Value Investing is not Dead

Value Investing is not Dead

The equity market in the U.S. has been characterized by above-average price performance and low volatility.  Despite the positive backdrop, concern has shifted to interest rate changes and the likelihood of the interest rate yield curve “inverting.”  Many believe that yield curve inversions precede recessions.  Accepting this as fact, what does this mean for equity market returns?  The answer is that the market tends to underperform while Value and Momentum provide opportunities for positive performance.

A quick review of yield curve terminology.  For this note, the yield curve refers to the spread between long-term and short-term interest rates, in this case the 10-year Treasury note and the 3-month Treasury bill.  The spread is usually positive which means that the 10-year rate is greater than the 3-month rate.  When the spread contracts, the yield curve is “flattening.”  A negative spread suggests that the curve has inverted.  An economic slowdown resulting in a recession is associated with an inversion.  The yield curve dominates other macroeconomic variables in predicting recessions two or more quarters in the future. (See Estrella & Mishkin, The Yield Curve as a Predictor of U.S. Recessions (1996)).

Source:  Sheth, Arnav and Lim, Tee, Fama-French Factors and Business Cycles (December 4, 2017)

 

A recent paper revisits yield curve inversion and the implications for equity returns by examining returns over the business cycle.  The authors showed that after the yield curve inverts, the equity market tends to trade relatively flat for about a year, followed by a steep decline then a strong recovery.  To better understand the returns, the authors used Fama/French and Carhart factors and presented cumulative returns for the 24-month period after start of the inversion.  Some observations:

1) Few clear trends among the Fama/French and Carhart factors
2) Cumulative returns were positive; Momentum was the best; Size was the worst


The behavior of the yield curve changes across the business cycle.  In the paper, the authors segment the business cycle into 4 stages:  Early, Late, Very Late, and Recession.  Assuming that the business cycle is in the Late or Very Late stage prior to Recession, consider that cumulative returns attributable to the Market factor are at their highest during these stages followed by Momentum.  The most notable drop-off in performance is attributed to Value.

During recessions, the factors’ cumulative returns tended to be positive.  The exceptions were the Market and Size factors.  The top performers were Investment, Value, and Momentum.

In conclusion, an inverted yield curve tends to foretell a recession two or more quarters in the future.  Whether the curve inverts or not, there are and will be opportunities for positive equity returns especially among value strategies.