Is the Value outperformance ending?
That may seem like a strange question, as value, represented by the Vanguard Value ETF (Ticker: VTV) has massively outperformed growth, represented by the Vanguard Growth ETF (Ticker: VUG) on a YTD basis, as VTV is down just 9% while VUG is down a massive 27%.
Yet since early May, growth has very quietly outperformed value, as VUG is down just 1.4% since May 9 while VTV is down 4.4%. That begs the question of whether, after massive outperformance from value/underperformance from growth, is it time to rotate back to growth on a go-forward basis?
To answer this question, I first want to go over why I favored value over growth starting over a year ago and compare those reasons to the current macroeconomic outlook. So, if the next 9 months is likely to look like the past 9 months, we would expect value to continue to outperform. But if the next nine months is going to look different, then rotating from value to growth may well be a key to outperforming going into the end of the year.
To look back, we advocated an overweight to value styles and cyclical sectors starting in mid-2021, and that strategy was based on three factors:
Rates were going to rise. In Q4’21, the 10-year yield was trading around 1.5% despite inflation surging at multi-year highs, extremely strong economic growth, and a Fed that was about to hike rates. It was reasonable to "assume" rates were going to rise, and that would hurt growth styles and the most expensive sectors of the market and favor value and cyclical sectors such as financials and commodities.
“Growth” and tech were unsustainably overvalued. The forward P/E on growth reached 30X in late 2021, a historically high level. So, as rates rose and the Fed got more hawkish, the market was likely going to punish those “expensive” stocks and instead we wanted to be in “value” names with lower P/E ratios to protect against any downside.
Growth and inflation were strong. We expected continued near-term strong economic growth and higher inflation that favored cyclical sectors that I over weighted in more value ETFs.
Those three factors came to pass and value outperformed growth as expected. Then, an event we did not see coming, the war in Ukraine, supercharged that trend as inflation exploded driven by surging commodity prices. That, in turn, sent yields even higher, and helped in the massive outperformance of value stocks in 2022. Looking forward, however, the factors that led to value outperformance are changing.
Rates may move higher, but the majority of the move is likely behind us. The 10-year yield has exploded higher from about 1.5% to a high of 3.5% in just over eight months. That 3.5% 10-year yield is an 11-year high! Rising bond yields have been a massive headwind on growth ETFs and the tech sector more broadly. But the Fed will have unleashed more than 200 basis points of rate hikes in just over four months by August, and with economic growth losing momentum and inflation possibly peaking, the case can be made that while yields may still rise, the vast majority of the move higher is now behind us. If that’s the case, then stable-to-falling yields will remove a major headwind from growth ETFs and tech more broadly (this is what’s happened since May).
Valuations have changed materially. In late 2021, “growth” styles were trading with a 30X forward multiple. Now, after the collapse in tech stocks, the forward P/E on “growth” has declined to just below 20X. That’s the lowest level since 2018! Meanwhile, on a relative basis, growth sectors were trading at nearly 2X the P/E of value in late 2021. That’s dropped to much closer to 1.5X, meaning growth has become materially cheaper compared to value. Bottom line, the overvaluation that left growth and tech stocks vulnerable to these intense YTD declines has at least partially corrected itself, and at this point the vast majority of growth ETFs are trading at multi-year lows on a valuation basis!
Finally, the U.S. economy is losing momentum. Numerous signals imply the U.S. economy is clearly losing momentum and the chances of an economic stall or outright contraction are rising. The 10s-2s yield spread has materially inverted, financial conditions are tightening dramatically, corporate commentary has turned more cautious, and the global economy faces numerous headwinds from Chinese lockdowns, EU energy supply problems, and geopolitics. In a slowing economic environment, yields should decline (or at least be stable) while money should rotate back into super-cap tech stocks such as APPL/MSFT/INTC/GOOGL/QCOM, etc. Those names are the heaviest weightings in most growth ETFs, but while they are “growth” they also have defensive properties for investors because they are free-cash-flow-generating machines. Now, an important distinction needs to be made between very profitable, free-cash-flow-generating tech stalwarts such as the names mentioned above, and the high-revenue/no-profit tech companies that defined the tech boom of 2021 (cloud names, self-driving cars, metaverse, etc.). Those are still to be avoided.
To be clear, I’m not advocating for a wholesale rotation from value to growth. But if I were allocating new capital into the market right now, I’d be inclined to make growth an overweight in those allocations vs. value. Additionally, if I looked at my portfolio construction and saw I was materially underweight growth (which has been the right move YTD), I’d begin to correct that so growth and value come more into balance from an equity exposure standpoint.
Bottom line, if the market is going to rally, it’ll rally because the hopes of peak inflation and peak hawkishness become reality, and in that environment, we’ll likely have lower yields and slow growth, and that should have the super-cap tech stocks that make up the major growth ETFs in the market.
I tend to be a little early on these equity rotations and bear markets take time so only time will tell.
For now, we are going to sit on our 70% cash position and wait until the market tells us where the bottom is.
Feel free to reach out to me and use me as a sounding board.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President