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We are often asked the difficult question of when is a good time to invest in [fill in your favorite investment]. While the answer is never 100% accurate, we can often offer insights into the future by looking at the past and analyzing the fundamental relationship between economic variables. After all, we know that most of the time when you hear thunder, it is followed by rain, therefore it is not difficult to predict that it will pour after a loud rumbling in the sky.
The challenge with looking at the past is that every economic cycle could be different in terms of its duration and magnitude. Further, new macro developments or financial instruments that did not exist in the past financial cycles may complicate the analysis and render past economic relationships worthless; hence we need to proceed with extreme caution when looking at past data.
One question on many investors’ minds lately, after a long period of outperformance by growth stocks, is when will growth-style investing fall out of favor, or put another way, when will value-style investing be in favor again? After all, growth has been outperforming value on a year-to-date, 1yr, 3yr, 5yr, 10yr, and even 15yr basis, albeit not every single period within those time frames.
Before we attempt to answer the question, let’s define what growth and value stocks are. To put it simply, growth stocks are shares of those companies that grow their revenues/cash flows/earnings at above-average rates and therefore warrant a higher valuation. Value stocks on the other hand are those that trade at rather inexpensive valuations relative to their earnings and growth counterparts due to slower growth prospects.
While we can never pretend to know the future and ascertain when the tide will turn against growth and towards value, we offer the following insights on the behavioral aspects of the two schools of investing:
• Growth and value style investing tends to have equal frequency of outperformance relative to each other.
• Larger outperformance by one style tends to be followed by roughly equal amount of outperformance by the other.
• Growth tends to outperform in a slow growth environment due to predictability of earnings, when investors bid up companies with higher earnings.
• Value tends to outperform during recessions and bear markets due to the lower beta (market risk) of the staples, utilities, and telecom sectors that are heavily represented in value indices.
• The latest period of growth outperformance (since 2008) surpassed what was until then the longest period of growth outperformance (in the 1990s).
• Steep yield curve environment is better for value stocks due to the outperformance of the financial sector during such times, as banks earn a wider spread between their borrowing costs and lending rates.
• Falling interest rate environment is better for growth stocks. Value stocks have lower dividend cushions during those times, which make them less appealing to investors.
• Value stocks may do well during the early part of an economic recovery when growth is abundant and there’s no need to pay up for growth, but typically lag growth stocks in late innings when investors pay a premium for growth. By way of example, growth outperformed value by a whopping 17% last year.
• Value stocks should have lower volatility in theory since they include larger, more established companies, but actual results show that value stocks display slightly higher risk than growth stocks. This may have to do with value traps and dead cat bounce effects when seemingly cheap stocks bounce around violently after steep selloffs and may get even cheaper.
• Growth does well when the technology sector does well. Value does well when financials and energy sectors do well.
Based on these insights, it is not hard to see why growth has been such a loved strategy recently; we have been in a slow-growth environment since the 2007-2009 bear market, yield curve has been flattening, interest rates have been falling (until recently), equity markets are described by most as being in the late innings, and technology stocks have been on a tear. These are all signs of a growth-led market.
However, it is not hard to see the reasons why a rotation into value stocks may be in the near future: a recession or a bear market is likely in the next few years, interest rates are finally rising, and the energy sector is finally beginning to shine. These are all signs of a value-led market.
The timing of any market rotation is extremely hard to predict. Although we may be in the late innings of the current investment cycle that favors growth stocks, may I just state that the longest game in professional baseball history lasted 33 innings?
Fortunately for our clients, we offer in-house strategies that have characteristics of growth stocks (Core Strategy), value stocks (Income & Appreciation Strategy), as well strategies that systematically blend the two schools of investing and add strong downside protection (Planned Return Strategy). We also offer numerous third-party strategies that complement our in-house capabilities. We continue to recommend that clients do not try to time the market, and stay invested in a diversified portfolio with different return drivers and one that meets their long-term investment objectives and risk tolerance.
Erman Civelek, CFA, CAIA, CFP®