What is Value in an Equity Market?

Volume 15, Number 3, 2017
Michael Suen, Hany Guirguis, Stan Beckers and Ted Theodore

What is value in an equity market? Among investors, there is no universally accepted definition. This paper constructs a value index for the US equity market using the Stock and Watson (1988, 1991) methodology. The new value index is derived from a dynamic single factor model taking five relative valuation metrics as inputs. These inputs are commonly used by investors to gauge whether the market is expensive (low in value) or cheap (high in value). The value index is the (unobserved) common component in the Stock and Watson model. Investors can gauge whether the equity market is cheap or expensive by referring to a historical time series of the value index. We also develop a tactical asset allocation strategy based on the trend of the value index. Its performance indicates that the new value definition contains investible information.