The "In(de-)flated" Value Premium

Abstract

The value premium has disappeared over the last decade and this paper provides a risk-based explanation for its disappearance. I document a positive linear relationship among the value premium and the expected inflation at both high frequency and lower business cycle frequency. A heterogeneous cash flow model featuring inflation non-neutrality is proposed to justify the observed pattern. The estimated results suggest that value firms are more exposed to high-frequency fluctuations in aggregate consumption growth but less exposed to the low-frequency consumption risk. This finding is consistent with the documented inflation-return relationship but it contrasts with the previous findings suggesting that value firms are more sensitive to long-run consumption risk. Simulation-based results show that the positive linear relationship among the value premium and the expected inflation can be recovered when inflation is non-neutral and the relationship turns into uncorrelated when inflation is neutral. Therefore we argue that inflation non-neutrality can justify the positive relationship among inflation and value premium. Meanwhile, value firms tend to under-perform growth firms when the inflation is in low range, and it leads to the disappearance of the value premium.