Morningstar Advisor - August/September 2009 - 40

Spotlight In an average month over the past 80 years, the returns of small caps exceeded those of large caps by about 0.3%. In the year coming into a recession’s midpoint, they lagged large caps by 0.3% a month. After the inflection point, however, they led large caps by an impressive 0.9% per month on average. This result was just shy of statistical significance because of wide variations and the relatively small number of data points. (Only 156 months qualified as late recession returns, versus 895 months in our entire data set.) Still, Exhibit 4, which charts small-cap outperformance, shows just how convincing the numbers are. The median cumulative outperformance a year after the inflection point was 11.5%, and even the second-worst relative performance for small caps in our entire data set (illustrated by the bottom edge of the lighter region) was virtually level with large caps and the market as a whole. While the economic sources of the value premium remain a mystery, this data shows that the small-cap premium stems from the economic vulnerability of the underlying companies. Because they tend to show less diversification across countries and products and have fewer established relationships with banks or other large institutional creditors, these smaller companies have more to fear from a U.S. downturn and rocky equity markets. Thus, they underperform as the recession continues to worsen and investors do not know where the bottom lies, leaving room for a much more substantial bounce back than the broad market once the inflection point is hit and eventual losses become more apparent. Momentum Acts Contrarian remains a bit of a mystery, but its presence in the data is undeniable. In the average month, stocks with a high price momentum outperformed those with a low price momentum by an incredible 0.8%. Interestingly, during a recession, these high-momentum stocks performed opposite from every other category we analyzed in this survey. While small caps and the broad market sagged going into a downturn and excelled on the way out and value merely stagnated relative to growth, high-momentum stocks showed some outperformance going into a recession and lagged in the postinflection-point rally. Neither of these results was statistically significant, but their size was strongly suggestive. When we charted cumulative returns like those for the value and size premiums, momentum stocks showed no average outperformance in the year after inflection points. To move from typical returns of 0.8% a month to nearly flat is a very notable result, and it gibes with our economic intuition for these companies. Those stocks with high momentum entering a recession are the companies that had the strongest performance over the previous year. These companies tend to be in the best possible position entering a recession, with the fastest-rising profits and brightest prospects. Thus, as the economic decline weighs on weaker companies, high-momentum stocks outperform more than usual. Conversely, as the bottom comes into sight at the inflection point, high-momentum stocks already held most of their value through the early stages of the recession and thus have the least room to rebound on positive news. What’s Left in This Rally? 47%. Given cash returns near 0%, this stock market performance would already put us in the top quartile of returns for the year after a recession’s inflection point. For only three months after the turnaround, it is off the charts. Even if we end up with the best stock market return coming out of a recession since the Great Depression rally of the early 1930s, we would still only have another 5% to 10% to rise by March 2010. The outlook for small caps is slightly better, as our current 12% cumulative outperformance falls only around the median for previous recessions. If we follow in the footsteps of the 1980 or 1991 recession rallies, we may have another 5% of outperformance to come. Current lower valuations for small caps in terms of price/book value and price/cash flows make modest outperformance possible, but we are unlikely to see much more substantial returns from this point. This study’s implications for a macroeconomic turnaround are less sanguine. We found that the inflection point, as marked by significant stock market rallies, tended to lie about halfway through the progression from economic peak to trough. The National Bureau of Economic Research placed the start of the current recession at December 2007. If March marked the midpoint, we should not expect a return to economic growth until spring or summer of 2010, though this contradicts the economist consensus of growth resuming in late 2009. This slow return to growth will provide little fuel for another major jump in equities, though it also does not suggest that a decline is in store. With the rallies in small caps and the broad market already having exceeded the average cumulative return, and with months to go before we can expect the true economic trough, it may be time to batten down the financial hatches. K Bradley Kay is an ETF analyst with Morningstar. Finally, we wanted to look at another major return factor in stock markets: momentum. Academic researchers over the past two decades have shown that companies whose stock price or earnings substantially rose in the past year tend to have better stock returns in the following year. Like the value effect, the economic source of these higher returns What does our study tell us about today’s market and economy? The starting point of our major post-inflection-point rally undoubtedly occurred on March 9, with the S&P 500 hitting its 13-year low of 667. Through June 15, the S&P 500 rallied about 35% from its low close, and the Russell 2000 returned nearly 40 Morningstar Advisor August /September 2009

Morningstar Advisor - August/September 2009

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