Andy Berkin Head of Research at Bridgeway bio image

Andrew L. Berkin, PhD

Geoff Crumrine

Examining factor returns from past recessions reinforces the importance of diversification and the dangers of market timing

It’s official. On June 8, 2020, the National Bureau of Economic Research (NBER) declared that the United States entered a recession in February of this year. Somewhat anomalously, on that same day the S&P 500 gained 1.21% to move back into positive territory for 2020. After falling roughly 33% from its high to usher in a bear market, the index rallied nearly 45% from its lows on March 23 through the date of NBER’s recession announcement.

So, while it is bad times for the economy, the stock market is regaining its former euphoria. It’s understandable if investors are wondering what this means for stocks going forward, and for the factors that shape their returns. While we can’t predict the future, we can examine how these factors have performed during past recessions—and what happened before and after those events.

Bridgeway’s research into past recessions uncovered data that reminds investors that it’s risky to try to time both the economic cycle and market’s performance. Individual factors don’t move in lockstep during recessions. Some, like momentum, hold up fairly well. Others, like small size and value, lag. However, our research on past recessions also shows that factor performance can turn around quickly, with small size and value enjoying strong returns in post-recessionary periods. We believe this encouraging evidence reinforces the importance of diversifying portfolios across factors and staying the course.

A Historical Look at Factor Returns and Recessions

What are Factors?

Factors are the specific characteristics of stocks and other securities that both drive their returns and explain their performance across different market conditions and business cycles.

Over the very long run, stocks and the economy are related. A better economy means better earnings and valuations for stocks. But the stock market is forward-looking. Investors don’t just wait for official confirmation of economic or company news, but rather act on what they expect to happen. How does this gap between economic performance and investor expectations play out in historic stock returns?

Chart 1 shows the average monthly returns for the Fama-French factors and momentum in a variety of economic environments. The data goes back to July 1926 and includes 15 recessions. The current recession is excluded as it has yet to run its full course.

15 past recessions going back to 1926

Fama-French Plus Momentum Factors, Average Monthly Returns (%)

Market premium (Mkt-RF)Small size (SMB)Value (HML)Momentum (MOM)Profitability (RMW)Conservative investments (CMA)
All Months0.670.190.350.660.260.27
12M Pre Recession0.34-0.220.620.980.710.53
12M After Recession1.950.980.650.540.590.39

*Average returns through January 2020. Mkt-RF, SMB, and HML data starts in July 1926. Momentum data starts in January 1927, and profitability and investment factors data start in July 1963 Source: Ken French Data Library

As we see in the chart’s top row, all factors have positive returns when invested over the long term. Performance differences first appear when we look at the next two rows, which assign these months into two categories: expansions and recessions1. During expansions, all factors are again nicely positive, and are statistically and economically significant. The story is somewhat different when we look at recessions: Both the market’s excess return and small size returns are now negative, and value returns are notably reduced.

These results are not surprising, given that the original Fama-French three factors, which built on the work of others, are often called “risk premiums.” While some have argued that these excess returns are due to behavioral considerations, there is ample evidence for both sides2. During the tough times of a recession are exactly when risk shows up. Investors flee from risky stocks—especially the riskiest beaten down names. Conversely, investors seek out quality companies with good financial health. This helps explain the better returns of the profitability and conservative investment factors, which are stronger than typical during recessions.

Given that we have entered a recession, should investors cut their equity allocation? Or should they move exclusively to larger stocks with good company financial health? The answer is no, not necessarily, because those moves present their own risks.

First, the results above are true on average, but do not happen every single time. Second, factor results depend not just on whether there is a recession, but also on the specific economic and market environment of each instance. What occurs before and after a recession matters, and timing can be crucial.

Timing Matters

Factor behavior can change dramatically during the run up to a recession and in the subsequent recovery. Unfortunately, we can’t know exactly when recessions will begin or end. Those dates are determined by NBER, often well after the fact and subject to subsequent revision.

We see evidence of these shifts in market behavior in the two rows of Chart 1 that give factor returns before and after recessions. There is no standard way to define these periods, so for consistency and convenience we have arbitrarily chosen 12 months3. Periods before a recession are often marked by euphoria: The Roaring 20’s, the tech bubble of the 1990’s, and the period before the recent Great Financial Crisis are well-known examples. Such an environment is particularly reflected in the strong returns for momentum, as stocks that have done well continue their positive run.

