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From 1928–2017 the value premium in the US had a positive annualized return of approximately 3.5%. In seven of the last 10 calendar years, however, the value premium in the US has been negative.
This has prompted some investors to wonder if such an extended period of underperformance may be cause for concern. But are periods of underperformance in the value premium that unusual? We can look to history to help make sense of this question.
Exhibit 1 shows yearly observations of the US value premium going back to 1928. We can see the annual arithmetic average for the premium is close to 5%, but in any given year the premium has varied widely, sometimes experiencing extreme positive or negative performance. In fact, there are only a handful of years that were within a 2% range of the annual average—most other years were farther above or below the mean. In the last 10 years alone there have been premium observations that were negative, positive, and in line with the historical average. This data helps illustrate that there is a significant amount of variability around how long it may take a positive value premium to materialize.
Exhibit 1: Yearly Observations of Premiums, Value minus Growth: US Markets, 1928–2017
In US dollars. The one-year relative price premium is computed as the one-year compound return on the Fama/French US Value Research Index minus the one-year compound return on the Fama/French US Growth Research Index. Fama/French indices provided by Ken French.Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.
But what about longer-term underperformance? While the current stretch of extended underperformance for the value premium may be disappointing, it is not unprecedented. Exhibit 2 documents 10-year annualized performance periods for the value premium, sorted from lowest to highest by end date (calendar year).
Exhibit 2: Historical Observations of 10-Year Premiums, Value minus Growth:
US Markets 10-Year Periods ending 1937–2017
This chart shows us that the best 10-year period for the value premium was from 1941–1950 (at top), while the worst was from 1930–1939 (at bottom). In most cases, we can see that the value premium was positive over a given 10-year period. As the arrow indicates, however, the value premium for the most recent 10‑year period (ending in 2017) was negative. To put this in context, the most recent 10 years is one of 13 periods since 1937 that had a negative annualized value premium. Of these, the most recent period of underperformance has been fairly middle-of-the-road in magnitude.
In US dollars. The 10-year rolling relative price premium is computed as the 10-year annualized compound return on the Fama/French US Value Research Index minus the 10-year annualized compound return on the Fama/French US Growth Research Index. Fama/French indices provided by Ken French. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.
While there is uncertainty around how long periods of underperformance may last, historically the frequency of a positive value premium has increased over longer time horizons. Exhibit 3 shows the percentage of time that the value premium was positive over different time periods going back to 1926. When the length of time measured increased, the chance of a positive value premium increased. For example, when the time period measured goes from five years to 10 years, the frequency of positive average premiums increased from 75% to 84%.
Exhibit 3: Historical Performance of Premiums over Rolling Periods, July 1926–December 2017
In US dollars. Based on rolling annualized returns using monthly data. Rolling multiyear periods overlap and are not independent. Fama/French indices provided by Ken French. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.
What does all of this mean for investors? While a positive value premium is never guaranteed, the premium has historically had a greater chance of being positive the longer the time horizon observed. Even with long-term positive results though, periods of extended underperformance can happen from time to time. Because the value premium has not historically materialized in a steady or predictable fashion, a consistent investment approach that maintains emphasis on value stocks in all market environments may allow investors to more reliably capture the premium over the long run. Additionally, keeping implementation costs low and integrating multiple dimensions of expected stock returns (such as size and profitability) can improve the consistency of expected outperformance.
STOCK PRICES ARE CHANGING EVERY DAY – AND AS PRICES CHANGE, SO DO EXPECTED RETURNS.
It has been more than 50 years since the idea of stock prices containing all relevant information was put forth. Information might come in the form of data from a company’s financial statements, news about a new product, a change in the regulatory environment, or simply a shift of investors’ tastes and preferences toward owning different investments.
Information is incorporated into security prices through the buying and selling process. While fair prices may
not depend on a certain level of trading, over $400 billion of stocks traded on average each day in the world equity
markets suggests that a great deal of information is incorporated into stock prices.
As investors, we should consider whether we want to use the price we observe or look for a better price. A recent
study from Dimensional Fund Advisors shows that over the 15-year period ending December 2017, only 14%
of investment managers that attempted to outguess the market survived and beat benchmarks.
This study is just one of many conducted over the past 50 years that have documented similar results. With investing, many things are out of our control, but we can make decisions that improve our odds of having a positive investment experience. Looking at these results, attempting to identify a better price than the one we observe in the market may not be accomplishing this objective.
WHAT CAN WE LEARN FROM THE PRICE
Beyond the challenge of trying to outguess the market, why is price so important? We should first understand
the connection between the price you pay and the return you expect to receive.
Let’s consider an example: Imagine that you want to buy a house and you know for certain the house will be worth $2 million 10 years from now. If you pay $1 million for the house today or you pay $500,000, in which case would you earn a higher return? Obviously paying less, $500,000, would earn you a higher return.
Of course, investing offers few, if any, guarantees, and we can’t know for certain what something will be worth in the future. Given this, investors should think in terms of expected returns and what decisions will lead to an investment with higher expected returns. Holding other factors constant, the lower the price you pay, the higher the expected return, which is why it’s so important to consider a stock’s observed market price. The price paid has a direct connection to the return we expect to receive.
AS PRICES CHANGE, SO DO EXPECTED RETURNS
We also know that, in a changing world, new information becomes available on a regular basis and that new information can affect the price of stocks. Let’s imagine a pharmaceutical company announces a new drug that investors believe will generate substantial revenues for the company. If this news was previously unknown, once it becomes available, it will likely influence the price of the stock. The price will adjust based on new information, and as the price changes, so will the expected return. Changes in stock prices are taking place every day, and as prices change, so do expected returns.
