- At least 7 million shareholders had defected from the stock market since 1970.
- Equities, more than ever, are the province of giant institutional investors.
- Pension money could now be invested in not only stocks and bonds but also in real estate, commodity returns, and even gold and diamonds.
- Institutions could withdraw billions from both the stock and bond markets.
This led BW to conclude:
Before inflation took hold in the late 1960s, the total return on stocks had averaged 9 percent a year for more than forty years, while AAA bonds rarely paid more than 4 percent. Today the situation has reversed, with bonds yielding up to 11 percent and stocks averaging a return of less than 3 percent throughout the decade.
Based on the above, BW issued its famous warning:
This death of equity cannot be seen as something a stock market rally will check. Only the elderly who have not understood the changes in the nation’s financial markets, or who are unable to adjust to them, are sticking with stocks.
- For better or for worse, then, the U.S. economy probably has to regard the death of equities as a near-permanent condition.
Analyzing the 1994-1999 PeriodDuring this period (which followed on the heels of the publication of the famous Fama-French research demonstrating the existence of the size and value premium), large value stocks underperformed the S&P 500 by 108 percent, and small value stocks underperformed by 84 percent. As mentioned in the first paragraph, the recent cumulative underperformance for large value has been 90 percent and for small value 41 percent. There’s another important similarity between the two periods (2009-April 2019 and 1994-1999).
|Annualized Return (%)||Total Return (%)|
|S&P 500 Index||23.6%||256%|
|Fama-French Large Value Research Index||16.4 %||148%|
|Fama-French Small Value Research Index||18.2%||172%|
Returns to Companies with Negative Cash Flow and Negative EarningsIn the vast majority of years, companies with negative cash flow produce negative returns for investors. For example, data from AQR Capital Management over the 24-year period, 1995-2018, show that there were just five years when they produced positive returns, and in only two of those were the returns above a few percent. Those two years were 1999 and 2018. In 1999 companies with negative cash flows returned 19 percent, and in 2018 they returned 6 percent. Similarly, companies with negative earnings produced negative returns in all but seven of those years, and in just two of them were the returns above a nominal percentage. In 1999, companies with negative earnings returned 27 percent, and in 2018 they returned 8 percent. In both cases, these abnormal/unexpected outcomes contributed to the negative value premium. However, over the long term, companies with these traits do not make for higher-returning investments. In fact, the AQR data shows that, over the 24-year period ending in 2018, they have produced negative returns—about -3 percent for companies with negative earnings and about -5 percent for companies with negative cash flow. It’s important to note that, while we or any researcher can do these types of diagnostics ex-post, they don’t provide an ability to predict when this happens ex-ante. The same argument applies to the equity premium—when the stock market tanks, we can ex-post talk about why, but it’s not clear that there is an ability to predict it in advance. That is why it is called risk. And risk has to be unpredictable.
Been There, Done ThatThe evidence demonstrates that the decade-long underperformance of value stocks is not unusual. It’s worth noting that during this period of the late 1990s, when technology stocks dominated (similar to the recent experience), legendary investor Warren Buffett was thought to have “lost his touch,” as he dramatically underperformed. 1 However, Buffett did not lose faith in his belief in value investing during that period. And I believe it is safe to say he hasn’t lost confidence today either. What many investors fail to understand is that such periods of outperformance typically are caused by dramatic changes in valuations, with the underperformance of value stocks causing them to become much cheaper relative to growth stocks, which eventually has led to the restoration of the value premium. As the table below demonstrates, that’s exactly what happened over the eight years after the growth bubble burst in 2000—large value and small value outperformed by 60 percent and 218 percent, respectively.
Analyzing the 2000-2007 Period
|Annualized Return (%)||Total Return (%)|
|S&P 500 Index||1.7%||14.1%|
|Fama-French Large Value Research Index||7.1%||73.6%|
|Fama-French Small Value Research Index||16.2%||232.1%|
In reviewing the above tables, some might question their shorter-term nature relative to the now decade-long underperformance of value. To address that issue, let’s again go to our trusty videotape for a history lesson.
How Long Is Long Enough?If the decade-long underperformance of value has convinced you that the value premium is gone, would the much longer 17-year period of a negative equity premium have convinced you (as it did many, including Salomon Brothers and Businessweek) that the equity premium was dead?
Analyzing the 1966-1982 Period
|Annualized Return (%)||Total Return (%)|
|S&P 500 Index||6.8%||206%|
|One-Month Treasury Bills||7.1%||218%|
|Fama-French Large Value Research Index||11.9%||574%|
|Fama-French Small Value Research Index||16.9%||1,323%|
Over this 17-year period, the S&P 500 Index not only underperformed totally riskless one-month Treasury bills but also underperformed large value stocks by 368 percent and small value stocks by 1117 percent! It’s also worth noting that the S&P 500 Index underperformed totally riskless one-month Treasury bills over the 13 years 2000-12 and the 15 years 1929-43. Note that the three periods total 45 years, or half of the 90 calendar years since 1929! And, in each of these periods, value stocks provided diversification benefits, outperforming the S&P 500.
