When do the risks of value stocks appear?

(MoneyWatch) It's well known that value stocks have provided higher returns than growth stocks.

For the period from 1927-2011, the average monthly value premium was 0.38 percent, producing an annual premium of 4.7 percent.

There are many academic papers that provide simple and logical risk explanations for the value premium. For example, value companies typically:

• Are more leveraged, meaning they have higher debt-to-equity ratios
• Have higher operating leverage, making them more susceptible to recessions
• Have higher volatility of dividends
• Have more "irreversible" capital, meaning they have more difficulty cutting expenses during recessions
• Have more exposure to aggregate distress risk

For these reasons, they tend to do worse in bad times. Assets that tend to perform poorly in bad times (when labor capital experiences increased risk) should command a large risk premium.

The following data provides some interesting insights. Let's look first at how the value premium performs in recessions. While the value premium is larger during periods of economic expansion, during recessions there's still, on average, a monthly value premium of 0.15 percent. However, the median value premium during recessions is -0.31 percent. Thus, more times than not the value premium turns negative during recessions. So the risks of value stocks have a tendency to show up during bad times.

If we look at the returns for periods of deflation (186 months), we find that the value premium turns negative, producing a monthly premium of -0.20 percent. This shouldn't be an unexpected outcome, as deflation increases the real cost of debt and value companies tend to be highly leveraged.

And if we look at periods when we have both deflation and recession (the riskiest of times), we find that for the 68 months the monthly value premium is a -0.63 percent. During these months, the monthly stock risk premium was -1.95 percent.

The bottom line is that the risks of value stocks shows up in the riskiest of times -- during financial crises that strain the banking system -- providing a logical explanation for the value premium. Consider the following:

• From 1930 through 1931, the annual average value premium was -19.2 percent.
• From 1937 through 1939, the value premium was negative all three years. The annual average premium was -7.9 percent.
• From 1978 through 1980, the value premium was negative all three years. The annual average premium was -7.2 percent.
• From 1989 through 1991, the value premium was negative all three years. The annual average premium was -8.3 percent.

The first period was the beginning of the Great Depression. The GDP fell sharply, and we experienced a severe deflation. The economy began a strong recovery in 1933, which lasted through 1936. In 1937, bad fiscal and policy decisions pushed us back into another depression, and we once again experienced deflation.

1979-81 was the period of the Great Inflation, when the Federal Reserve drove the federal funds rate to almost 20 percent in an effort to dampen inflation. That drove the economy into a recession, and unemployment eventually exceeded 10 percent. 1989-91 was the height of the S&L crisis. And the financial crisis that began with the fall of Lehman Brothers has produced a similar outcome.

The value premium has been negative for four of the five years since the financial crisis began in late 2007. The annual average premium was -4.1 percent. And it has continued to be negative in 2012. Is it a coincidence, or is it simply the risk showing up just as the academic literature suggests it should?

Image courtesy of Flickr user 401K 2012.