Source: University of Michigan, University of Michigan: Consumer Sentiment [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UMCSENT, 1/1/1978 to 6/30/2022 monthly. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
It’s one of Warren Buffett’s best-known sayings: “Be fearful when others are greedy and greedy when others are fearful”. While contrarians know this on the whole to be sage advice, there is one indicator of fear that has been particularly useful for gauging potential opportunities for small stocks in general and small value specifically in recent history. And that indicator is a plunge in consumer sentiment.
Heartland Advisors recently examined the historic relationship between stock market performance and the mood of U.S. consumers. We looked at past periods when the University of Michigan’s Consumer Sentiment Index fell sharply and dropped to a level of 65 or lower, which has coincided recently with heightened episodes of economic anxiety such as the global financial crisis, the 1990 recession, and the stagflationary era of the early 1980s. What we found is that over the rolling three-year period after the sentiment levels sank to such historic lows, the Russell 2000 Index performed surprisingly well. In fact, small stocks in the Index generated an average return of 24.7% for the annualized returns during each period, representing a 5% advantage over the S&P 500 Index (large cap). Small value did even better, returning an average of 26.2% over the rolling three-year period, a 6.5% advantage over large cap stocks.
Why is this important? This year, amid rising inflation and recession fears, the University of Michigan’s Consumer Sentiment Index has again plunged, with levels as low as they have been since inflation last reached these heights in the early 1980s. History says this degree of worry could be an indicator that it’s time to focus on those parts of the market that have been overlooked and undervalued in the prior era—which seems to point to small and value stocks.
Of course, there are other reasons to look at small value now. For starters, out-of-favor and attractively priced stocks have generally held up better than the broad market during these kinds of downturns, as investor appetite for speculation and risk-taking generally give way to a newfound respect for fundamentals and valuations. This could attract new investors to small value, especially after the markets start to stabilize. Moreover, small stocks have historically outperformed in the early stages of new economic cycles following recessions, which tend to be foreshadowed by plummeting consumer sentiment. So, there’s a cyclical argument to at least begin looking at small caps.
Finally, there’s the contrarian argument. As one of Warren Buffett’s mentors, Benjamin Graham, famously stated: “An intelligent investor gets satisfaction from the thought that his operations are exactly opposite to those of the crowd.” This is why it often makes sense to “buy when most people, including experts, are pessimistic.” And if recent history is any guide, this should be especially true when it comes to considering small value stocks after consumers turn glum.