New Paradigm or Same Old Hype in Equity Investing?

Abstract

The recent relative stock-price performance of six U.S. equity asset classes (classified by size and by value-versus-growth style) differs markedly from the historical pattern. Large-capitalization growth stocks have apparently taken the place of small-capitalization and value stocks in investors' hearts. Have the size and value premiums of the past vanished for good? We explore three explanations of recent market behavior—the “rational-asset-pricing” hypothesis, the “new-paradigm” viewpoint, and the “behavioral” or “institutional” explanation. In our study, we examined the operating performance of the equity classes to see which hypothesis accounts for the recent behavior of returns. Our findings provide the most support for the behavioral explanation.

The recent relative stock-price performance of equity asset classes based on size and value-versus-growth orientation differs markedly from the historical pattern. On the one hand, large-capitalization growth stocks earned dramatically higher returns than the other equity classes in the 1996–99 period, and at the time this article was written, the relative valuations of the large-cap growth group of companies stood at record levels. On the other hand, the recent disappointing performance of small-cap and value stocks has left scars on many active money managers. Value-oriented money managers are coming under pressure to become more growth oriented, and some plan sponsors have simply given up on active managers and shifted to indexing.

Have the apparent size and value premiums vanished for good? Whether the recent experience represents a long-lasting shift in relative equity valuations or a string of unexpected temporary shocks has important implications for portfolio allocation decisions. This article explores three explanations for the recent relative performance of the six size and value-versus-growth equity classes—the “rational-asset-pricing” hypothesis, the “new-paradigm” viewpoint, and the “behavioral” or “institutional” explanation. To see which, if any, of these explanations can account for the recent behavior of returns, we examined the stock-price returns and operating performance of the different classes for 1970 through 1999.

We found that, contrary to the rational-asset-pricing hypothesis, the recent large gains in the stock prices of large-cap growth stocks cannot have been triggered by their operating performance as measured by variables that included sales growth and growth in earnings. For example, over the 1996–98 period, a portfolio of large-cap growth stocks grew in sales by an average of 6 percent a year, whereas the mean for the 1970–98 period was 10.3 percent a year. Stock returns for this equity class over the 1996–98 period averaged 34 percent a year, whereas they averaged 11.6 percent for 1970–1998. We also found that the disappointing returns on small-cap and value stocks are not likely to be the result of poor operating performance on their part.

Our conclusions are based on recent experience versus long-run patterns. Of course, future patterns of growth in profitability may be radically different from the past, but justification of today's valuations of large-cap growth stocks requires heroic assumptions about the sustainability of high growth and superior operating performance by this group of companies. Thus, the most likely explanation for the recent behavior of the relative prices of U.S. equity classes is a behavioral or institutional one.