Handing the Baton from Growth to Value
Why Value’s time may be more lasting than the market currently expects
Famed investor Howard Marks once wrote, “In the world of investing, nothing is as dependable as cycles.”¹ Of course, it is always easy to see cycles in hindsight, but the challenge is recognizing real-time changes in cycles, which affect new leadership in markets. Investors tend to assume the ongoing cycles will last forever given the entrenched dynamics, leading most people to assume that any deviation in the moment is just a pullback within the greater trend and that the dominant trend will remain in its current direction.
Three months ago, we penned “The Times They are a-Changin’,” a piece focused on the market dynamics that led us to declare that a baton handoff from Growth to Value was in the works. Growth had been leading since August 2006, and its dominance lasted a bit more than 14 years according to our calculations, returning ~3.5 times that of Value (Figure 1)*. Our conviction in Value’s emergence as the leader remains unchanged today, as the market dynamics we identified in March have only strengthened since then: we see continued weakness in the more speculative areas of the market and further strength in bond yields and commodities. Importantly, our confidence goes beyond merely the underlying market dynamics. So, what else underpins our belief that this is not merely a pullback within a greater Growth cycle?
Before delving into the reasons we believe the Value strength we have seen is not merely a pit stop, let us establish some context. Since the advent of each index in 1979, the Growth and Value indices have returned essentially the same total return. Between August 1979 and May 2022, a span of 514 months, Growth has a total return of 11.67% while Value has a total return of 11.60%, where total return encompasses income (i.e., dividends often expressed as a yield) and capital appreciation. Unsurprisingly, the composition has been different for each style: Growth is more heavily geared into capital appreciation (price return of 9.74%, yield of 1.75%) whereas Value has a more meaningful percentage accrued as income (price return of 7.80%, yield of 3.52%).
Importantly, their paths to reach the same total return have been different in composition and timing. In Figure 1, you can see that both Growth and Value have taken turns outperforming and underperforming over the past 43 years, as demonstrated by cycles. Each row in the chart represents a cycle. We found each cycle by looking at market peaks and troughs from 1979-present. Figure 2 shows the rate of growth of the Russell 1000 Growth Index and Russell 1000 Value Index. Figure 3 show the performances of Growth and Value relative to each other. It illustrates the Growth and Value cycles by calculating growth divided by value, which yields slope. Sections of the graph with a slope traveling up and to the right indicate a growth cycle, while sections with a slope traveling down and to the right indicate a value cycle.
Figure 1. Historical cycles in Growth and Value over the last 43 years.
Figure 2. Growth and Value – same destination, different path
Source: FactSet and Balentine
Figure 3. Growth relative to Value
Source: FactSet and Balentine
If we are at the beginning of a new Value cycle, there should be a decent amount of room for Value to outperform Growth – for example, Value is outperforming Growth by 35.2% today and it has outperformed Growth by as much as 209.6% in the past (Figure 1). Once these cycles get going, they really go, and there should be a decent amount of runway ahead of Value if the baton has been passed. Beyond that empirical evidence, let’s discuss the fundamentals of why we believe the Value cycle has a while to go.
1. Economic weakness and crises are often the catalyst for change.
Looking at the dates in Figure 1, it is not a coincidence that each transition from Growth to Value or vice versa has often bookended economic weakness or stock market crisis (e.g., 1980 recession, 1987 Black Monday, 2000 Internet bubble crash, 2006 housing bubble peak, 2020 Covid crash). Though each index was created in 1979, examples of trends shifting from Growth to Value, or vice versa, in response to crises are evident before that date. Prior to the deep recession of 1973-1974, the winners were Growth stocks (the so-called “Nifty Fifty”). During the bear market that coincided with the recession, the Nifty Fifty crashed harder than much of the remainder of the market. Investors, feeling burned by their investment in the Nifty Fifty, adjusted their risk appetite after the recession and decided to invest in stocks with slower upward trajectories. This behavior is common after recessions as investors effectively hit a reset button on their holdings and begin anew to build wealth. It’s easiest psychologically to do this when markets have declined, as there is a feeling of a reset playing field, so to speak.
