💸 $($1$)$ Value Investing – Buying a $1$ Bill for $50$ Cents
Value Investing is like thrift shopping in the stock market. You’re not buying the flashiest thing — you’re buying what’s undervalued.
📘 Book Value per Share:
$\text{Book Value per Share} = \frac{\text{Assets} – \text{Liabilities}}{\text{Shares Outstanding}}$
🔍 Value Stocks: High book-to-market ratio
🚀 Growth Stocks: Low book-to-market ratio
📈 A strategy that’s long value and short growth is called a value-growth strategy.
🧠 Historical Fun Fact:
$1$ invested in a value-growth strategy in 1965 grew to over $6 by 2012, peaking at nearly $8 in 2006–2007. Not bad for a strategy that buys boring stuff!
But why does it work? 🤔
Is there a systematic factor at play here? Or are we being rewarded for bearing risk in bad times?
To answer that — let’s meet the villains and heroes of market returns: the macroeconomic risk factors.
🌍 $($2$)$ Risk Premiums – The Market’s “Danger Pay”
Risk premiums are the market’s way of giving you a treat 🍬 for taking a beating 🥊.
They’re driven by:
- 🌡️ Macroeconomic factors: inflation, volatility, productivity, demographics
- 💼 Style factors: value, momentum, size
📌 The value premium might be a reward for risk during downturns, or it might be due to market mispricing $($see LO 86.e for juicy details$)$.
But let’s say a hurricane’s coming. It’s not the normal weather that worries you — it’s the shock. Similarly, macro shocks — not levels — shake markets.
Let’s explore each one.
📉 $($3$)$ Economic Growth – When the Economy Catches a Cold 🤧
Growth is the heart rate of the economy.
Performance in Recessions:
- 🛡️ Government Bonds: 12.3%
- 🧱 Investment-Grade Bonds: 12.6%
- 😬 Large Stocks: 5.6%
- 📉 Small Stocks: 7.8%
Performance in Expansions:
- 💪 Large Stocks: 12.4%
- 🚀 Small Stocks: 16.8%
- 🧱 Investment-Grade Bonds: 6.0%
So, when the economy hits the gym, equities flex. When it’s coughing on the couch, bonds shine.
📊 High GDP growth = stocks do well
📊 Low GDP growth = bonds play safe
Question: If growth affects returns this much… what happens when prices of everything shoot up? 🧯
🔥 $($4$)$ Inflation – The Wallet-Eating Monster
Inflation is the pickpocket of your portfolio — sneaky and destructive.
Low Inflation:
- 📈 Large Stocks: 14.7%
- 💼 Bonds: 9%+
High Inflation:
- 😟 Large Stocks: 8.0%
- 💸 Government Bonds: 5.4%
🔑 Why bonds suffer: They offer fixed payments, but inflation eats away real value.
💭 Why stocks suffer: Though they own real businesses, uncertainty and cost pressures reduce returns.
Volatility also spikes during high inflation.
Next question: If inflation’s dangerous, what about something even more unstable — volatility?
⚡ $($5$)$ Volatility – When Markets Have Mood Swings
Imagine the market as a drama queen 🧟. Volatility measures how often it screams.
📉 VIX — the Volatility Index — tends to rise when stock returns fall.
Two reasons why volatility hurts stocks:
- 📉 Leverage Effect: Equity prices fall → debt remains → firm looks riskier
- 🧮 Higher Required Return: Investors demand more return → stock prices fall
🧠 CAPM confirms: When volatility spikes, stock prices must drop to offer better future returns.
So volatility doesn’t just cause fear — it has math on its side.
Still with me? Good. Because now we’re stepping into the extended family of macro mischief-makers.
🧬 $($6$)$ Other Macroeconomic Factors – The Surprise Bosses 🎮
These aren’t the main villains — but they’re sneaky and deadly:
💡 $($a$)$ Productivity Risk – When Innovation or Inefficiency Takes Over
- 🧟 Low productivity $→$ lower firm output $→$ lower stock returns
- 🚀 High productivity $→$ growth booms like the 1990s tech wave
Correlation with returns? About 50%. That’s a strong handshake.
👨👩👧👦 $($b$)$ Demographic Risk – When Boomers Sell and Zoomers Can’t Buy
OLG $($Overlapping Generation$)$ models say:
- 👶 Young/Mid-age: Save and invest
- 🧓 Retirees: Sell to fund lifestyle
Problem? If too many old and too few young, stock prices crash 💥.
🧠 Insight: Older people are more risk-averse, so as the population ages, equity risk premiums might increase.
🏛️ $($c$)$ Political Risk – Not Just an Emerging Market Problem Anymore
Political drama now affects even developed countries.
Remember 2008? Political indecision added fuel to the financial fire. Sovereign risk became mainstream.
🧠 Final Thought – Can We Outsmart the Macro Mayhem?
Let’s recap with icons:
| 📊 Macro Factor | 📉 Impact on Stocks | 📈 Impact on Bonds |
|---|---|---|
| 🧭 Low GDP Growth | ❌ Bad | ✅ Good |
| 🔥 High Inflation | ❌ Bad | ❌ Very Bad |
| ⚡ High Volatility | ❌ Bad | 😐 Mixed |
| 💡 Productivity Fall | ❌ Bad | ❓ Depends |
| 👨👩👧👦 Demographic Shock | ❌ Bad | ✅ Safer |
| 🏛️ Political Risk | ❌ Bad | ❌ Bad |
🚀 What’s Next?
You now understand:
- How value investing works and why it might offer a premium
- How macro shocks — not just levels — influence all types of assets
- How different economic weather patterns impact stocks vs bonds
- And how invisible factors like demographics and politics also matter