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It's been a tough year for value stocks. Is that surprising? No, although it reminds that Mr. Market prices certain slices of the equity market differently throughout the business cycle.

For the year through June 26, the rebound in equities has been powered mostly by growth stocks, according to Russell indices. As the chart below relates, growth stocks in general have been the conspicuous leaders through the first half of 2009.

This is hardly surprising in light of the unfolding story in financial economics over the past generation. Return premiums are linked with macroeconomic risks, which means that investors are compensated over the long haul for taking certain risks. Some of those risks pay higher rates than others and if you wait long enough, you'll probably realize the higher returns. All the more so if you pay attention to the fluctuating price of risk in the short term.

The small-cap value ((SCV)) factor (as originally outlined by Professors Eugene Fama and Ken French) is among the most widely known return factors beyond the market overall. The source of SCV's higher return through time is higher risk linked to the business cycle. Economically, there can be no free lunches, at least in the long run and so any expectation of earning a higher return must be connected with assuming a higher risk.

Since 1928, small-cap value stocks have posted a clear return premium over U.S. equities generally, as defined by the S&P 500 and its predecessor benchmarks, based on analysis of data from Ibbotson/Morningstar (see graph below). Even over somewhat shorter periods, although well beyond "trading" horizons, small-cap value has held up well. For the 10 years through the end of last week, for instance, the small-cap Russell 2000 Value Index posted a 5.4% annualized total return, comfortably above the 1.4% loss for U.S. stocks overall, as measured by the large-cap Russell 1000 Index over that stretch.

Why should investors expect to earn higher returns in SCV? Chart 1 above offers a clue, namely: In the short run, small stocks trading at low prices relative to book value and other accounting metrics tend to be more vulnerable in tough economic times. There are a number of reasons for this, as many economists discuss in the literature published over the years. The simple answer is that small firms trading at low valuations tend to be shaky operations to begin with and so the arrival of a macroeconomic headwind makes the prospects for success even more remote.

Individual companies perish, but as an asset class small-cap value shares survive, although not without a roller coaster ride in the interim. For obvious reasons, most investors shun risk during recessions, especially one that's been as deep as the current contraction. But as Professor John Cochrane at the University of Chicago likes to say, someone holds these stocks, even in the worst economic recession since the Great Depression. The question is why? The answer is intimately tied up with the connection between economic cycles and how Mr. Market prices assets.

Of course, investing and risk management are always about the future. That leads to the perennial question: What comes next? Will small-cap value stocks continue to outperform? That's always a topical question when this slice of the equity market is suffering, as it is currently. Looking backward is one thing; committing real money today in anticipation of a repeat performance is something else.

In fact, no one can be sure that SCV will remain true to its historical trend. Yes, there are persuasive arguments for expecting the long-run future will look like the long-run past, but in the short term there's risk -- considerably more so than the long-run past suggests. That's one reason for being cautious about betting the farm on SCV, which is to say holding lots more of these equities than the market-cap equity indices do.

On the other hand, if you're persuaded that there's an economic logic to SCV's historical return premium, owning a bit more of these stocks above Mr. Market's asset allocation looks reasonable. Just remember, even if your bet pays off, it'll come at a price, as the first chart above reminds.

Source: Small-Cap Value: What the Future Holds