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It’s Too Soon to Say the Value Premium is Dead

The underperformance of U.S. value stocks since the Great Recession has received much attention from the financial media, and prompted at least some investors to conclude that value investing is dead. That has led to papers being written, such as AQR’s May 2020 article, “Is (Systematic) Value Investing Dead?” Because the value premium has been much larger in small stocks than in large, we’ll review the performance of small-value stocks compared with broad market indexes. From 2008 through July 2023, while the S&P 500 returned 9.8% per year, the Fama-French small-value research portfolio returned 8.6%, an underperformance of 1.2 percentage points annually. (Fama-French data is from Ken French’s website.)

A Cautionary Tale

We heard the same argument about the death of the value premium in 2000. From 1994 to 1999, the S&P 500 returned 23.6%, annually outperforming the Fama-French small-value research portfolio by 7.2 percentage points. However, the declaration of the death of the value premium was premature. From 2000 to 2007, while the S&P 500 returned 1.7%, the Fama-French small-value research portfolio returned 16.2%, outperforming by 14.5 percentage points annually. Such performance should be a cautionary tale for those declaring the death of value.

If the underperformance of the value premium in U.S. stocks since 2008 was a sign that value was dead, we should see similar underperformance outside the U.S. From 2008 through July 2023, the MSCI EAFE Index returned 3.2%, but the Dimensional International Small Cap Value Index returned 5.2%, outperforming by 2.0 percentage points annually. In emerging markets, while the MSCI Emerging Markets Index returned 1.7%, the Dimensional Emerging Markets Targeted Value Index returned 4.1%, outperforming by 2.4 percentage points. Thus, outside the U.S., investors who diversified their portfolios to include small-value stocks benefited.


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Taking Tax-Loss Harvesting to the Next Level

 The empirical research has shown that tax-loss harvesting strategies in separately managed accounts can improve the post-tax returns of an investment portfolio by employing a strategy of selling positions in securities with losses in order to generate capital losses that can be used to offset gains generated in the overall portfolio. The Internal Revenue Code permits capital losses to be netted against capital gains in the year they occur. Unused losses can be carried forward indefinitely, deductible against future net capital gains plus an additional $3,000 deductible against ordinary income per year.

Since long-term capital gains are often taxed at lower rates, a tax-loss harvesting strategy can improve a portfolio’s after-tax performance. While long-term losses are generally hard to realize systematically because stock positions on average appreciate over time, in the short term, volatility allows for the capture of short-term losses. The result is that most losses end up being short-term, which can be used to offset highly taxed short-term gains. With that said, most of the benefit from tax-loss harvesting is from the deferral of gains (offsetting realized gains from other assets in the portfolio).

 A key benefit of tax-loss harvesting is that it can allow investors with concentrated positions in low-basis stock to diversify their holdings as tax-loss harvesting losses are realized—the losses are used to offset some, or all, of the taxes due on the sale of the low-basis stock. It can also help offset the capital gains taxes generated by less tax-efficient (higher turnover) equity strategies such as those of active managers.


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How Likely Are Market Crashes?

It is well known that equities are subject to both booms and busts, testing the discipline of most investors and leading legendary investor Warren Buffett to conclude: “Investing is simple, but not easy.” Perhaps the best example of the boom-and-bust nature of equity markets is the late 1990s. From January 1995 through February 2000, the S&P 500 boomed, returning 25.8% per year. By the end of the period, the ShillerCAPE 10 had reached 42.2, producing an earnings yield of just 2.4%. The CAPE 10 earnings yield has been as good a predictor as we have of future equity returns. At the time, the yield on 10-year Treasury Inflation-Protected Securities was in excess of 4%. In other words, the expected real return to equities was almost 2 percentage points less than the riskless real return on TIPS. If anything is a sign of a bubble, that is the leading candidate. Then, from March 2000 through September 2002, the S&P 500“busted,” producing a cumulative loss of 38.3%.

Another boom and bust was experienced from October 2002 through October 2007 when the S&P 500 returned 15.5% per year. That boom, which pushed the CAPE 10 to 27.3, producing an earnings yield of 3.6% (just 1.5 percentage points above that of the yield on 10-year TIPS), ended in a bust that saw the S&P 500 lose a total of 51.0% from November 2007 through February 2009.

The next boom and bust occurred a decade later. After returning 26.1% a year from 2019 through 2021, producing a total return of just over 100% in three years—a boom that pushed the CAPE 10 to 38.3 (an earnings yield of just 2.6%)—from January through September 2022, the S&P 500 lost 23.9%.

The historical data demonstrates that extremes in the right tail of the return distribution (caused by rising valuations) can portend sharp reversals and painful performance downturns.


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Aging Population Affects Economic Growth but Not Stock Returns

While it’s true that population growth and productivity determine the rate of growth in a country’s economy, the conventional wisdom that faster-growing economies lead to higher investment returns isn’t true. The wrong conclusion is reached because it fails to account for the fact that markets are highly efficient in building information about future prospects into current prices. There are also other explanations.


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What Happens to the Market if America Goes to War?

The stock market hates uncertainty, and there is plenty of uncertainty with respect to the conflict between Russia and Ukraine.

This post focused on violence in the Middle East, specifically Syria, and the potential that the United States could enter the conflict and what that might mean for the markets. Given the recent turmoil in Eastern Europe and the developing international crisis, we are responding to requests from Enterprising Investor readers to provide an update.

So, is now the time to beat a hasty retreat from stocks?

Let’s examine how capital markets have performed during times of war.


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