Value investors deny that the market is efficient. In their view, stock prices are subject to irrational waves of optimism and pessimism. That’s mostly true. But just sometimes, the market’s mood isn’t too far off. A value trap appears when a falling share price correctly anticipates a company’s deteriorating fundamentals. Over the last year, some of America’s best investors have been misled by apparently cheap prices into buying financial stocks. The worst may not be over. If the economy goes into a deep recession, investors could face the greatest value trap since the Great Depression.

As a group, value investors have many attractive qualities. They are contrarian and stoical, knowing that successful investing requires long-suffering patience. They also have fewer illusions than most, modestly acknowledging that they can’t forecast the twists and turns of the economy.

Value investors dismiss the efficient market hypothesis (EMH). Benjamin Graham, the spiritual father of this investment sect, argued that asset prices were unduly influenced by shifting market psychology. As he put it, over short periods the market was a voting machine, but over time it became a weighing machine. Investors make money by buying when “Mr Market" is depressed and stocks are at fire-sale prices. Value investors also reject the notion that market volatility is a proper measure of risk.

Several of Graham’s followers have amassed great fortunes, most notably his former student Warren Buffett. There’s plenty of research to show that cheap stocks—whether measured by low price-to-book, a low price-earnings multiple or high dividend yield—have outperformed the market over long periods. There’s a good behavioural explanation for this. Investors tend to extrapolate recent performance, ignoring the tendency of earnings to revert to the mean. As a result, they overpay to acquire the stocks of companies which are growing rapidly and conversely undervalue firms which have run into a rough patch.

The crash of the technology bubble provided value investors with their finest hour. In the late 1990s bull market, they avoided growth companies like the plague and instead piled into those out-of-favour stocks which met their stringent valuation criteria. This was a painful strategy before the bubble burst, but afterwards it paid off handsomely. The current bear market, however, has produced rather different results.

Why has value done so badly of late? Well, for a start it had enjoyed a tremendous run since 2002. Easy access to credit and the booming global economy inflated the profits of the cyclical companies which typically comprise the value universe. The private equity craze provided many value stocks with a buyout premium. The same stocks were also attractive to the new generation of hotshot hedge fund managers. By 2007, value stocks (as measured by price to book) had never been more expensive relative to the market. Since the credit crunch hit in the summer of 2007, the cheapest segment of the US stock market has underperformed the most expensive stocks by roughly 30 percentage points.

Furthermore, the credit crisis is revealing a profound weakness in the value discipline. Graham maintained that analysis should be “concerned primarily with values which are supported by facts and not with those which depend largely upon expectations". The housing bubble, however, changed many facts. But some of the world’s leading investors appeared not to have noticed. First, several prominent names piled into housing stocks when they were selling at around book value. This proved a disastrous move as falling land prices and slowing sales generated massive losses for home builders. Then, some of the same investors charged into banks, figuring they were cheap. That also turned out to be a poor idea.

The ongoing travails of value investors raise the question of whether the historically high returns from value are merely compensation received by investors for taking on more risk.

Value has outperformed the market in every economic downturn since 1975, says Societe Generale SA strategist James Montier. “Much as fans of the efficient market hypothesis would love us all to believe that value tends to underperform because it is riskier, there is virtually no evidence that this is the case, the risk-based explanations of the value premium are as hollow and meaningless as the rest of EMH."

The trouble with this analysis is there has been no truly devastating economic downturn during the study period. Value stocks tend to be found among smaller, more cyclical companies. When the 100-year flood arrives, such stocks are likely to be hardest hit. Graham recommended buying stocks which were priced in the market at less than their net current assets (calculated as cash and working capital less all liabilities). Montier recently published a list of current stocks which met Graham’s deep value criteria. Yet many of the names on this list look like potential value traps, vulnerable to both the credit crisis and an economic downturn.

The credit bust is bringing fundamental changes to the economy at a mind-numbing speed. Investors have been drawn into one value trap after another. As the credit crisis continues and the global economy worsens, things could get a lot worse for Graham’s disciples. In the three-quarter of a century since the Great Depression, value investors have earned a generous premium for investing in smaller and more cyclical stocks. Now they are paying the price.