The lack of a sizable value premium in the nasty 2008 equity sell-off is highly unusual over the past 30 years. In Figure 4, we outline all of the S&P 500 down markets greater than 15% since 1979. Value won handily in the markets of the early 1980s and 2000-2002 while also outperforming in the crash of 1987. Value stocks have performed better in past bear markets because they enter the periods with cheaper valuations, whereas the growth shares are "priced for perfection."[6] As the economic picture worsens, growth shares have historically suffered more because of the greater revision to future expectations for them. (In the mini sell-off of 1998, growth slightly outperformed value, but that bear market never took hold; it was over before many of us returned from our summer vacations!) In this latest bear market, we find for the first time in a sustained bear market in the past 30 years, that value's performance versus growth is virtually flat.

We believe the major reason that 2008 bucked the trend toward a clear outperformance by value in a down market is "distress." Value stocks are cheaper for a reason: They have issues, warts, and problems. Normally, as the economy heads south, these problems don't prove to be a hindrance to value performance because an expectation of problems is built into the value stocks' prices. When the outlook turns from recessionary to depressionary, however, the floor under the cheap valuations caves in. Investors' primary question turns from "how long will it take for the company or industry to turn around?" to "how long will it exist?" More to the point, investors stop asking, "What's the return on our money?" and start asking, "Will we ever see a return of our money?" With these questions circulating, any security giving off a whiff of distress—in the form of high debt levels, liquidity issues, and so on—begins to sell off regardless of its relative price.[7]

Table 1 provides an attribution of returns based on deciles of the price-to-book ratio (P/B), which often serves as a proxy for the continuum from value to growth. Consistent with our expectations, the FTSE RAFI US 1000 was considerably underweighted in the most expensive stocks in the large-cap universe (7.9% versus 13.8%). This is a natural outcome from weighting stocks based upon today's size, not expectations of how large they will be in 5 or 10 years. Just like previous bear markets, these high-priced growth stocks got hammered (down 42.7% in the Russell 1000), as a softening economy rapidly altered expectations. The RAFI strategy earned excess returns for having less exposure and better stock selection. However, the RAFI strategy promptly gave up this premium and then some on the flip side of the spectrum. The fear of distress caused the cheapest stocks to do even worse than the most expensive. Thus, the RAFI strategy entered 2008 with a larger exposure to the bottom two deciles of P/B. Looking at the 10th decile (stocks priced below 1.1x's book value as of December 31, 2007), the FTSE RAFI US 1000 strategy had a 6.6% exposure to these stocks versus the Russell's 4.4% exposure. This small delta was magnified enormously when this batch of stocks finished with declines averaging more than 65%.

The fear of distress, and its effect, is also clearly seen in the role of industry/sector "detractors" in the FTSE RAFI US 1000 relative performance. The U.S. automobile industry was the poster child for distress (it detracted 57 basis points from the FTSE RAFI US 1000 net performance) toward the end of 2008, but this sector represented a rather small holding in both the RAFI and Russell indices. The financial sector held a much larger cumulative position in the FTSE RAFI US 1000 (with a beginning weight of 18.7%) and in the Russell 1000 (17.5%), and it went through a crisis in which many companies' ongoing viability was cast into doubt. The small overweight in financials in the FTSE RAFI US 1000 was the primary detractor in the RAFI index underperformance in the U.S. large company market. As we stated in August,[8] the current upheaval in this sector bodes well for future RAFI performance for two reasons. First, most financial stocks are priced to reflect the most dire of outcomes, meaning that if they simply avoid the worst-case scenarios, they could provide outsize performance. Second, every failure of a financial firm reduces competition and gives the survivors more pricing power.

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