Will value stocks lead market out of recession?

If past recessions are any guide, value stocks could emerge as the front-runners as the economy starts heading to a recovery.
During the past four recessions, value clearly outperformed growth in the early periods of economic expansion, according to a market research report by Russell Investments of Tacoma, Wash. Although growth typically does better during recessions, the outperformance of growth reverses almost immediately when the economy bottoms, Russell said in the report.

Investors who bought the Russell 3000 Value Index three months after the economy bottomed went on to outperform Russell 3000 Growth investors by an average of 10.7 percentage points over the next 12 months.

Judging by how value has been behaving, the market could be signaling that the economy has bottomed, industry observers said.

“We've seen since the low in March that the [Russell value] indexes have been beating their growth counterparts,” said Dave Hintz, head of U.S. equity research at Russell Investments.

From March 10 through May 28, the Russell 3000 Value Index was up 40.12%, while its growth counterpart trailed at 32.60%.

“Once we're in a recovery, strategies that work would be low price-to-book and low price-to-earnings,” said Jim Swanson, chief investment strategist with MFS Investment Management of Boston.

Even if the economy weren't suffering from a credit crisis, banks would probably be one of the first leaders out of a recession, said Mr. Swanson, who thinks that the economy will bottom later this year.

Bank stocks are heavily represented in value indexes.

Financial institutions do well coming out of recessions, because the Federal Reserve usually cuts rates to stimulate the economy, and the cheap money lets banks earn attractive spreads.

“That's how [banks] earn their way out” of recessions, Mr. Swanson said. “It happens in every cycle.”

During recessions, growth stocks tend to do better because they are better able to generate earnings, Mr. Hintz said.

At the same time, value stocks usually lag because their fundamentals tend to deteriorate more, according to Russell Investments. Financial companies in particular can get hit hard.

The Russell research also found that the outperformance of value during economic recoveries was most pronounced with small-cap stocks.

Because small-caps overall typically get hit hardest in a downturn, they have also outperformed after an economic recovery begins, according to a study last year from JennisonDryden, the money management unit of Prudential Financial Inc. of Newark, N.J.

JennisonDryden analyzed the recoveries from the last nine recessions, going back to 1953.

Every market period is different, of course, and there's no assurance that this time, value once again might lead the way out of recession. In fact, the valuation differences between growth and value stocks are small right now, which may diminish any performance differentials.

The current situation is in sharp contrast to the last recession, which ran from March 2001 to November 2001, when growth stocks had vastly outperformed value for a decade.

“In the last recession, value had a multiyear winning period that started before the end of the recession, but this time, [outperformance] could be shorter because [value is] not as cheap” relative to growth, Mr. Hintz said.

BANK STOCKS

Enlarge This Photo In addition, many of the bank stocks that Russell categorizes as value will shift to growth when it reconstitutes its indexes this month, said Ron Surz, president of PPCA Inc. in San Clemente, Calif., an investment consultant who sells his own line of style indexes. That's because the earnings at some of the banks and brokerage firms have fallen to such low levels that their valuations are now relatively high.
Large-cap-value indexes are currently overweighted with financial stocks, Mr. Surz said, which has boosted returns since the March lows.

Banks and value stocks probably won't be the only plays on a recovering economy.

Mr. Swanson said the consumer discretionary sector usually rallies about four months before a recession ends.

“If this is [a sustained rally], sectors like casinos, entertainment, cars [and] restaurants — stuff consumers like but don't need — [are] following the script,” he said.

“Consumer discretionary is typically a leader,” said Paul Schatz, president and chief investment officer of Heritage Capital LLC in Woodbridge, Conn., which advises on about $130 million in assets.

HAMSTRUNG CONSUMERS?

But he is worried that the current downtrend is similar to that of the 1930s. Then, consumers “spent a decade and a half trying to fix their own balance sheets,” Mr. Schatz said. “If we have the same thing now, consumers will be hamstrung as they pay debt down.”
Better bets to lead the recovery are technology, emerging markets, and energy and materials, Mr. Schatz said.

Mr. Swanson said late cyclicals such as mining and energy stocks should pick up when the consumer discretionary sector fades and excess supplies of commodities get used up.

Barry Mendelson, managing partner at Capital Market Consultants LLC in Milwaukee, a provider of money manager platforms and due diligence, also feels consumer demand will be weak.

“The stocks likely to benefit [from a recovery] will have some sort of flows of [government] cash — materials and [infrastructure] construction,” he said.

Small-cap value might also be a good play because many healthy small banks are included in that style category, Mr. Mendelson added.

“There are a lot of well-run regional and community banks that should fare pretty well,” he said.

The strength in emerging markets and technology at this juncture of a recovery is unusual, Mr. Swanson said.

“Everyone senses that if the U.S. stops shrinking, emerging markets will do well [and] technology will do well if the market stabilizes [because technology stocks are] still cheap,” he said.

By Dan Jamison