The Performance of Late-Cycle Premiums
Re-Cycled News
The media has been sharpening its focus on cycles lately, but not in anticipation of the Tour de France. Rather, the financial media’s spotlight is on business cycles.
A common refrain from the industry is that the performance of certain groups of stocks is tied to the business cycle. For example, it has been argued that some factors or investment strategies are “defensive” because they perform well late in the cycle when economic growth begins to slow, while other premiums should be avoided because historically they have underperformed during this phase. Investors who are pessimistic about the direction of the economy may be tempted to wonder if it’s time to reevaluate how their portfolios are positioned.
It is important to be cautious when interpreting research conducted on a small number of observations. The National Bureau of Economic Research (NBER) has identified 15 recessions in the US since the start of stock market data coverage in 1926. Small sample sizes can be especially susceptible to the effect of a handful of outliers.
We assessed the behavior of stock market premiums—size, value, and profitability1—and found no reliable evidence that their performance fares differently deep into an economic expansion. Our results suggest that pinpointing where we are in the business cycle is unlikely to yield useful inputs for one’s asset allocation.
Late to the Party?
The NBER retrospectively classifies the US economy through time by identifying peaks and troughs that define recessions. The last trough was determined to be June 2009, marking the end of a recession beginning December 2007.
While the NBER effectively provides a binary historical classification of the economy (recession or not), many in the industry describe fluctuations in the economy as business cycles with four phases: expansion, peak, contraction, and trough. The nearly 10 years that have elapsed since the last NBER trough have prompted many to suggest we are nearing the end of the current expansion prior to the next recession, a stretch some refer to as “late-cycle.”
For the purposes of our study, we define late-cycle using the chronological midpoint between NBER trough and peak dates, as shown in the illustrative example of the business cycle in Exhibit 1. Late-cycle months therefore compose the second half of each expansion period.
Illustrative example of the business cycle
Late-cycle periods defined for each NBER expansion using the halfway point between each trough and peak.
How have size, value, and profitability premiums fared during the oft-discussed late-cycle periods? As we see in Exhibit 2, the premiums in late-cycle months were positive on average and similar in size to their full-sample historical averages. The average monthly return difference between small caps and large caps in late-cycle months was 0.23%, compared to 0.28% in all months from June 1927 through December 2018. Value and profitability premiums were both slightly higher than their overall historical averages. And all three premiums were positive at least 50% of the time in late-cycle months, with similar frequencies to their full history. It appears that, despite the fanfare over late-cycle investing, there is no evidence that the size, value, and profitability premiums perform any differently late in the business cycle.
Average size, value, and profitability premiums
All Months consists of observations through December 2018 and beginning from June 1927 for small caps vs. large caps, July 1926 for value vs. growth, and July 1963 for high vs. low profitability. Late-Cycle Months includes months after the midpoint of each expansion period up through the subsequent peak.
While the average premiums are similar between the late-cycle months and all months, an investor may be wondering how the range of outcomes compares. Specifically, are the premiums more prone to especially bad outcomes late in the business cycle? The distributions illustrated in Exhibit 3 suggest not. The distributions of premiums in late-cycle months are quite similar to the overall distribution in all months. In other words, there is no reason to expect different size, value, or profitability premiums just because we are many years into the current economic expansion.
Distributions of monthly size, value, and profitability premiums
Includes monthly observations through December 2018 and beginning from June 1927 for small caps vs. large caps, July 1926 for value vs. growth, and July 1963 for high vs. low profitability. Months classified as late-cycle marked in teal.
Value Minus Growth
High Prof Minus Low Prof
Breaking the Cycle
What we know is that the US expansion is in its 10th year. What we don’t know is how much longer this cycle will last. With historical US expansions lasting an average of about four years, many in the industry would agree we are late in the cycle. What does that imply about the distribution of size, value, and profitability premiums? Not much, according to the historical evidence. While the premiums are not assured over any time frame, research suggests the most reliable way to capture them is through a disciplined approach that maintains consistency through time. For investors still craving some news about cycles, better to focus on ones with handlebars.
Footnotes
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1Size premium: The return difference between small market capitalization stocks and large market capitalization stocks. Value premium: The return difference between stocks with low relative prices (value) and stocks with high relative prices (growth). Profitability premium: The return difference between stocks of companies with high profitability over those with low profitability.
Appendix
Dimensional US Small Cap Index: Compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose market capitalization falls in the lowest 8% of the total market capitalization of the eligible market. The index emphasizes companies with lower relative price and higher profitability. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Small Cap Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose market capitalization falls in the lowest 8% of the total market capitalization of the eligible market.
Dimensional US Large Cap Index: Compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose market capitalization falls in the highest 90% of the total market capitalization of the eligible market. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007.
Fama/French US Value Research Index: Provided by Fama/French from CRSP securities data. Includes the lower 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973).
Fama/French US Growth Research Index: Provided by Fama/French from CRSP securities data. Includes the higher 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973).
Fama/French Top 30% Operating Profitability Portfolio: Provided by Fama/French from CRSP securities data. Formed at the end of each June and consists of US firms with operating profitability (OP) greater than that of the 70th percentile NYSE firm ranked on OP.
Fama/French Bottom 30% Operating Profitability Portfolio: Provided by Fama/French from CRSP securities data. Formed at the end of each June and consists of US firms with operating profitability (OP) less than or equal to that of the 30th percentile NYSE firm ranked on OP.
Profitability is defined as operating income before depreciation and amortization minus interest expense scaled by book. Relative price refers to the share price (or market cap) of a firm’s stock, divided by a fundamental variable of the firm (e.g., earnings, cash earnings, dividends, net assets). One of the most widely used measures of relative price is the price-to-book ratio.
Disclosures
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Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.
Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, an affiliate of Dimensional Fund Advisors Canada ULC.
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