Value ETFs Leading the Way to Recovery?

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 |  Includes: IVE, IVW, IWD, IWN, VOE, VOT
by: Michael Johnston

Conventional wisdom says that while growth stocks outperform their value counterparts during recessions, value stocks gain the upper hand once the economy hits bottom, leading the way during the early recovery stage of most economic cycles.

That’s according to a report by Russell Investments of Tacoma, Washington, which indicates that growth outperformance tends to reverse as soon as the economy bottoms. So what are the numbers telling us about the market’s bullish run over the past few months? Is it the beginning of a recovery or simply another glimmer of false hope?

Here’s the logic behind the “rules of thumb,” according to an article by Dan Jamieson: during recessions, the fundamentals of value companies tend to deteriorate rapidly, leading to underperformance. Financial companies are particularly susceptible to underperformance (a trend once again characteristic of this recession). Once the economy “turns,” however, companies with low price-to-book and price-to-earnings ratios are often among the first to be gobbled up. Banks tend to do well particularly during a recovery, since the Fed often cuts interest rates, allowing financial institutions to generate profitable spreads on their loan products. Obviously the Fed’s hands are tied somewhat in the current economic environment, but banks have definitely seen a nice recovery in recent months.

So what are the numbers telling us about the most recent economic collapse and subsequent “recovery”? Using September 1, 2007 as the start date of the most recent recovery and March 9, 2009 as the “bear market bottom,” some interesting trends emerge. Across all size classes, growth ETFs did indeed outperform value funds, sometimes by a wide margin, during the 18-month downturn.

But since the market bottom (or at least what I hope and believe was the market bottom), the tables have turned. While both growth and value ETFs are up sharply, value funds have led the way.

These trends would seem to be a positive sign for investors, particularly those who believe in recurring trends across time (I, for one, am somewhat skeptical of such blind reliance, especially in an environment so drastically different from anything we’ve seen before).

Even if this trend of value fund outperformance is indeed playing out again, it’s difficult to tell exactly what stage of the economic cycle we’re currently in.

Supposing that we did indeed scrape bottom in March of this year, it’s impossible (for me at least) to say that value funds will continue to outperform growth ETFs, or for how long. While investors who had the foresight to tilt their portfolios towards a value allocation in March have been handsomely rewarded, those doing so now risk trying to catch a ship that has already sailed, and ending up all wet.

Disclosure: No positions at time of writing.