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30 September 2019 Andrew Wellington, Lyrical Asset Management

Lessons from history: does a recession always spell bad news for value?

Since the time of the global financial crisis, value stocks have been sensitive to fears of recession. Investors are gripped by concerns that an economic downturn could result in further underperformance, within a style already hard hit in current conditions. The depth of underperformance of value stocks in the last recession has left deep scars, but 2007 to 2009 marks just one example of how value stocks perform in a recessionary environment.

To gain a better understanding of how value stocks fare when trouble strikes, we have looked back at how the style performed in the last three recessions, to work out what might happen when the next downturn inevitably comes. Calculating the performance of the lowest price-to-earnings (PE) quintile of the largest 1,000 listed US stocks, we compared how they performed relative to the S&P 500 during cycles in which the last three major recessions occurred – one in 1990 1991, a second in 2001, and the notorious crash of 2007-2009.

 

2007-2014

The recession clearest in most people’s minds, and the one which continues to impact how many think about markets, officially took place from December 2007 to June 2009. Value stocks entered a downcycle in May 2007, shortly before recession hit, and significantly underperformed throughout the end of 2008. This is what sticks in the minds of many investors to this day.

However, value soon began a fiveyear upcycle in early 2009, before the recession ended, which ran until mid-2014. Over this full seven-year cycle from 2007 to 2014, low PE stocks returned 98%, while the S&P 500 returned 42%.

The experience of 2008 established a fear of value stocks in relation to recessions, but the style still managed to outperform the markets over the full cycle. We believe 2008 looks more like an exception rather than the rule, and looking back over previous economic cycles validates this view.

 

1998-2007

In 1998, the Asian and Russian financial crises started a downcycle for value stocks, which lasted until the internet tech bubble infamously burst in March 2000. From March 2000 value stocks began a seven-year upcycle that included the recession that started in 2001. During that recession, value continued its outperformance unabated. Over the full nine-year cycle, low PE stocks returned 331%, a significantly higher return than the S&P 500’s 61%.

 

1989-1998

Travelling back farther, in the late 1980s, low PE value stocks performed well. In fact, during the crash month of October 1987, low PE stocks outperformed the wider market by 400 basis points. However, by April 1989 value had entered a downcycle, and by July 1990 economic recession had hit. In hindsight, the recession marked the end of the value downcycle, as low PE stocks began to outperform again. The recession marked the start of a value stock upcycle that lasted almost eight years. During the full eight-year cycle, value returned 450%, against the S&P 500’s return of 356%.

 

LESSONS FROM HISTORY

History dispels the notion that recessions mean only bad news for value stocks. The 2001 recession was a period of great relative performance for value, while the 1990 recession saw the beginning of value outperformance that continued for many years.

We believe the next recession is more likely to reflect the conditions of 2001 or 1990, than 2008. This is because the relative valuations of value stocks currently resemble those that were present before the ‘good’ value recessions, rather than those present before the ‘bad’ 2008 recession. The ‘good’ recessions for value started after a well-advanced downcycle among low PE stocks.

When recession hit, value stocks were akin to a coiled spring ready to pop, and their compressed valuations drove strong relative outperformance. Comparatively, value stocks had not suffered significant underperformance prior to the ‘bad’ value recession of 2008, and so had less upside potential.

Today, we again see value stocks as a tightly coiled spring. The highest PE stocks continue to perform best, with the lowest PE stocks performing worst. This is unusual, with only two occasions over the past 20 years where we have witnessed valuation spreads so wide. Both occasions proved to be extraordinary entry points for owning value stocks.

Markets have a tendency to judge stocks harshly on the back of risks such as trade wars and recessions, but we believe such reactions today are overdone. If we do enter a recession, past experience shows it need not be bad for the performance of value. At these historically wide discounts to the wider market, we believe value is poised to significantly outperform when a downturn hits. As to when that is to happen, we do not claim to know; but if history is a guide, these value cycles do not typically last more than 24 months. With the current cycle duration at 21 months, perhaps the turn is imminent.

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