Joanne Howard, CFA, SVP, Investment Counselor and Portfolio Manager
June 30, 2021
The Value vs. Growth rotation and the reflation trade have dominated investor dialogue and decision-making this year. (1) This article reviews the past where growth has outperformed, the present where value has performed better since the introduction of the COVID-19 vaccine, and the future where we provide reasons to expect growth to produce superior returns. Exhibit 1 provides rear-view perspective on the 40-year history of the relative performance of growth and value. As displayed, there are times when value outperformed growth—including the first five months of 2021—but growth has outperformed both absolutely and relatively over most cycles in that 40-year period.
Exhibit 2 provides visual evidence of how the outlook for high inflation in the U.S. has appeared after a twelve-year absence. On June 16th, comments from the Federal Reserve suggested it was viewing inflation as perhaps more than transitory, signaling interest rate hikes may begin in late 2023 rather than 2024. As a result, some Fed members placed their tightening dots in 2022. The Fed has a vested interest in keeping interest rates as low as possible for as long as possible, thereby minimizing interest payments due on U.S. Treasury debt.
The U.S. stock market seemed to have been anticipating this more-hawkish stance from the Fed, as growth stocks outperformed value stocks for most of the month of June. This was in sharp contrast to the first five months of 2021, when the Russell 1000 Value Index (+18.4%) outpaced the Russell 1000 Growth Index (+6.3%) by 12% in anticipation of reopenings around the country. Moreover, since the Pfizer vaccine was known to be over 90% effective in November 2020, the Russell 1000 Value Index has outperformed its Growth Index by 20%. Exhibit 3 shows the zigzag performance of these indices since January 2020. And, the table in Exhibit 4 provides more detailed performance for various time periods since the start of the COVID-19 pandemic.
As Exhibit 5 shows, now is the time in the economic cycle when a quality growth investment philosophy is the most challenged. Early in a recovery from an economic downturn or unexpected adverse event, such as the COVID-19 pandemic, the most economically-sensitive sectors and highly-leveraged stocks have tended to outperform. This includes industrials, raw materials, consumer discretionary, and financial sectors. As economic growth decelerates, growth stocks (which generally are found in the technology, health care, and media sectors) are expected to outpace the average. Finally, as the economy slows further, the more defensive sectors such as consumer staples, utilities, and telecom tend to do better and growth stocks usually continue to perform well based on favorable relative earnings.
During most of 2020—from the beginning of the pandemic until the announcement of the 90% effectiveness of the Pfizer vaccine in November 2020—the equity markets rewarded companies whose sales far exceeded expectations due to the work-from-home protocol. Examples of these beneficiaries included Zoom, DocuSign, DoorDash, Peloton, as well as the FAANG stocks (Facebook, Amazon, Apple, Netflix, Google). In many cases, these stocks had negative earnings as they were reinvesting cash flow into future growth through research and development, new products and/or capital expenditures. With the Pfizer vaccine approval in hand, the market assumed that the reopening recovery was a certainty even though it was months away, favoring all the industries that had been operating way below normal, i.e., hotels, restaurants, cruise lines, airlines, retail stores, and ridesharing. As cyclical and value stocks have outperformed, the valuation premium for growth has narrowed and is approaching pre-COVID levels. This is particularly noticeable in the relative price/earnings to growth ratio (known as the PEG ratio) shown in Exhibit 6.
While S&P 500 earnings per share may increase 30% to $190 per share, it is generally assumed that 2021 earnings are borrowing from earnings growth in 2022, which is estimated at $210 per share before any changes in tax policy. We are now confronting shortages of both labor (as many workers find unemployment benefits exceed after tax earnings less child-care expenses) and parts, especially semiconductor chips. While the earnings outlook is favorable, margins may be near peak levels and, pending forthcoming legislation, it is likely that corporate and individual tax rates may be rising in 2022.
Stock prices have performed well, in aggregate, and valuations are high by almost every measure, except relative to bond yields. There are also indications of excess speculation reminiscent of the dot-com era of 1999 to 2001. These warning signs include high valuations for companies with negative earnings, record-high issuance of SPACs (Special Purpose Acquisition Companies) in both numbers and dollars, performance of meme (2) stocks, creation of the NFT (non-fungible tokens) market for digital images, and the focus on cryptocurrencies. As interest rates rise valuation levels will be under more pressure, especially long-duration technology stocks. Technology stocks are also more exposed to minimum tax and/or foreign tax proposals as well as threats of increased regulation and/or break up of some of their divisions. Health care stocks are exposed to Congress imposing drug price controls; this risk increased with the approval of Biogen’s Alzheimer’s drug, which has a list price of $56,000 per year.
As the market deals with the mixed messages of higher inflation and decelerating economic growth, we believe the seesaw pattern between growth and value will persist for the rest of the year. Some days value and cyclical stocks will outperform, as the market rewards stocks most impacted by infrastructure stimulus, onshoring of supply chain essentials, and economic expansion. Other days—when the market is “risk-off” with lower inflation prospects—growth and stable stocks will perform better. Growth will also respond to news on innovations in alternative energy, gene editing, artificial intelligence, virtual reality, security/ cloud technology, 5G, precision cancer therapies, and comparable breakthroughs. Exhibit 7 is provided to compare earnings growth over the last 20 years for growth and value stocks in the S&P 500 Index.
During the balance of 2021, we expect the Fed to gradually introduce hints of tapering of monetary stimulus. At the same time, fiscal policy, which included $6 billion to offset the economic loss from COVID-19 in 2020-21, will also have less impact on the economy in 2022. As fiscal and monetary policies moderate and GDP growth slows back to trend, the market should pay more of a premium for the relative earnings. This is when the market should have more confidence in the relative earnings, which would be expected to reward both growth and GARP (growth at a reasonable price) stocks.
When in search of quality companies in the growth stage of their life cycle, volatile times such as these call for both patience and perspective. To that end, this piece provides a strong history of relative and absolute growth and value stock prices, valuations, and economic relationships.
1 The reflation trade describes the focus on investments that traditionally benefit from an expanding economy during a time of rising consumer prices.
2 Meme stocks are those whose price movements are influenced more by social media chatter than by investment fundamentals.