By Richard de Chazal, CFA
Last week, we took a look at the equity market through the lens of the Gordon growth model. Our analysis suggested that for the market to continue to rise from here, the biggest driver might have to be compression of the (still very high) equity risk premium, which comes against rising interest rates and a lower longer-term earnings growth rate. In this week’s Economics Weekly, we take a look at what the current macro environment was telling us with respect to investing in growth or value stocks. Our conclusion is that while the growth stocks cycle might look a little long in the tooth, there is still further room to run.
In the relative performance of the 10-year CAGRs of the Russell 3000 Total Return indices for growth versus value, growth has been winning the race for some time now—to the point where relative returns are drawing close to being a whopping two standard deviations away from their mean (see chart 1). While there was a brief run from the value stocks through 2012 to early 2014 (which at the time we admittedly thought would last longer) and through the second half of 2016, those have, or seem to have, faded out. The chart above is a little disingenuous, as it assumes that the relative performance is mean reverting, whereas a host of academic studies have shown that value has tended to outperform growth in the longer term. Nevertheless, the chart does highlight the strong performance from growth stocks in the last decade, which has caused a number of analysts to opine that growth stocks have had their day. We suspect, however, that there is likely to be a little more room to go still.
It is worth remembering at this point just how the two styles (growth vs. value) tend to be classified. It does not amount to simply ranking the constituents of a stock index by price-to-book value and dividing it in two. Rather, when referring to growth stocks we mean companies with above-average expected longer-term earnings growth, which the market may be undervaluing. These companies are typically earlier in their life cycles, have higher barriers to entry, are exposed to fewer threats from competition, and as a result, have higher valuations. What’s important to note here is that because they tend to be earlier in their growth phase, growth stocks also tend to be less economically sensitive, meaning that they are often considered to be good defensive plays when aggregate profits start to decline. For that reason they are often viewed as being a pessimist’s investment and not, as you might expect, by optimists looking for growth. The downside of faster growth rates is that the stocks’ higher valuations tend to be more sensitive to systematic (market) risk, which is reflected in their higher betas.
Value stocks, meanwhile, often exhibit slower growth rates, are more advanced in their life cycles, have lower barriers to entry, and therefore, tend to have lower valuation multiples. For them to be attractive, their market value needs to be lower than their intrinsic value. This means that relative to growth stocks, value stocks tend to be more highly leveraged to the economic cycle, but then have the advantage of being less sensitive to systematic risk. They perform better when the economy is firing on all cylinders, profits are growing for all companies, or when the economy is completely bombed out in a recession.
Lastly, because value stocks tend to be later in their growth stage relative to younger growth stocks, they also tend to pay higher dividend rates, meaning that their duration is shorter than that for a growth stock, many of which tend to not even pay a dividend.
Hence, from a top-down perspective, the key drivers are where we are in the economic cycle, inflation, the profits cycle, and the behaviour of interest rates. In addition, given that scenario, relative valuations can be an important factor.
With regard to the economic and profit cycle, we think we are in the later stages of both; though importantly, we are still likely to be a few years away from the end (i.e., the next recession) just yet, particularly if we do, in fact, see some Trump fiscal stimulus start to come through.
As chart 2 shows, we are now 8 years into the current economic expansion, compared to a historical average length of 5 years. This makes it the fourth-longest expansion in postwar history. It has also been the slowest-growing recovery on record. Yet, this probably means that many of the excesses that might typically build up during a faster growth recover—ones that would eventually topple the recovery (in Hyman Minsky-like fashion)—are taking longer to build. And, this evident in the fact that private sector debt accumulation has been slower and therefore not contributing that extra kick to growth that has taken place so often in past recoveries.* As a result, this recovery may not be as unstable 8 years in, as other have been only 3 or 4 year in. Yet, this is also not early days in the cycle.
