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The value cycle

Stock market mispricings don't disappear for good, but come and go. This offers hope for value investors
The value cycle

In the early 1980s, economists pointed out that smaller stocks had outperformed larger ones for decades. That inspired investors to pile into them and into the new small-cap funds set up to meet that demand. Such big buying, however, pushed up smaller stocks’ prices too far – so much so that in 1998 Paul Marsh and Elroy Dimson, two economists at the London Business School, pointed out in a paper entitled 'Murphy’s law' that the small-cap premium had disappeared. But then Murphy’s law asserted itself in another way, and small-caps beat bigger ones in the following five years.

I mention this because it offers hope for income investors. Perhaps higher-yielding stocks will follow a similar trajectory. Certainly, there have been parallels so far.

In 1997, Nobel laureate Eugene Fama pointed out that value stocks had beaten growth stocks over the long term, just as economists in the early 1980s had pointed to small-caps’ outperformance. This discovery, allied to the bursting of the tech bubble, led to value stocks doing well, just as small-caps did in the years after the discovery of their historic performance. Such a good run, however, led to value becoming overpriced just as small-caps did in the late 1980s: in the past 15 years total returns on the FTSE 350 high-yield index have been four percentage points a year worse than those on the low-yield index (this pattern is not confined to the UK. Adam Zaremba at Montpelier Business School and colleagues point out in the latest issue of the Journal of Banking and Finance that value investing has stopped working in most developed markets in the last 15 years).

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