Such a narrow stock market!

This story has frequently been told but as parts of the elephant rather than of the entire beast. One theme has been the struggle of retailers. Another, the continued expansion of the service economy at the expense of manufacturing. A third, the triumph of the FAANG stocks--that is, Facebook (FB), Amazon.com (AMZN), Apple (AAPL), Netflix (NFLX), and Google (GOOGL) (Alphabet Inc.). A fourth, the weak relative performance of small-company and/or value stocks.

It’s not difficult to connect the pieces. Not only have companies that sell services replaced manufacturers in importance (with services now accounting for 80% of U.S. gross domestic product), but companies that offer virtual services, such as Netflix, Alphabet, Microsoft (MSFT), or Amazon (which has delivery trucks but which communicates with its customers at 186,000 miles per second) are supplanting brick-and-mortar rivals.

The competitive field has therefore narrowed. Consumers once dispersed their monies among hundreds of vendors. However, their supplier list has shrunk, because the major virtual-services companies have convinced them to simplify their purchasing lives. Need a spreadsheet application? No worries, Microsoft has added that to its bundle. Seeking art supplies? Amazon has plenty of those.

Traditionally, growing market share so aggressively would challenge corporate managements, who required time and money to ramp up factory production, build new retail outlets, and/or hire staff. What’s more, they faced the possibility of financial ruin if the new customers did not repeat and sales subsided. But virtual-services companies are largely immune to such problems. They can quickly scale up--or down, if necessary.

Large growth’s victory
In summary, FAANG stocks have thrived not because investors have overpaid but because those companies have met, or even exceeded, their aggressive expectations. Their stock market gains reflect their business success. For example, Alphabet has grown its revenues sevenfold over the past decade, while generating high free cash flow and having low debt. It would be illogical for investors not to reward such behavior.

And reward they have. In the second half of last decade, large-growth mutual funds, which own the fortunate few companies, thrashed small-value funds, which invest in the broadest segment of the broad market. The former placed first among the nine sections of the Morningstar Style Box, while the latter was dead last.

This result contradicted academic theory, which expects small companies to outgain their larger competitors and cheaper stocks to outdo pricier growth companies. Such were the findings in the famous 1992 paper by Gene Fama and Ken French, “The Cross-Section of Expected Stock Returns,” and such was the belief of the founders of Dimensional Fund Advisors, which had opened its doors a decade earlier.

Well, such things happen. Nobody claimed that academic factors will always hold. True, those five years treated the theory particularly harshly, with the cumulative return for large-growth funds registering 76%, as opposed to only 31% for small-value funds. That’s a large gap. But such things happen. If investments always followed the same pattern, they would be risk-free assets, not investments.

The trend continues
Then came 2020. The news for small-value shareholders got worse. Much worse. Below are the year-to-date totals for mutual funds through Wednesday, April 1.

Just brutal. With that 40.9% loss, small-value funds haven’t made a penny in seven years. The average fund is worth what it was in spring 2013. Meanwhile, large-growth funds rest at early 2019 levels. Small-value funds have shed seven years’ worth of gains; large-growth funds, a mere 12 months. If I had money in small-value funds (happily, I do not), I would ask the professors for a refund.

Unfortunately, for small-value shareholders, the stock market’s behavior appears to be logical. The coronavirus crisis has only increased the prevailing trends. Millions of American businesses have been shuttered, including most retailers save for grocers and pharmacies. Consumer movement has been restricted. What else is available besides virtual services? The rich are becoming even richer.

To be sure, normalcy will eventually return, permitting sidelined businesses to re-emerge. However, one suspects that some habits will be permanently changed. For example, virtual-services companies won’t immediately threaten the restaurant industry, but they will further erode retailers’ positions. Some consumers who have grown accustomed to shopping online will continue to do so when the restrictions are lifted. Such actions would have ripple effects, including depressing the commercial real estate market.

Also affecting commercial real estate will be the increased tendency to work at home. Once again, this process was already underway; over the past few years, many employees (and their employers) have learned that not every job requires their physical presence in an office. After the current crisis, even more will share that belief. Demand for office space will slacken, as will the patronage of businesses that depend on commuters, such as trains, downtown shops, and business attire.

This time is different
My point: Over the past several years, history has been a poor investment guide. Unfortunately for small-value investors, that failure can be blamed neither on investor fashion nor solely to temporary conditions. The sluggish performance of small-value funds, and the corresponding success of large-growth strategies, owes mainly to economic reality. A few companies are eating America’s lunch.

As the investment cliché goes, a rising tide lifts all boats. Thus, when the next bull market arrives, I would expect small-value companies to fare well, perhaps even lead the way. (They did so in 1988, following Black Monday’s crash. Twenty-one years later, in 2009, they weren’t the single best-performing investment style, but they nevertheless beat most rivals.) Tactically, small-value investing looks timely.

Strategically, not so much. Academic investment research implicitly assumes that the economic conditions that created those results will persist. There is strong reason to believe that will not be so.