Most economists expect the US economy to decline during the next few quarters as the Fed does what it takes to tame inflation. Given the negative market returns of 2022, it appears most investors expect a recession too.
Chart 1: Recession Odds
Notwithstanding the thoughtful analysis supporting economic predictions, we would note that estimating the timing, duration, and severity of recession is inherently unreliable and not terribly fruitful for long-term investors. For example, most hedge fund managers whose goal it is to beat the market based on predicting the impact of macroeconomic events have had trouble keeping up with their equity peers and the broader equity market. Analysts make simplifying assumptions to model the economy; unfortunately, the economy is too complex to be characterized by these assumptions which in turn makes their models inherently unreliable.
While fraught with uncertainty, we can look back over the last century and observe the impact of recessions on long-term stock returns. The chart below shows that 16 recessions occurred over the last century yet small cap value stocks continued to march higher. Other than the great depression, recessions were transitory events on the path to higher stock prices.
Chart 2: Small Cap Value Investment Growth
If we assume that we are going to have a recession this year, what does that mean for future returns? We looked at the last 13 recessions and noted that small cap value stocks declined by about a third on average. While you might want to avoid that nasty draw down, you might be too late as small caps have fallen -27% from the market peak in 20211 . This steep decline suggests investors have already priced in an average recession. While we can easily incur more pain from where we are today, we note that small cap value stocks tend to more than double in price in the three years following the trough. In our experience, recessions create new opportunities to buy companies at very depressed multiples of normal or recovered earnings which sets the foundation for attractive investment results.
Chart 3: Small Value More Than Doubles on Average Following Recession Troughs
While recession concerns drove stock returns in 2022, another important driver is emerging – style reversion. History shows that the longer a style has been out of favor and the deeper the valuation disconnect from historical trend, the longer and greater the subsequent style recovery is. The last decade was one of the worst relative return periods for value, primarily due to low interest rates and the phenomenal earnings performance of mega cap tech stocks such as the FAANGS. Both trends appear to be reversing. Against this backdrop, we believe the current value recovery will likely be stronger and last longer than past value cycles.
Chart 4: Length of Value Cycles
During periods of heightened uncertainty, such as the Global Financial Crisis or the recent pandemic, we find the guiding beacon to better returns is valuation. Paying a low price relative to a company’s ability to generate sustainable long-term earnings is generally a good way to outperform the market. In fact, the longer one’s time horizon, the truer this statement is. For example, the R2 of initial valuation explaining the subsequent return of the stock market jumps from less than 30%, essentially a minimal predictive value, to 80% once your investment horizon approaches 10 years2 . This means if you have a long investment horizon, maybe you are saving for retirement or you need to pay obligations decades in the future, you should align your portfolio with value.
Chart 5: Valuation and Future Stock Performance
From a size perspective, small cap stocks look attractive relative to large caps stocks. The only era where small caps were less expensive than today was during the tech bubble of the late 1990s.
Chart 6: Relative Valuation of Small vs Large Stocks
Looking within the small cap market, small cap value stocks look particularly attractive relative to history, especially when one excludes companies with negative earnings. This level of discount supports the expectation of strong future returns for small cap value stocks.
Chart 7: Russell 2000 Value is Cheap Relative to its History
We are frequently asked about inflation and stock prices. The short answer is value stocks do better than growth stocks during periods of inflation. When looking at the stagflation decade of the 1970s, small cap value was one of the best performing asset classes while growth was one of the worst, even worse than corporate bonds. Looking at small cap market data over the last 6 decades, value outperformed growth by 7% when inflation was over 3%. More importantly, value outperformed growth by 5% over the entire time period.
Chart 8: Small Value vs. Small Growth During Inflationary Environments
What explains this phenomenon? Inflation lowers the current value of distant cash flows. In the case of growth stocks, inflation is much more corrosive to returns because more of the future cash flow is coming from distant time periods as compared to value stocks. Drawing a bond analogy, growth stocks are long duration securities compared to value stocks. So when inflation rises, value stocks tend to outperform growth stocks.
In conclusion, we believe investors’ fear of a recession has created an opportunity for the investor with a long time horizon. Valuation of small cap value market is attractive, recent price declines have discounted a good portion of a recession impact, and the opportunity for economic recovery and the associated returns appear to be underappreciated. And finally, the value investing style is reasserting its dominance after a prolonged period of underperformance. Given the length and depth of the underperformance, we see a multi-year tailwind for value stocks.
Hotchkis & Wiley Research