What we have seen in the last 21 months resembles the prior periods. Many of the winners are down in excess of 75% while the prior laggards have finally caught the eye of many investors. For example, Growth winners now down 75% include, in no particular order, Peloton, Zoom, Shopify, and Carvana. Finally catching the eyes of investors are Chevron, Freeport McMoran, IBM, and Merck. Does the resemblance to prior periods guarantee that the Growth stocks winning before the baton handoff will lag? No, but history suggests that the odds are very much in favor of it.
Whether one believes current inflation is transitory or sticky, evidence suggests, but does not guarantee, that in either scenario inflation is not returning to the ~2% seen in the 2010s. Rather, the debate is whether it will settle in the 3%-4% range vs. remaining in the 6%-8% range. Either scenario favors Value, as seen historically in Figure 4. Figure 4 shows inflation rate plotted versus the percent difference between Growth and Value. Because we are subtracting Value from Growth, the greater the negative percentage, the more Value is outperforming Growth at any time. You can see that Value outperformance shares a relationship with high inflation due to the cluster of points in the lower right quadrant of the graph.
Figure 4. A higher inflation rate tends to favor Value stocks over Growth stocks.
Source: FactSet and Balentine
Why does this happen? There are two related — but somewhat distinct — reasons. First, the stocks that tend to benefit directly from inflation are those whose products are directly tied to inflation: think energy, materials (e.g., metals and chemicals), and real estate, which all comprise a larger part of the Value indices than the Growth indices. Second, interest rates tend to rise during inflationary times, and higher interest rates mean the present value of future cash flows is lower. Value stocks tend to have a greater percentage of their future cash flows closer to present than Growth stocks, whose cash flow projections are further into the future but generally show much higher growth. Thus, higher interest rates should hurt Growth stocks more because the higher hurdle rate makes future growth not worth as much.
3. The name Value finally comes to mean something.
In periods of low risk aversion or rapid growth, investors may throw caution to the wind and be inclined to invest in the areas that are likely to deliver the highest growth. During this period, inexpensive stocks are often overlooked because investors prefer the glamour growth stocks. Behaviorally, investors prefer a company with a narrative about their future vs. a company whose main thesis is that it is undervalued or beaten down in price. The longer this goes on, the more the potential rewards, both in magnitude and in duration. Eventually, a catalyst arrives to move investors to appreciate the hidden gems of Value stocks.
In summary, the market moves in cycles, and once enough momentum gets going in a new part of the cycle resulting from a catalyst, then typically there is a long runway for outsized returns. We continue to believe that is the case here with Growth vs. Value, where the reversion to a post-pandemic world will catalyze further gains in Value stocks. This does not mean Growth stocks cannot have countertrend rallies during the Value cycle. In fact, we expect such rallies, and moreover, we expect them to be strong. Looking at an extreme example, in the aftermath of the 2000 bursting of the Nasdaq bubble, the Nasdaq saw three countertrend rallies in excess of 35% and an additional four in excess of 15% on its way to its ultimate low in late 2002. But in the end, we expect the Value cycle to power through all of these rallies as investors spend the next few years digesting the idea that buying Growth at any price is not a panacea for investors to reach their ultimate goals and adjust their portfolios as such. To that end, even with the recent 18-month outperformance in the Energy sector, it’s up to only 5% of the S&P 500, up from 2% at the pandemic low but still well below the 11% in 2008 and the 28% in 1980. We expect this to change, as well as some of the other Value sectors, as investors continue to shift out of the longer duration, more speculative Growth names into the more modest Value names.
* In this article, we utilize the Russell 1000 Growth and Value indices to demonstrate the shift in market dominance from Growth to Value.
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