of extreme crisis, and that investors demand a premium to hold value
stocks in case those circumstances arise. Indeed, value stocks did under-
perform growth stocks during the Great Depression and the stock mar-
ket crash of 1929 through 1932. But since then, value stocks have actually
donebetterthan growth stocks during both bear markets and economic
recessions, so it is doubtful this is the answer.^26
Another possible reason why value stocks outperform growth
stocks is that the use of beta to summarize the risk of a stock is too nar-
row. Beta is derived from the capital asset pricing theory, a static pricing
model that depends on an unchanged set of investment opportunities.
In a dynamic economy, real interest rates proxy changes in the opportu-
nity set for investors, and stock prices will respond not only to earnings
prospects but also to changes in interest rates.
In an article entitled “Good Beta, Bad Beta,” John Campbell sepa-
rates the beta related to interest rate fluctuations (which he called “good
beta”) from the beta related to business cycles (which he called “bad
beta”)^27 based on historical evidence. But recent data are not supportive
of this theory as growth stocks rose from 1997 to 2000 when real interest
rates were rising and fell subsequently as real interest rates dropped.
Another theory about why growth stocks have underperformed
value stocks is behavioral: investors get overexcited about the growth
prospects of firms with rapidly rising earnings and bid them up exces-
sively. “Story stocks” such as Intel or Microsoft, which in the past pro-
vided fantastic returns, capture the fancy of investors, while those firms
providing solid earnings with unexciting growth rates are neglected.^28
The Noisy Market Hypothesis
A more general theory for the outperformance of value stocks is that stock
prices are constantly being impacted by buying and selling that is unre-
lated to the fundamental value of the firm. These buyers and sellers are
called “liquidity” or “noise” traders in the academic literature. Their trans-
actions may be motivated by taxes, fiduciary responsibilities, rebalancing
of their portfolio, or other personal reasons. In order to explain the value
158 PART 2 Valuation, Style Investing, and Global Markets
(^26) John Y. Campbell (with Jens Hilscher and Jan Szilagyi), “In Search of Distress Risk,” revision of
National Bureau of Economic Research (NBER) Working Paper No. 12362, Cambridge, Mass.,
March 2007.
(^27) John Y. Campbell and Tuomo Vuolteenaho, “Bad Beta, Good Beta,” American Economic Review, vol.
94, no. 5 (December 2004), pp. 1249–1275.
(^28) Behavioral finance is the topic of Chapter 19.