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.