Further EvidenceEugene Fama and Ken French examined the volatility of the market beta, size, and value premiums in their study “Volatility Lessons,” published in the Third Quarter 2018 issue of the Financial Analysts Journal. 2 The study covered the period from July 1963 through December 2016. Fama and French noted that, while most of the news about equity premium distributions for longer return horizons is good, there is bad news. They used the realized monthly returns from the period their study covered to construct long-horizon simulation returns and found that for the three- and five-year periods that are often the focus of professional investors, negative equity premiums occur in 29 percent of three-year periods and 23 percent of five-year periods of simulation runs. Even for 10- and 20-year periods, negative premiums occur in 16 and 8 percent of simulation runs, respectively. Fama and French found similar results for the size and value premiums and concluded that this is simply the nature of risk—if you want to earn the expected (the mean of the distribution of potential outcomes) premiums, you must accept the fact that you will experience losses, no matter how long your horizon. Said another way, if you can’t stand the heat, get out of the kitchen. They concluded:
Clearly, the returns to all risk assets are not only time-varying, but all risk assets can be expected to experience long periods of underperformance. That means that discipline is the key to successful investing. If you don’t know your history and don’t have faith, long periods of underperformance will lead to the abandonment of a strategy, typically right before returns revert to their long-term mean performance. A key ingredient for having faith is understanding why a premium should exist and what might cause it to underperform.
The high volatility of stock returns is common knowledge, but many professional investors seem unaware of its implications. Negative equity premiums and negative premiums of value and small stock returns relative to market are commonplace for three- to five-year periods, and they are far from rare for ten-year periods. Given this uncertainty, investors who will abandon equities or tilts toward value or small stocks in the face of three, five, or even ten years of disappointing returns may be wise to avoid these strategies in the first place.
Source of the Value PremiumOne of the great debates in finance is whether the source of the value premium is risk-based or a behavioral anomaly. In our book, “Your Complete Guide to Factor-Based Investing,” Andrew Berkin and I present the evidence showing that there are good arguments on both sides. Thus, it’s likely the answer isn’t black or white. For example, we show that the academic research demonstrates that value firms not only have poorer earnings and profitability compared to growth firms, but their greater historical leverage and more irreversible capital increases their risks in times of financial distress. Stocks that do poorly in bad times should command large risk premiums. Thus, investors demand a higher return on value stocks than on growth stocks as compensation for higher vulnerability due to financial distress. That said, the literature also provides us with several behavioral explanations for the value premium. One such explanation is that investors are systematically too optimistic in their expectations for the performance of growth companies and too pessimistic in their expectations for value companies. Ultimately, prices correct when expectations are not met. My ETF.com post of November 29, 2017, also includes a detailed discussion. Before concluding, let’s turn to consider a possible explanation for why value has underperformed over the past decade.
Explaining Value’s UnderperformanceOne candidate for explaining the poor performance of value stocks is the difference in duration of value and growth stocks. Growth stocks, with more of their earnings in the distant future, are longer duration stocks than value companies (which have more of their cash flows “front-loaded”). With that in mind, consider what the economic environment has been like since the onset in 2007 of the Great Financial Crisis:
- Economic growth has been much weaker than after any other economic recovery, with not a single year so far with as much as 3 percent growth in GNP.
- In addition to weak economic growth, all the surprises on the inflation front have been below expectations.
- The combination of weak economic growth and lower than expected inflation (a global phenomenon) has led to a sharp decline in interest rates, both nominal and real.
- Falling interest rates benefit longer duration stocks more than shorter duration stocks.
- Does the stock market react to unexpected inflation differently across the business cycle?
- Returns of what types of stocks respond more negatively to unexpected inflation?
- Are the responses asymmetric across the business cycle?
- There is strong evidence that nominal equity returns of firms with lower book-to-market (BtM) ratios (growth stocks) are more negatively correlated with unexpected inflation. Growth stocks are longer duration stocks, and thus an increase in the stock risk premium impacts them more than it does value stocks. In addition, value companies typically are characterized by having more leverage, and inflation reduces the real cost of fixed rate debt.
- The lower the BtM ratio (the more “growthy” the stock), the stronger the negative correlation between the nominal equity returns and unexpected inflation at the time of recession.
- There are significant cyclical patterns in the responses of the excess market return to unexpected inflation. The stock risk premium responds much more negatively to unexpected inflation during contractions than expansions. The results are statistically significant.
Has the Value Trade Become Overcrowded?The December 2018 study “Characteristics of Mutual Fund Portfolios: Where Are the Value Funds?” by Martin Lettau, Sydney Ludvigson and Paulo Manoel, provides a comprehensive analysis of portfolios of active mutual funds, exchange-traded funds (ETFs) and hedge funds through the lens of risk (anomaly) factors such as size, value and momentum. Among the questions they try to answer are: To what extent do active fund managers exploit these factor premia? If there are limits to arbitrage, do active funds contribute to the existence of these anomalies, or do they overweight underpriced stocks? Among their important findings was that neither mutual funds nor ETFs systematically tilt their portfolios toward profitable factors, such as high BtM ratios, high momentum, small size, high profitability and low investment growth. In fact, for some factors, mutual funds target the low-return leg of long/short factor portfolios rather than the high-return leg. This bias is especially strong for BtM ratios. In fact, they found that there are virtually no high-BtM funds in the sample, while there are many low-BtM “growth” funds. For example, only seven out of 2,657 funds in their sample have a BtM score in the fourth quintile or above. Supporting evidence comes from David Blitz, who demonstrated in his February 2017 paper, “Are Exchange-Traded Funds Harvesting Factor Premiums?” that, while some ETFs are specifically designed for harvesting factor premiums, other ETFs implicitly go against these factors. 3 Specifically, Blitz found:
We can also address the issue of overcrowding by examining the spreads in valuations of growth and value stocks. If overcrowding has occurred, we should see a dramatic narrowing in valuations.
From a factor-investing perspective, smart-beta ETFs tend to provide the right factor exposures, while conventional ETFs tend to be on the other side of the trade with the wrong factor exposures. In other words, these two groups of investors are essentially betting against each other.