In the late 1990s, the ink was barely dry on Fama and French's investigations into the small-cap value equity premium when it looked like the research was crashing and burning. If any corner of the stock market was likely to offer a premium over equities generally, large growth companies looked like obvious candidates, thanks to their soaring prices at the time. The premium in small-cap value, meanwhile, was missing in action.

Or so it seemed until mid-2000, when the great bull market in equities started coming apart. Small-cap value was an exception. Instead of crumbling, it posted a tidy advance in the otherwise ferocious bear market of 2000-2002.

It was the first test of the Fama-French three-factor model (FF3) over a full business cycle since the research was published, and the results looked impressive. Perhaps the small-cap-value premium would be worthy of its own allocation, just as the research by Fama and French implied. If so, investors would need to consider these equities as a distinct beta from the broad stock market.

For some, the counsel is self-evident, given the research and the subsequent track record logged by small-cap value stocks over the decades. Nonetheless, the idea remains controversial 17 years after the first of several FF3 papers formally identified the concept.

Like most notions in financial economics, FF3 is continually debated, tested, retested and then questioned anew. No wonder, then, that the consensus is as elusive as ever that small companies trading at deep discounts to book value are effectively a separate asset class. The idea may be destined for eternal debate, but after nearly two decades of discussion and research, one might wonder: What, if anything, have we learned?

Quite a bit, it turns out. What's more, the lessons are especially timely now, in the middle of the worst recession since the Great Depression.

Let's start with a brief review of the economic logic behind FF3 and why one particular slice of the stock market-and a rather small one at that-should carry so much relevance for managing equity allocations. The answer lies in the finer points of risk, of which small-cap value harbors an outsized helping for its puny market cap.

The reason is that small companies trading at low multiples to book value and other fundamental measures tend to be distressed firms, even in the best of times. During the dark side of the business cycle, small-cap value stocks are clearly the poster children for vulnerable companies. Think of them as the antithesis to blue chips. Expecting small-cap value to bear the brunt of a recession, investors are inclined to abandon the stocks in search of safer terrain. When the outlook improves, sentiment changes and the market breathes a sigh of relief, giving the sector a renewed aura of possibility.

Because investors shun the weakest in times of high economic stress, it's expected that small-cap value would generate a risk premium over the stock market generally. These stocks, in the language of financial economics, have a higher covariance with the business cycle than stocks overall. In that sense, we can think of small-cap value as a recession beta-a beta that's expected to generate a return premium above and beyond what's dispensed by a passive measure of stocks generally.

This perspective gains more support when we review how these equities fared against the broad market-cap-based measure of stocks following recent recessions. Figure 1 shows the return difference for the Russell 2000 Value Index (a small-cap value benchmark of U.S. stocks) less the performance of the Russell 1000 (large-cap U.S. stocks). Following the end of the three previous recessions (as defined by the National Bureau of Economic Research), small-cap value earned substantially higher returns against the broad market. For instance, in the 12 months after the 1981-1982 recession that ended in November 1982, the Russell 2000 Value gained 41% while the Russell 1000 earned 25.1%-a return premium of 15.9% in favor of small-cap value.

Far more encouraging is the fact that the small-cap premium holds up over longer periods. For the 80 years through last year's close, small-cap value posted an annualized total return of 13.4%, based on the Fama-French data series as published in the Ibbotson 2009 Classic Yearbook. That's comfortably above the 9.6% return for large-cap stocks (based on the S&P 500) over those decades as well as other major style and capitalization subcategories of U.S. equities. The small-cap-value premium also remains intact through time in many foreign markets in the developed world, several studies have shown.

Small-cap value's history is even more compelling when we consider research published over the last 20 years demonstrating that business cycles are partially predictable. If we know that small-cap value generates a premium in the long run, and that the premium is linked to the risk inherent in the business cycle, clues about the odds of future recessions and economic rebounds are particularly valuable. It's also timely in 2009, given the current recession.

To understand why, let's review research suggesting that the yield curve is a useful measure for predicting business cycles. In the late 1980s and early 1990s, a new generation of studies appeared finding that the inversion of the Treasury yield curve (short rates above long rates) was a sign of an approaching recession. Normally, the yield curve is upward sloping, meaning that longer maturities command higher yields. This is the normal state of affairs for the bond market. Economic logic suggests that longer holding periods incur higher risk, so investors should be compensated with higher yields.

One 1991 Journal of Finance study was an early effort in academia at demonstrating that the yield curve offers practical information about the timing of the business cycle (it was called "The Term Structure as a Predictor of Real Economic Activity," by A. Estrella and G. Hardouvelis). The main point is that the curve tends to be downward sloping (with short yields over long yields) when it is at or near the onset of a cyclical downturn. During recessions, the curve is upward sloping (short yields below long yields).

This offers a rationale for anticipating a positive relationship between the shape of the curve and the future equity risk premium. A 1989 research paper by Fama and French, for instance, notes that expected stock market returns are higher in recessions than they are amid forecasts during economic expansion ("Business Conditions and Expected Returns on Stocks and Bonds," Journal of Financial Economics, 1989).

More recently, a 2001 study finds that the yield curve inverted ahead of each of the five recessions from 1969 through 2001. The current recession was also foreshadowed by a rise of short rates above long rates. In late 2006 and early 2007, the three-month Treasury yield rose above the rate on the ten-year Treasury note. As we now know, a recession began soon after, starting in December 2007, according to the National Bureau of Economic Research.

