Behavioral finance researchers have identified several cognitive errors that often cloud investors' judgment. One of the most common is recency bias, or the tendency to place too much weight on the latest performance trends while giving short shrift to other factors, such as fundamentals, valuation, or long-term market averages.
It's not always obvious when recency bias might be creeping in to the investment decision-making process. For one, there's evidence near-term performance trends do persist. This is also known as the momentum effect, in which stocks with above-average performance over the past 12 months* often continue to pull ahead. And at the asset class, region, and style level, performance trends can persist for much longer periods – even a decade or more.
In this article, I'll look at three performance dichotomies that have been seemingly unstoppable: large versus small, growth versus value, and US versus international. I'll also examine the reasons behind their persistent dominance as well as countervailing factors that investors might want to consider.
Large Versus Small
In theory, smaller companies have more room to grow because they haven't yet reached their full potential or scale. Academic research has often highlighted the long-term performance advantage of smaller-cap stocks. They've pulled ahead of their larger-cap peers by about two percentage points per year over the full period from 1926 through mid-2024. This performance edge was driven by their strong advantage over several periods, such as the late 1930s and early 1940s, the stretch from 1974 through 1983, the early 1990s, and most of the period from 2000 through 2010.
More recently, however, large-cap stocks have trounced their small-cap counterparts by more than six percentage points per year, on average, over the trailing 10-year period through June 30 2024. This disappointing showing was partly driven by differences in sector composition. Compared with the market overall, small-cap benchmarks have less exposure to technology stocks and more exposure to "old economy" sectors such as consumer cyclicals, financials, real estate, and industrials. Despite generally strong economic growth, these sectors haven’t kept pace with technology-related stocks.
However, small-cap stocks are often more economically sensitive than stocks issued by larger firms and can therefore perform better during periods of strong economic growth. They're also cheaper. Whereas large-cap stocks covered by Morningstar's equity analysts are currently trading at a 7% premium to their Fair Value Estimates, small-cap stocks are trading at a 14% discount.
Growth Versus Value
There's been another long-running performance dichotomy between growth stocks, which sport above-average growth in earnings, sales, cash flow, and/or book value; and value stocks, which trade at relatively low prices on various metrics. Growth stocks have outperformed value issues by a wide margin over the trailing 10-, 15-, and 20-year periods. Value stocks held up much better than growth stocks during the 2022 bear market, but not enough to offset their lagging returns in previous periods.
One reason for this performance shortfall: value stock indexes are light on technology stocks, especially the "Magnificent Seven" group of mega-cap tech stocks that have powered the market in recent years. At the same time, they have more exposure to lagging sectors such as energy, financial services, and utilities.
What might reverse this trend? Some possibilities could be a valuation-driven correction or an economic downturn followed by a recovery. In addition, growth stocks are trading at relatively steep prices, even if they continue to generate above-average earnings and sales growth. The average growth stock held by Vanguard Growth ETF (VUG) is currently trading at a 12% premium to its estimated fair value. Holdings in the corresponding value fund (Vanguard Value ETF [VTV]) are trading about in line with their Fair Value Estimates.
US Versus International
The third long-running performance gap is between US-based stocks and equities from other markets around the world. Annualised returns for international stocks have fallen behind those of US stocks by nearly four percentage points per year over the past 20 years and even bigger margins over the trailing 10- and 15-year periods. Sector exposure is one factor behind this poor performance. Non-US stock benchmarks are light on technology and relatively heavy on old-economy sectors such as basic materials, financial services, and industrials.
Because non-US stocks have fallen behind for so long, however, they now offer more attractive valuations. US stocks are currently trading at about 33 times long-term, inflation-adjusted earnings (a multiple also known as the CAPE or Shiller P/E), compared with a longer-term average of about 24.5. Thus, even if US-based companies continue to deliver exceptional fundamentals, that may already be priced into their stocks. Non-US markets, meanwhile, have an average CAPE of about 19.8 as of May 30, 2024.
Currency movements are another factor to consider. The US dollar has generally trended higher against other major currencies over the past 10 years or so. That has been a negative for international stocks because their returns are worth less when converted into dollar terms. However, there's no guarantee the dollar's strength will continue forever. Some international managers, such as Oakmark International's David Herro, have recently argued that non-US currencies are better valued and should eventually appreciate as they return to purchasing power parity.
Conclusion
It's impossible to know if and when these seemingly unstoppable trends will reverse. Maybe we really are in a new era when traditional valuation measures are less relevant than they once were and mega-cap growth stocks in the US continue to dominate. To be fair, market valuations aren't as lofty as they were at the height of the dotcom bubble in 1999.
That said, seasoned investors have learned to be cautious when they hear shouts and murmurs arguing that "it's different this time." When those voices get louder and louder, some caution is warranted.
*Most researchers and index providers exclude the most recent month from momentum calculations because of another market anomaly (the reversal effect)
