Premiums Can Appear, Disappear and Reappear QuicklyMarch 28, 2017
Weather — a topic everyone likes to talk about and few seem to be able to predict accurately. You know how it goes…the forecast calls for sunshine so you don’t bring an umbrella, but then get stuck in a downpour. Even with all the high-tech devices for predicting the weather, sometimes Mother Nature surprises us.
Similarly, as investors, we often think we can figure out what is going to happen in the market, only to be completely surprised by something we never saw coming. Predicting which sectors of the market will do well at any given time is a perfect example. In the long term, as with the weather, certain larger patterns are more predictable. It is highly unlikely, for example, to see a snowstorm in August.
Science and research have identified certain risks that may be worth taking when it comes to investing. First, that stocks are riskier than bonds (but also provide greater potential returns). Second, that small and value stocks are riskier than large and growth stocks (but also have greater potential for returns).
When we talk about these categories of stocks and compare their returns, we refer to them as premiums. For example, the U.S Small Cap premium is the difference between the total return of an index of U.S. small capitalization stocks and the total return of an index of U.S. large capitalization stocks.
Individual premiums are unpredictable in terms of when they arrive, disappear and reappear, so to capture them you must constantly be in position to receive them. In other words, you need to be in the market. Premiums can not only reappear suddenly, but when they do, they can do so with gusto.
Consider the U.S. Value premium: If you were looking at the 12 months of market returns prior to August 2000 and hoping to see a decent Value premium, you would have been disappointed. It had been the “go-go” period of the Tech Boom where the one-year return of the Russell 1000 Value Index was 4.2% as of August 2000 as compared to a solid 33.5% for the Russell 1000 Growth Index. Growth had recently beaten Value over a one-year period by more than 29%, when just six months later, 12-month returns for Value stocks were 16.6% compared to -31.1% for Growth stocks. The Value premium, running at nearly 48%, was back in business.
Similarly, consider the U.S. Small Cap premium: in February of 1991, the Russell 2000 Small Cap Index was lagging behind the Russell 1000 Large Cap Index on a 12-month basis by more than 10%. Later that same year, in October, the Small Cap premium had fully turned around on a 12-month basis and was running at more than 22% over Large Cap.
We think it is reasonable to believe that we have seen a similar reversal in recent months in both the U.S. Value premium and the US Small Cap premium. The U.S. Value premium was running negative on a 12-month basis for more than two years up until about July 2016, and has been running at a positive value, on a 12- month basis, in each of the seven months since (as of March 1, 2017).
Likewise, the Small Cap premium had been running negative for a couple of years until around August of 2016, but has started to show signs of positive performance since.
No methodology has been developed to predict these short-run turnarounds in our key premiums, but long-run analysis has shown that historically, investors who stay invested to capture and accumulate these premiums generally build up a positive premium over time, and more so the longer they stay invested.
The risks associated with investing in stocks and overweighting small company and value stocks potentially include increased volatility (up and down movement in the value of your assets) and loss of principal. Small company stocks may be subject to a higher degree of market risk than the securities of more established companies because they may be more volatile and less liquid.
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