The Value Premium: What This Indicator Is Telling Us About The Business Cycle

Johnny HopkinsGeorge Athanassakos, Investing ResearchLeave a Comment

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Here’s a great article by George Athanassakos at The Globe and Mail. Athanassakos is a finance professor and the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario. He’s discussing a recent paper titled The Value Premium and Expected Business Conditions, which illustrates the correlation between the value premium and the economic cycle and what this may mean for investors saying:

“Academics and factor investing enthusiasts define statistically cheap stocks or value stocks to be the lowest quintile of stocks sorted by the price-to-earnings or price-to-book ratios; at the same time, the highest quintile stocks are defined as growth stocks. The difference in returns between these two groups of stocks is known as the value premium.”

“The thus-defined value stocks have been suffering this year: Value-stock returns, as indicated by P/E or P/B, have fallen below growth-stock returns, so the value “premium” has turned negative. Factor investors, hedge funds heavily tilted to value stocks and those following market neutral strategies all have had their worst first half of the year since 2011. And according to recent research, this does not bode well for the continuation of the economic cycle.”

Here’s an excerpt from that article:

Is the aging U.S. business cycle entering its last inning, or is there yet a lot more life left in it?

Given U.S. tax cuts and historically low unemployment rates, pundit consensus is for the latter – and the U.S. Federal Reserve seems to agree. In its semi-annual report to Congress, the Fed said it saw the economy’s solid economic growth continuing and reiterated its expectation of further gradual interest-rate increases. With most companies reporting earnings beating expectations and recent gains in stock prices, it’s apparent this expectation of economic growth is widespread.

However, a more forward-looking market indicator raises concerns about the continuation of the economic cycle – at least as far as the smart money are concerned. This indicator has to do with the value premium, given recent evidence of its relationship to economic activity.

Academics and factor investing enthusiasts define statistically cheap stocks or value stocks to be the lowest quintile of stocks sorted by the price-to-earnings or price-to-book ratios; at the same time, the highest quintile stocks are defined as growth stocks. The difference in returns between these two groups of stocks is known as the value premium. The thus-defined value stocks have been suffering this year: Value-stock returns, as indicated by P/E or P/B, have fallen below growth-stock returns, so the value “premium” has turned negative. Factor investors, hedge funds heavily tilted to value stocks and those following market neutral strategies all have had their worst first half of the year since 2011. And according to recent research, this does not bode well for the continuation of the economic cycle.

Chris Kirby at the University of Northern Carolina at Charlotte has written a paper titled The Value Premium and Expected Business Conditions in which he demonstrates that the value premium becomes negative during periods when economic growth is expected to be either negative or relatively weak.

Does the smart money know something the rest of the market does not? And despite all the brain power behind their models, have factor investing, statistical arbitrage programs and artificial intelligence models got the economy wrong?

Mr. Kirby investigated whether the value premium varies in a pro-cyclical way with expected business cycle conditions. He related the value premium to economists’ forecasts of the GDP growth rate. He found that, since 1973, there has been a positive and statistically significant correlation between the value premium and those forecasts of GDP growth. That is, he found the value premium depends on expected business conditions and it varies in a pro-cyclical fashion.

There are two explanations for that, both pointing to the same behaviour of the value premium versus expected economic growth. First, growth stock valuations are closely tied to growth opportunities. Growth stock expected returns are supposed be more sensitive to business conditions than those of value stocks. If weak economic conditions make growth stocks riskier than value stocks, then investors may demand a higher relative expected return to hold growth stocks during economic downturns. The other, simpler explanation is that value stocks do best during the early stages of the economic expansion when strong corporate profits will lift even the most chronically underpriced shares.

Irrespective of the explanation, the point is that since value stocks have been underperforming growth stocks as of late, the smart money is betting on a slowdown of economic growth. Who – or what – should you believe, the pundits or the value premium? I bet my money on the latter. This is also consistent with another key indicator of the economic cycle, namely the slope of the yield curve, which has been dangerously flattening over the past few months.

A word of clarification is in order here: The value premium referred to above has nothing to do with the performance of value investors. Value investors do not invest in all low P/E or P/B stocks. They invest only in those that meet the margin of safety requirement after careful due diligence and in-depth valuation.

But investors, whatever their strategy, would do well to keep an eye on the value premium.

You can read the original article at The Globe and Mail here.

You can read the paper The Value Premium and Expected Business Conditions here.

For more articles like this, check out our recent articles here.

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