A Macro View of Factors

How economic conditions drive the performance of the value and profitability premiums

By: Igor Vasilachi

US small-cap value stocks have staged a dramatic rally since COVID, about doubling the returns of the S&P 500 in the 12 months from March 2020, in one of the best ever periods of relative performance for value investing.

This dramatic outperformance marked a notable reversal for small-cap value. While small-cap value has outperformed the S&P 500 by 420bps per annum since 1970, it underperformed in both the 1990s and the 2010s. In fact, the period from Q1 of 2018 through Q1 2020 was the worst underperformance of small-cap value relative to the broader market on record, with data extending to the 1920s. This underperformance capped a decade in which the S&P 500 compounded at 14% per year, versus 10% per year for small value, before its rally began in Q2 2020.

Figure 1: US Small Value and S&P 500 Returns by Period (1/1970 – 6/2021)

Source: Capital IQ, Ken French Data Library

The S&P 500 had a wide range of performance across decades, from below zero in the 2000s to over 18% in the 1990s. Small-cap value, by contrast, produced double-digit returns in every decade (even the two in which it underperformed). This is perhaps the easiest way to contextualize small-cap value’s underperformance.

But we wanted to dive deeper and understand the role that the macroeconomy has played in the varying relative performance of small-cap value, especially to better parse the last decade’s disappointing results.

We looked at the variation in the high-yield spread across decades to better understand the influence of macroeconomic conditions. We believe that the high-yield spread is the best macro indicator. The spread is wide during periods of economic turbulence (recessions and recoveries) and tight during periods of economic calm (both bull markets and low-growth stagflationary markets). Below, we show the excess returns of small-cap value stocks and large-cap high-profitability stocks versus the S&P 500 depending on whether spreads were wide or tight.

Figure 2: Excess Returns over S&P 500 by Spread Level and Asset (1/1970 – 6/2021)

Source: Capital IQ, Ken French Data Library

US small-cap value has had higher returns in periods when spreads are wide and has tended to match the broader index performance when spreads are tight. Large companies with high gross profits-to-asset ratios (i.e., high profitability) tend to outperform across the full cycle, but do particularly well in periods when spreads are tight. We would note that these relationships are different in Europe, where small-cap value earned a premium above 3% annualized in both tight- and wide-spread environments. And the relationships are non-existent in Japan, where there is no high-yield market.

US small-cap value’s performance therefore should be relatively strong in decades characterized by wide high-yield spreads (more volatile macroeconomic conditions) and relatively poor in decades characterized by tight high-yield spreads (less volatile macroeconomic conditions). And we can see in the below chart that, indeed, the two worst decades for small-cap value, the 1990s and the 2010s, were disproportionately tight spread environments.

Figure 3: Economic Quadrant Full Period Prevalence and Deviation by Decade (1/1970 – 6/2021)

Source: FRED, Verdad

In other words, a large part of small-cap value’s underperformance in the last decade could be attributed to a prolonged period of tight high-yield spreads.

But a different roll of the macroeconomic dice might have resulted in very different factor premiums. And if investors believe that future decades might have more macroeconomic volatility and that the past decade might have been rather exceptional for the placidity of its macro conditions, small-cap value might deserve a relatively larger portfolio role.

For investors seeking to eliminate that implicit macroeconomic bet from their asset allocation, another option might be to adapt portfolio allocations to economic conditions. Investors could overweight small-cap value when spreads are wide and large, then shift to high-profitability stocks when spreads tighten.

Circling back to our first chart, we have updated the decade analysis by adding two strategies: one that is long large, high-profitability stocks, and one dynamic strategy. The dynamic strategy allocates 90% to small-cap value and 10% to large, high-profitability stocks when high-yield spreads are wide. These allocations reverse (10% to small-cap value and 90% to large, high profitability) when high-yield spreads are tight.

Figure 4: Returns by Period, before Trading Costs (1/1970 – 6/2021)

Source: Capital IQ, Ken French Data Library, FRED, Verdad

The above chart suggests that the twin problems of a lost decade among large caps in the 2000s and value missing out on a growth rally in the other periods can potentially be overcome by combining small-cap value and large, high-profitability stocks in a dynamic strategy. That is because the dynamic strategy combines the reliability of earning double-digit returns in small-cap value over long horizons with the premium that large, high-profitability stocks earn over the S&P 500 during growth rallies. Such a strategy would have delivered nearly 540bps in excess returns over the S&P 500 (before trading costs) over 50 years.

In sum, asset returns are impacted by macroeconomic environments. US small-cap value stocks tend to outperform the S&P 500 when spreads are wide. The 1990s and 2010s were the only two decades in our sample when tight spreads were overrepresented and the only two decades when small value underperformed the S&P 500. Conversely, the small-cap value rally in Q2 2020 coincided with high-yield spreads hitting the widest level since 2008 before the economy began to recover.

We believe the placid economic conditions with long periods of tight HY spreads that characterized the 2010s are unlikely to prevail in the next decade, so small-cap value will therefore likely have a better decade in the 2020s than in the 2010s. But we also think investors who don’t want to implicitly make that bet could take advantage of the high-yield spread relationship we discussed to time their equity exposures.