These days, the yield curve is upward sloping again, reflecting the Federal Reserve's efforts at trying to promote economic growth by lowering short-term interest rates. In early May, the ten-year Treasury was roughly 3.2%, far above the 0.16% yield on a three-month Treasury bill. The message: A rebound is coming, so the expected equity risk premium is relatively high.

In effect, the financial literature has caught up with the conventional wisdom, which says, "Don't fight the Fed." But while there's now more academic legitimacy for the idea, the question remains: Will the shape of yield curves continue dispensing strategic intelligence about the future path of business cycles? History is littered with studies that identify forecasting ability, only to see these conclusions end up fading. Is there any reason to think that the yield curve studies are different?

Yes, because interest rates are durable measures, ones closely linked to turning points in the economic cycle. Typically, the Federal Reserve raises short rates in order to slow a long-running expansion and head off inflation, which has a habit of rising after an extended period of growth. Eventually, the tighter credit conditions contribute to an economic downturn. Of course, other factors besides higher interest rates also lead to recessions, as the current troubles remind us. Nevertheless, the price of money invariably casts a long shadow on general economic trends, which is why the yield curve holds so much power as a forecasting tool.

"Typically, the reason for the curve inverting is tightening by the Federal Reserve at the short end of the curve, which pushes short rates up until they equal or exceed the long rate," says Bob Dieli, who heads up RDLB Inc., an economic consultancy in Lombard, Ill.

Once recession sets in, the threat of inflation recedes and the Fed eases credit conditions. The adjustment virtually assures that the yield curve will again return to normal, namely, upwardly sloping. When short rates fall below long rates after an inversion, that's a sign of improved odds that economic growth is coming.

The primary mission of central banks is protecting the integrity of the currency, and inflation has proved to be a major-if not leading-threat to paper monies throughout history. That's one reason why inverted yield curves are almost certainly in no danger of extinction. Ditto for the heightened odds of economic weakness following an inverted curve, which is a sign of tightening credit that eventually chokes off growth. The main threat to these assumptions would be if the Fed materially changed its mandate. Anything's possible, but more than three centuries of central banking (following Sweden's invention of the institution in the late 17th century) suggests that fighting inflation will remain the Fed's top priority.

If the connection between yield curves and economic cycles is so clear, then why hasn't the market learned to anticipate the signals? Perhaps because human nature favors seeing the future as an extension of the recent past. Think back to the roaring bull market of late 2006 and early 2007, when the curve inverted. Few investors were eager to entertain the idea that the economy was headed for recession. Even though all the recessions for the past 30 years were preceded by an inversion, there was little if any room in 2006 and 2007 for bearish views on the economy, much less the financial markets. A number of commentators simply dismissed the yield-curve warning as irrelevant in the new world order.

Even though it's widely known in 2009 that small-cap value stocks have a long history of dispensing higher relative returns than the stock market generally, human psychology will likely keep them trading at low multiples, since the crowd cares as much about risk as it does return. Holding small-cap value may be especially daunting (and costly) during periods of elevated economic turmoil, since these companies, for one reason or another, are out of favor with investors, carrying low prices for their book value. These stocks are also burdensome because many of them are thinly traded and the illiquidity makes them unattractive.

These characteristics aren't likely to fade away. Even though the word is out on small-cap value, periods of economic stress typically encourage (or re-encourage) investors to seek relative safety instead. Human nature, in other words, is likely to keep the small-cap value risk premium intact through time.

If we combine what we know about FF3 with the growing research on yield curves, we can then begin to manage the equity portion of asset allocation. If you're looking to beat the market over one or more business cycles, overweighting small-cap value looks like a reasonable strategy. This isn't speculation so much as it is exposing an equity portfolio to a higher degree of systematic risk, which has a history of delivering higher return.

Where does that leave us now? In recent years, small-cap value stocks have trailed the broad market. Meanwhile, the yield curve is now upward sloping in no uncertain terms. So history would suggest that this is a good time to begin overweighting small-cap value. Keep in mind that you already own it if you own a broadly diversified equity index fund.

At the end of April 2009, small-cap value represented roughly 4% of U.S. equity capitalization, based on the market cap for the Russell 2000 value index when compared with the broad Russell 3000 equity index. For clients with an above-average tolerance for risk with a medium-to-long-term horizon, raising the weight of small-cap value above 4% looks like a timely bet. One way to tilt the equity allocation is with ETFs, starting with a core position in a broad equity fund-the iShares Russell 3000 (IWV), for instance-and adjusting the small-cap value weight with a proxy fund, such as the iShares Russell 2000 Value portfolio (IWN).

Remember, though, that even with all the evidence supporting small-cap value, timing is always in doubt. As our experience in the 1990s reminds us, small-cap value risk doesn't churn out higher returns like clockwork. That's why it's called a small-cap-value risk premium. A similar caveat applies with the yield curve. Just as crowds were unwilling to consider the inverted curve's forecast of recession in 2006 and 2007, they may seem skeptical about an economic recovery amid the current recession. If it were otherwise, they would have already bid up small-cap value prices.

None of this is surprising. Most investors don't have the necessary contrarian instincts to profit from small-cap value. Good thing, too, because if everyone owned more small-cap value stocks than what might otherwise be allocated by a market-cap-based broad equity index, the expected risk premium would evaporate. It's unlikely that everyone does, which is why small-cap value is so compelling.

James Picerno is a freelance financial writer and editor of The Beta Investment Report (BetaInvestment.com).