Value And Growth Stock Price Behavior During Stock Market Declines
Daniel Folkinshteyn
Rowan University - Accounting & Finance
Gulser Meric
Rowan University - Accounting & Finance
Ilhan Meric
Rider University
July 27, 2016
Journal of Investing, Forthcoming
Abstract:
Using data for five major stock market declines during the 1987-2008 period, this paper provides evidence that value stocks are generally less sensitive to major stock market declines than growth stocks, controlling for beta, firm size, and industry group. Further analysis using several hundred different significant market move events between 1980 and 2015 confirms the observation that value stocks tend to outperform both the market average and growth stocks during market declines. The implication for investment practitioners is that following a value strategy does not lead one to assume greater sensitivity to unfavorable market conditions.
Value And Growth Stock Price Behavior During Stock Market Declines - Introduction
The phenomenon of the value premium, the observation that stocks that are priced lower relative to the fundamentals tend to produce higher returns, is a much-researched topic in finance. Since its early introduction into the practitioner literature by Graham and Dodd [1934], and confirmation by academic literature, such as by Basu [1977] and Lakonishok, Shleifer, and Vishny [1994], the value premium continues to be somewhat of a puzzle, seemingly contradicting the efficient market hypothesis. Fama and French [1992, 1996] developed and tested the three factor model, which showed significant improvement over the plain Capital Asset Pricing Model proposed by Sharpe [1964] and Lintner [1965] in explaining the cross-sectional variation in stock returns. One of the three factors was based on a common 'value stock' criterion, book to market value.
Value vs. growth stock investing continues to be an important decision for investors (see Chan and Lakonishok [2004] and Petkova, Ralitsa, and Zhang [2005]). In this paper, we examine the behavior of value and growth stocks during short term market declines. The basic economic framework of consumption smoothing suggests that the behavior of assets during times of crisis, when wealth is decreasing across the board, is more important than what happens when times are good (Yogo [2006]). Thus, examining these conditions should be particularly illuminating for the practitioner of value investing.
The value premium problem has attracted a wide-ranging research interest, resulting in many possible explanations of this persistent market anomaly. For instance, Jagannathan and Wang [1996] used a time-varying beta approach to explain variation in stock returns. Petkova, Ralitsa, and Zhang [2005], using a time-varying risk model, propose that value stock betas tend to covary positively with expected market risk premium. Lettau and Wachter [2007] build a model to explain the value premium in the context of a changing discount rate and different effective cash flow durations for growth and value stocks. The human element has also been explored, with proposed causes such as the investor behavioral biases described by DeBondt and Thaler [1985], and agency problems among analysts and institutional investors, as explained by Hong and Kubik [2003] and Jegadeesh, Kim, Krische, and Lee [2004].
A number of papers attempt to tie some source of risk to value stocks, and thereby claim that the value premium is nothing more than fair compensation for the extra risk. Lustig and Van Nieuwerburgh [2005] explain the value premium as due to the risk factor of housing collateral value, and Yogo [2006] proposes that it is due to low returns for value stocks during recessions, when consumption falls. Guo, Savickas, Wang and Yang [2009] propose that the value premium is due to value stocks being riskier than growth stocks in bad economic times, when the price of risk is high. However, Phalippou [2007] suggests that a number of risk-based theories explaining the value premium are not supported by data. (For a broader review of related literature, see Chan and Lakonishok [2004], who present a thorough summary of the academic research on value and growth investing.) In addition to the practical implications of value investing, our results will shed some light on one potential source of risk for value stocks, their sensitivity to short term market declines.
We conduct our study using data for five major stock market declines during the 1987-2008 period and several hundred stock market declines during the 1980-2015 period. For our core analysis, we selected a representative sample of five of the largest consecutive days of market decline in the S&P 500 index (following Wang et al. [2009]; Uygur, Meric, and Meric [2015]; and Folkinshteyn, Meric, and Meric [2015]), using daily stock price data during the 1987-2008 period. The periods included in the study are presented in Exhibit 1, and are hereinafter denoted as "major stock market declines". Additional analysis using a number of other event selection criteria is presented later in the Alternative Specifications section.
Our research makes several important contributions to the literature. We document a consistent pattern of lower than average sensitivity of value stocks to most stock market declines, in excess of that predicted by beta. We also document that growth stocks have a greater sensitivity to most major stock market declines. We find that the decline of 2008 was distinct from the other major stock market declines in our study, wherein equities across the value-growth continuum were evenly affected. Further analysis using several hundred different significant market move events between 1980 and 2015 confirms the observation that value stocks tend to outperform both the market average and growth stocks during stock market declines.
The paper is organized as follows: We provide information about our data and methodology in the next section. In the section that follows, we present our test results. We summarize our findings and present our conclusions in the final section.
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