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Is not simply a function of time.
Numerous studies document the existence of return premiums associated with investing in small firms and value stocks. Regardless of how "value" is measured (whether low price-to-book ratio, or low price-toearnings ratio), empirical studies find that value stocks have historically outperformed growth stocks (see Basu [1977], Peavy and Goodman [1983], and Chan, Jegadeesh, and Lakonishok [1995]). In a similar manner, small-cap stocks have historically outperformed large-cap stocks (see Banz [1981], Reinganum [1981], and Fama and French [1992]). The investment community has eagerly integrated these findings into practice, as the number of small-cap and value mutual funds has expanded enormously in the past decade.
Recent studies, however, question the consistency over time of small-firm and value stock premiums. For example, Bauman and Miller [1997] show that between 1980 and 1993, the return differences between value and growth portfolios (using price-toearnings, price-to-cash flow, and price-to-book ratios as value versus growth criteria) are insignificant or negative in eight of the fourteen years examined (also see Bernstein [1995]). Similarly, Siegel [1994] contends that small-firm premiums are not consistent over time. He claims that the entire outperformance by small-cap stocks from the end of 1926 through 1996 is due to the nine-year period from 1975 through 1983.
Jensen, Johnson, and Mercer (JJM) [1997] examine the consistency of small-firm and low price-to-book premiums, and find that their significance is related to the stringency of monetary policy. The JJM analysis is based on earlier research by Jensen, Mercer, and Johnson [1996], who find that monetary policy influences the risk premiums investors require due to changes in business conditions. JJM [1997] extend this earlier work and show that the relationships between stock returns and firm size or price-to-book differ across monetary periods. These findings support the view that monetary conditions influence the way business conditions and firm characteristics are incorporated into stock prices.
Other studies suggest several candidate variables for discriminating between value and growth stocks (see Bernstein [1995] and Christopherson and Williams [1997]). Low price-to-earnings ratios have long been a value indicator (e.g., Graham and Dodd [1934], Basu [1977], and Peavy and Goodman [1983]), and low levels of price-to-book and price-to-cash flow have historically led to higher average returns (e.g., Rosenberg, Reid, and Lanstein [1985],...