INDEX MANAGEMENT AND MARKET PRICES
Each year on the last Friday in June, the Russell indices go through a process called reconstitution. In this process, certain stocks are added and deleted from the index. The goal of reconstitution is to periodically rebalance the index to account for historical changes in stocks during the prior period. Index providers, such as S&P, Russell, or CRSP, have different processes for adding and deleting stocks, and while each will have some variation, all will establish pre-set points in time to make their adjustments.
To decide which stocks will be added or deleted, the index provider may look at the market price of a stock to determine what is a small cap vs. large cap stock or what is a value vs. growth stock. It is only during these pre-set dates of reconstitution that index providers might consider market prices. On all other days between the reconstitution dates, changes in the prices of stocks are not being incorporated by the index. And since there is a direct relation between the price of a stock and expected return of a stock, indices are considering differences in expected returns only at infrequent intervals during the year. It not only seems logical that we may want to consider changes in market prices more frequently, the failure to do so can have a direct impact on the expected return of the index.
Again, this is why we believe using market prices is so important. The price we see gives us information about what we expect to receive. If you want to have an investment approach that targets higher expected returns every day, you need to ensure the approach incorporates changes in price every day. Otherwise, investors may not be getting what they think they are paying for.
WHEN THE PRICES OF GOODS AND SERVICES INCREASE OVER TIME, CONSUMERS CAN BUY FEWER OF THEM WITH EVERY DOLLAR THEY HAVE SAVED.
This erosion of the real purchasing power of wealth is called inflation. Inflation is an important element of investing. In many cases, the reason for saving today is to support future spending. Therefore, keeping pace with inflation is a crucial goal for many investors. To help understand inflation’s impact on purchasing power, consider the following illustration of the effects of inflation over time. In 1916, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And more than 100 years later, nine cents would only buy about seven tablespoons of milk. How can investors potentially prevent this loss of purchasing power from inflation over time?
Exhibit 1: Your Money Today Will Likely Buy Less Tomorrow
In US dollars. Source for 1916 and 1966: Historical Statistics of the United States, Colonial Times to 1970/US Department of Commerce. Source for 2017: US Department of Labor, Bureau of Labor Statistics, Economic Statistics, Consumer Price Index—US City Average Price Data.
INVESTING FOR THE LONG TERM AND OTHER “TIPS”
As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power. Investors should know that over the long haul stocks have historically outpaced inflation, but there have also been short-term stretches where this has not been the case. For example, during the 17-year period from 1966–1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation it was 0%. Additionally, if we look at the period from 2000–2009, the so-called “lost decade,” the return of the S&P 500 Index dropped from –0.9% before inflation to –3.4% after inflation.
Despite some periods where stocks have failed to outpace inflation, one dollar invested in the S&P 500 Index in 1926, after accounting for inflation, would have grown to more than $500 of purchasing power at the end of 2017 and would have significantly outpaced inflation over the long run. The story for US Treasury bills (T-bills), however, is quite different. In many periods, T-bills were unable to keep pace with inflation, and an investor would have experienced an erosion of purchasing power. After adjusting for inflation, one dollar invested in T-bills in 1926 would have grown to only $1.51 at the end of 2017.
Exhibit 2: Growth of $1, 1926–2017
S&P and Dow Jones data © 2018 Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Past performance is no guarantee of future results. Actual returns may be lower. Inflation is measured as changes in the US Consumer Price Index.
While stocks are more volatile than T-bills, they have also been more likely to outpace inflation over long periods. The lesson here is that volatility is not the only type of risk that should concern investors. Ultimately, many investors may need to have some of their allocation in growth investments that outpace inflation to maintain their standard of living and grow their wealth.
One additional tool available to investors who are concerned about both stock market volatility and inflation are Treasury Inflation-Protected Securities (TIPS). TIPS are guaranteed by the US Treasury and as such are considered by the marketplace to have low risk of default. The Treasury issues TIPS with a variety of maturities, and these securities are easily bought and sold. Unlike traditional Treasury securities such as T-bills, TIPS are indexed to inflation to protect investors from an erosion in purchasing power. As inflation (measured by the consumer price index) rises, so does the par value of TIPS, while the interest rate remains fixed. This means that if inflation unexpectedly rises, the purchasing power of any principal invested in TIPS should also increase. Although they may not offer the long-term growth opportunities that stocks do, their structure makes TIPS an effective risk management tool for investors who are concerned with managing uncertainty around future purchasing power.
Inflation is an important consideration for many long-term investors. By combining the right mix of growth and risk management assets, investors may be able to blunt the effects of inflation and grow their wealth over time. Remember, however, that inflation is only one consideration among many that investors must contend with when building a portfolio for the future. The right mix of assets for any investor will depend upon that investor’s unique goals and needs. A financial advisor can help investors weigh the impact of inflation and other important considerations when preparing and investing for the future.
. Market prices incorporate market participants’ expectations about the future. Therefore, market participants’ expectations about future inflation should be incorporated into current prices. These expectations are referred to as expected inflation. Unexpected inflation refers to unexpected changes in inflation that deviate from prior market expectations. Unexpected inflation should be considered a primary driver of inflation risk.
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There are periods of good and bad in the stock market, but it is by far the BEST investment option we have. Understanding that the price of a stock is driven to fair value by the intense competition of companies and investors, allows us to focus on CONTROLLING what we can: RISK, FEES AND DIVERSIFICATION.
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