Periods following recessions are often filled with cautious optimism about an improving future and increased risk appetite. This is when the stock market—particularly small and value segments—typically put in their strongest performance, reversing their recession blues. Trying to time the market and factor performance runs the risk of missing out on these very substantial gains. It’s not just when you get out, but also when you get back in that matters.

One recent example is that when the impact of COVID-19 became clear, the market sold off rapidly. It then rebounded in anticipation that the unprecedented monetary and fiscal stimulus will moderate the economic damage. Investors who abandoned stocks in anticipation of a recession may well have captured the downside but missed the subsequent rally we have experienced.

Case Study: Recession of 2001

Diving deeper into our data, the recession of 2001 is an interesting example of the risks of attempting to time recessions and adjust factor exposure. We chose to highlight this period because the strong returns for small and value stocks in the 2001 recession is a cautionary tale for those tempted to take refuge in large growth stocks now. The chart below shows the same factors as before, but isolates the months before, during and after this event only.

Recession of 2001 (March – October, 8 months)

Fama-French Plus Momentum Factors, Average Monthly Returns (%)

Market premium (Mkt-RF)Small size (SMB)Value (HML)Momentum (MOM)Profitability (RMW)Conservative investments (CMA)
During Recession-1.991.150.682.122.041.06
12M Pre Recession-1.76-1.744.54-1.054.372.82
12M After Recession1.950.980.650.540.590.39

Source: Ken French Data Library

While small size (SMB) and value (HML) have typically been negative or weak during a recession, both factors had strong returns in the recession of 2001. Large cap and growth stocks had dominated in the tech bubble that grew during the last two years of the 1990s and the first quarter of 2000. Their collapse not only helped usher in the subsequent recession, but also set the stage for historically cheap and beaten down small and value stocks to recover strongly. This outperformance continued after the recession ended. It’s also interesting to note that in the case of value, this reversal actually began before the official start of the recession, which would have provided an important cushion for portfolios that had maintained exposure to value during the tech bubble. That certainly did not happen for value investors before the current recession, but we still believe there is strong evidence that value’s performance will turn around in the future.

Key Takeaways

If timing recessions is hard and picking which factors would do well even harder still, what can investors do? We at Bridgeway go back to the importance of diversification. It is a crucial concept for all investors, and for Bridgeway it includes not just the way we invest but also how we run our firm and the people we hire. Bridgeway focuses on the three broad investment themes of value, company financial health, and momentum. Those stocks with the strongest factor exposures are often smaller, typically giving our portfolios a tilt to smaller size as well. As seen in the top row of Chart 1, all of these factors have worked over time. They usually don’t all work at the same time, and when one is lagging, others often do well.

Bridgeway therefore does not make dramatic changes to our portfolios because we are in a recession, and we think all investors should avoid the temptation. These moves are potentially costly in terms of trading needed to implement those changes and the substantial risks of not getting that timing call exactly right. Instead, we stick with our process and monitor our portfolios to ensure they maintain their targeted allocations to diversifying exposures. The run up to the current recession saw smaller and deeper value stocks lag by historic amounts. If history is a guide, we expect the fortunes of these factors to reverse as the current market cycle runs its course. We don’t know when that turning point will come, but when it does, we believe that investors who’ve maintained a diversified portfolio with broad factor exposure will be rewarded for their discipline.

1 Recessions are defined by NBER. About 18% of the full period months and 12% of the months since July 1963 are in recessions. The remaining months are not in recessions.

2 For a broader discussion of this issue and factor investing generally, see the book “Your Complete Guide to Factor-Based Investing” by Andrew L. Berkin and Larry E. Swedroe.

3 In two instances recessions were less than 24 months apart, so some months were within 12 months of both the prior and next recessions. To give each month a unique classification, we simply divided the intervening time period in half. The before and after recession periods in those cases had less than 12 months.

The opinions expressed here are exclusively those of Bridgeway Capital Management (“Bridgeway”). Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

Mkt-RF or the equity risk premium is the expected excess return of the market portfolio beyond the risk-free rate. SMB or the size premium measures the additional return investors have historically received by investing in stocks of companies with relatively small market capitalization. HML or the value premium measures the additional return investors have historically received for investing in companies with high book-to-market values. MOM or the momentum premium measures the additional return investors have historically received for investing in companies with positive acceleration in stock price. RMW or the profitability measure is the difference between the returns of firms with robust (high) and weak (low) operating profitability. CMA or the investment factor is the difference between the returns of firms that invest conservatively and firms that invest aggressively.

Diversification neither assures a profit nor guarantees against loss in a declining market.