E How To Approach The Growth To Value Rotation

Over the past few weeks, there has been a notable hype around the shift from growth stocks to value stocks. Since the beginning of the bull market on Mar. 9th, 2009, the iShares S&P 500 Growth ETF (IVW) has returned 302.62%, while the iShares S&P 500 Value ETF (IVE) has returned 190.66%. In this article, we will assess various factors that induce such shifts and their sustainability. While as a group value could outperform growth for a certain period of time, it is important to keep in mind that individual stocks can still outperform both groups regardless of the investment-style it falls into.

(Click on image to enlarge)

Source: Yahoo Finance

When do valuations matter?

Amid the shift from growth to value recently, one of the main arguments in favor of this shift is the excessive valuation of the growth sector relative to the value sector. This is indeed valid, given that the forward PE multiples of certain individual growth stocks are sky-high, and the forward PE of the growth sector overall is 21.2 vs. 14 for the value sector. The chart below compares the forward PE of two investment styles since 1995.

(Click on image to enlarge)

Source: Yardeni

While there is certainly a notable divergence between the growth and value forward multiples presently, it is not nearly as divergent as it was during the dotcom bubble, following which we witnessed several years of value outperforming growth. Hence, recent calls of vast underperformance of the growth sector relative to value the way we saw during the mid-2000s may be overblown, as growth valuations overall haven’t gotten that excessive.

However, in the event that we do witness a plunge in growth stocks, the question then becomes at what point is it appropriate to buy into growth again? Well from the chart above we see that the multiples contraction in growth stocks ended when the forward multiple of both investment-styles reached equality. Hence in the event of a downturn, keep an eye out for the forward PE of the growth sector approaching that of the value sector, as this would signal that the underperformance of growth is nearing its end, and about to reverse.

That being said, while the excessive valuations of growth stocks is a rational reason to rotate out of them and into value stocks, the truth is that growth stocks have been expensive for a very long time, so why do valuations suddenly matter now and not earlier?

Let’s start off by exploring what induced the outperformance of growth stocks over the past decade. Amid the onset of the financial crisis, the forward PE multiple of both investment-styles were equal in early 2009. When the gap between growth and value forward multiples is narrow/non-existent, investors tend to focus on fundamentals such as earnings growth prospects, stability of such earnings growth, and ROIC. Hence given that growth stocks offered more attractive fundamentals overvalue, investors ended up allocating more capital towards growth. Furthermore, while loose monetary policy conditions since the crisis helped stave off another economic depression, the economic growth rates have been rather sluggish. As a result, investors sought pockets of above-average growth rates to generate excess returns amid sluggish economic conditions, which further encouraged them to turn towards growth stocks over value stocks and consequently helped further widen the divergence in forward multiples. This has been especially true since early 2018 amid the start of the global trade war, which has deteriorated global economic conditions and made the excessive growth rates of growth stocks, particularly software stocks, even more, attractive relative to value, bolstering investors to assign excessive premiums to the growth space.

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