Equity investing involves significant risk of large losses—if those bear markets didn't occur, investors would not have earned those great returns that disciplined buy-and-hold investors were rewarded with because the risk premium would not have been there in the first place. Bad periods remind investors that there really is risk and that risky investments are priced to compensate investors for taking risk.

Returning to our discussion on value stocks, let's look at some important data related to HmL.

The Value Premium

• The value premium has appeared with a high degree of persistence—HmL was positive in 51 of the 80 years from 1927 through 2006, or 64 percent of the time. Of course, that means it was negative 36 percent of the time. That is the nature of risk.
• The standard deviation of HmL was over 2.5 times the annual premium at 12.7 percent. This high figure shows the risky nature of investing in value stocks. The highest HmL occurred in 2000, when it reached 37.8 percent. Ironically, the lowest occurred the prior year when HmL was a negative 26.1 percent (probably causing many investors to panic and sell).
• There have been relatively long periods where HmL has been both positive and negative. For example, in the five-year period 1927-31, HmL was negative in four of the five years. It was also negative in four of the six years 1934-39, three of the five years from 1949-53, three of the five years from 1956-60, four of the six years from 1966 through 1971, all three years from 1978-80, and five of the seven years from 1985-91. On the other hand, it was positive all nine years from 1940 through 1948, all five years from 1961 through 1965, all six years from 1972 through 1977 and all seven years from 2000 through 2006.

While HmL has been fairly persistent, there has been no predictable pattern to the premium. The only way investors could have reliably earned the value premium is if they had the discipline to maintain their exposure. This means that investors would have had to have ignored the clarion calls from Wall Street and the media that are often made after a few years of value outperformance. Calls like "This is the year of growth stocks," had been heard almost continually since 2002.

Keep in mind what would have happened to investors who, after experiencing the huge value premiums of the first three years of the new century (2000-02) when HmL was 37.8, 14.4 and 12.2 percent, respectively, listened to such calls and sold their value holdings to buy growth stocks. They would have missed the next four years when HmL was 3.0, 8.3, 8.3 and 12.7 percent, respectively.

The evidence from academic studies shows that there has been no persistent ability to time the market, increasing equity allocations ahead of the bull emerging into the arena, and lowering them ahead of the bear emerging from its hibernation or to shift allocations between asset classes. Consider the following example. A study of 100 large pension funds and their experience with market timing found that while they all had engaged in at least some market timing, not one had improved its rate of return as a result. In fact 89 of the 100 lost as a result of their efforts, and their losses averaged an incredible 4.5 percent over the five-year period.¹

There are two reasons that trying to time the market is unlikely to be successful. As we have discussed, ex-ante (before the fact) there should always be an equity risk premium because stocks are always riskier than one-month Treasury bills. All that high valuations predict is relatively low future expected returns; but those returns should still be higher than the returns on a riskless security. Second, the equity risk premium is so high that timing efforts would have to be right almost all the time to be successful. The same is true of the value premium.

Just as there is no evidence supporting the view that investors are likely to succeed in their efforts to time the market, there is no evidence that they can "time" the value premium with persistence. If there were, we would see evidence of active managers outperforming passive benchmarks with persistence greater than randomly expected. Yet, we don't see such persistence.

There is an important fact about value stocks and their returns that investors should understand because it will help them ignore the media (and their friends). Most of the HmL premium comes from a small percentage of value stocks that produce very high returns. Their outperformance often leads to them "migrating" out of the value asset class, leaving a different group than the prior year. The same thing is true of small-cap stocks.

Even with this knowledge, there are those that believe the value premium can be timed based on the relative spreads between the valuations of value and growth stocks. In other words, when the spread between the book-to-market (or price-to-earnings) ratios of value and growth stocks is wider than the historical average, investors should load up on value stocks. On the other hand, when the ratio is relatively low, they should abandon value stocks and move to growth stocks. This would seem to make sense since studies have found that when the spread in book-to-market (BtM) ratios between value stocks and growth stocks is high, the subsequent value premium tends to be high. The reverse is also true.

Evidence On Trying To Time The Value Premium

Based on that information, if next year's value premium is expected to be high, it would seem logical to own value stocks. If it were expected to be low, then growth stocks would seem to become the logical choice. Is it really that simple to earn abnormal returns? Does a statistical relation always translate into a viable portfolio strategy? These are the questions Jim Davis asked and answered in his 2007 study "Does Predicting the Value Premium Earn Abnormal Returns?"² The study covered the period July 1927-June 2005.

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