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.