the economy and arises through macroeconomic risk. That’s one vote for the risk story.


Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.

 

 

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