Year-to-date, the Russell 3000 Growth Index is up 19.5% (through 9/13/17). The Russell 3000 Value Index is up 5.0% in the same period. In 2016, Value prevailed, outperforming Growth by over 11 percentage points. Keep in mind that, over the long term, the average annual performance divergence between Growth and Value is close to zero (7 basis points since 1995). Notably, Value beats Growth in in down markets, and the generally higher dividend yields of Value stocks provide an additional cushion.
There are a number of reasons for Growth’s recent outperformance and reasons to be cautious about concluding the need for more exposure to Growth.
In Market Dynamics and the Growth Versus Value Trade, Farris Shuggi and Som Priestley of T. Rowe Price outline some of the risks that have built up by the outperformance of Growth relative to Value. We encourage you to read the whole article, but I’ll summarize a few key points:
- The largest securities in the core benchmark (Russell 1000) are much more growth-oriented than they were 10 years ago. Similarly, Growth indexes are much more concentrated than value indexes. A relatively small number of outperformers have skewed the indexes towards this overconcentration. Inflows into passive strategies have further exaggerated the effect. As a result, future changes in sentiment will likely magnify the market movements in Growth stocks and indexes.
- T. Rowe Price attributes the Growth outperformance to “slow economic growth, a low inflation and low interest rate environment, and, more recently, the economic challenges facing the energy sector, which has a significant weight in the value universe.”
- Slow economic growth tends to favor Growth because of a preference for companies that perform independently from broader economic trends.
- Similarly, low interest rates allow investors to discount long-range cash flows at a lower interest rate, meaning a higher current value for distant earnings. Some Growth stocks may be very sensitive to interest rate changes.
A tip toward higher growth/inflation/rising interest rates will likely suddenly reverse the recent outperformance of Growth stocks. We witnessed this following last year’s presidential election when sentiment changed radically in light of stated policies to increase economic growth. Following the election, Value stocks rallied immediately and strongly. That sentiment appears to have reversed, for now.
Conversely, a tip toward recession will deflate the entire market with outsized effects on stocks with much higher valuations (mostly Growth stocks).