This is evident by the fact that inflation is starting to firm, the unemployment rate is at 4.7% (which is roughly at or very close to full employment), and importantly, wages and salaries are finally taking a larger slice of the economic pie. Wages and salaries have just about always tended to rise from midcycle, when the economy starts to come closer to full employment, until the cycle ends (as shown in chart 3). From this perspective (and despite a much flatter Phillips curve), the current cycle would seem to be no different from past cycles, which again confirms that we are later in the recovery
From an investor style perspective this is significant, as historically value stocks tend to outperform very early in the cycle and growth through the mid-to-late portion of the cycle. We also know that as we push into the later stages of the economic cycle and wages and salaries start to rise, pressure on profit margins increases. When aggregate profit margins are expanding, there effectively is a rising tide lifting all boats, and there would seem to be little need to pay a premium for stocks that are more consistent earnings growers. When margins are squeezed, however, the consistently growing stocks become more scarce, and investors typically will gravitate toward those companies, even though they often come with a valuation premium. Hence, the fact that we are closer to full employment and wages and salaries are rising, but inϔlation is only moderately rising suggest that margins may start to be pressured, which should help keep growth stocks in favour (chart 4).
What about the current interest rate environment? Typically, a steepening yield curve has favoured investing in value stocks, given that it’s a sign of a strengthening of the economic expansion (chart 5). Furthermore, the fact that growth stocks tend to be longer-duration equities than their value brethren might also make them appear less attractive in a rising interest rate environment. By the time the Fed gets around to tightening, however, while the yield curve may shift upward, it also typically starts to flatten out and might eventually invert if the Fed pushes rates up by too much (at which point value will start to outperform).
Hence, today, with the Fed increasing rates for a third time—and likely to increase it twice more this year, unless some signiϔicant stimulus actually comes through from President Trump’s proposed fiscal expenditures (the prospects for which are increasingly coming up against the Congressional hurdles the political system was designed for)—a sharp steepening in the yield curve seems unlikely, even though the yield curve itself is likely to shift upward.
Second, while the Fed seems to be more confident in the expected path of future interest rates than was the case at the start of the year, the ultimate end-rate, R* (i.e., the real short-term rate of interest over the longer term), is likely to be much lower, probably around 1% this time around, relative to a historical 2%.
Lastly, we need to look at the relative valuations. With a multiple of 20 times trailing earnings on the S&P 500, the equity market is certainly fully valued. Meanwhile, this month’s bout of IPO activity has rekindled memories of those heady days during the great internet boom of the mid-to-late 1990s. Yet, if we look at the relative valuation of the Russell 3000 Growth to Value index, despite the longrun growth cycle we’ve already been in, growth stocks do not appear enormously overvalued. The relative index at 1.17 is below the historical median from 2001 to 2017 of 1.33, and miles away from the peak relative multiple of 3.66 reached in August 2000. Hence, despite chart 1 suggesting that we are quite late in the growth cycle, on a valuation basis, the cycle does not look to be so stretched.
Value stocks typically outperform when the economy dips into recession and in the early days of the economic recovery, when the yield curve is steep and earnings growth becomes more plentiful. At present, we are pushing into the later stages of the economic cycle—a point when growth stocks typically perform better, profit margins start to come under more pressure, and investors are willing to pay up for growth. While this growth stock cycle does look long in the tooth already looking at the relative performance, the beliefs that we are not yet at the end of the economic cycle, that the yield curve is unlikely to steepen dramatically when the Fed is raising rates, and that relative valuations are by no means excessive suggest that there should still be further room to run on this growth stock expansion.
Richard de Chazal is William Blair Intl. Ltd.’s U.S. macroeconomist from London. He is a Chartered Financial Analyst and has previously worked at UBS Warburg and PaineWebber Intl. Ltd.
Richard de Chazal attests that 1) all of the views expressed in this research report accurately reflect his personal views about any and all of the securities and companies covered by this report, and 2) no part of his compensation was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed by him in this report. We seek to update our research as appropriate. Other than certain periodical industry reports, the majority of reports are published at irregular intervals as deemed appropriate by the research analyst.