History Shows 2009-2010 Could Be Smallcap Value's Time to Shine

by: Maheep Hayer

In my previous article I mentioned that I believe the secular bear market is not over. However, that doesn't mean we are going straight down until great values (6% dividend yield on S&P 500 and 10 year cyclically adjusted PE below 9) are discovered. A secular bear market can last over 20 years, but that doesn't mean you cannot make tremendous profits after a long period of poor performance. There have been 5 years in the past 80 years where the return on large cap stocks over the previous 5 years had just turned negative. The 2004-2008 timeframe happens to be one of them. The S&P 500 has a total return of -12% over these 5 years. This could mean that 2009-2010 could deliver big returns. For the previous 4 periods, I will display and show the subsequent return over the next two years.

1. 1927-1931. From 1/1/1932 to 12/31/1933 the large cap index returned 41% total. Small value stocks trumped those numbers with a 108% return over the two year time frame. This even after dropping over 43% by June 8,1932 and both indexes actually ended 1932 down.

2. 1937-1941. From 1/1/1942 to 12/31/1943 the large caps returned 81% and small value returned 187%.

3. 1970-1974. From 1/1/1975 to 12/31/1976 large caps returned 69.5% and small value returned 151%.

4. 1998-2002. From 1/1/2003 to 12/31/2004 large caps returned 42% and small value returned 92%.

5. 2004-2008. What will happen from 1/1/2009 to 12/31/2010 is still very much a question mark as only 4 months have passed. Both the large caps, as depicted by the S&P 500, and the small value stocks, as depicted by the Russell 2000 value index, are down for 2009 even after a tremendous run from March 6. If this method of serious 5 year underperformance is followed by fabulous subsequent two year returns then you would want to buy now since we are still not positive for 2009.

To take advantage, you could buy either IWN, the Russell 2000 Value ETF, or DFSVX, the DFA US small cap value mutual fund. These two vehicles follow the small cap value index very closely.

I would caution you that although the previous 4 times the market did wonderful in the 2 year period after first turning in a negative 5 year return, in only one of those 4 times did "Robert Shiller's CAPE" not fall to below 9 at minimum, the 2003-04 period. Also, all 4 of these periods involved at minimum 2 years in a row of negative returns coming in, and so far, we only have one negative S&P 500 year, 2008.

This article's main point is to show that the bulls and bears could both be right at the same time. The bears don't believe we're at the ultimate bottom because of low dividend yields and high price ratios while the bulls can argue that terrible performance is followed by strong performance. Personally, I'm taking a neutral approach and believe we can have some great years without having hit the bottom. Gold monthly averages are the #1 indicator. But that's another story...

Disclosure: no positions