Several weeks ago I wrote about the valuation of the S&P after removing the four FANG stocks (Facebook, Amazon, Netflix and Google) from the calculation. Using this measure, the S&P was inexpensive relative to history. FANG stocks, like a lot of momentum driven growth stocks, have performed incredibly well over the past 2 years. Remarkably this is actually historically unusual. With interest rate expectations moving higher along with some bloated growth valuations there are a lot of reasons to believe that the shift back towards value stocks has begun.
Growth stocks have indeed been pummeling value stocks for the past 2 years. If this were a post-season baseball game it would be the equivalent of the Red Sox beating the Yankees 16-1. The Russell 1000 Growth index has outperformed the Russell 1000 Value index by about 27% cumulatively over this 2-year period. This is a staggering level of outperformance that hasn’t been seen since 1998-1999, and before that in 1990-1991 and 1930-1931 before that. In all of those periods, the two subsequent years after growth rallied the trend reversed so sharply that over an entire 4-year period of time growth underperformed value
The average outperformance of value versus growth was over 60% for the cumulative 2-year period of time.
value has overwhelmingly outperformed growth. There are various estimates of these levels of outperformance but the average outperformance is about 5% per year. In fact, value outperformed growth for every decade since 1930 with the lone exception being the 1990s where an unprecedented bubble in dot-com stocks took place. Yet, despite that run in the late 1990s, growth stocks only outperformed by an average of 2.5% for that decade. And during ever other decade value stocks outperformed growth stocks by at least that much on average each year. Many of us remember how strong growth stocks performed during the 1990s. Yet that 10-year performance was only good enough to equal value stocks’ weakest decade back in the 1930s (Source: Fama and French, ACM).
During our present decade, growth has again outperformed value. There are a few potential explanations for this period’s outperformance. As my colleague Dr. JoAnne Feeney has noted in a past commentary, interest rates have remained historically low allowing companies with a lot of future earnings to enjoy rising valuations. The U.S. has never had such an extended period with such low interest rates. This phenomenon alone is worthy of a commentary. But this benefit is disappearing quickly as rates are now rising and signs materialize of an economy that may be overheating. One such sign is the 50-year low both in the number of people filing for unemployment and in the unemployment rate. Job openings have just set another record since the report began and are now almost 50% higher than the peak of the last expansion. Job openings (the yellow line) have been shooting higher since the start of 2018 with little relative increase in the rate of employment. Employers are having an increasingly difficult time finding workers.
Another possible explanation for growth’s outperformance is found in the changing nature of startup businesses. During this decade, it has become possible for a company to go from startup to one of the largest companies in the world in less than 15 years. The internet makes this possible. Fifty years ago when Walmart was growing quickly, it could grow at 25% a year and that was considered rapid growth. It still took decades for it to become one of the most valued companies because it had to build more stores. That takes time and money. Today Facebook and others have the capacity to expand without having to spend a penny. Even brand-new websites reach a global market immediately. With a team of good programmers and a great product any company can become massive very quickly. Hiring needs may be relatively limited. But this wave of rapid mega companies is slowing. The internet is maturing and competition is growing. So even if this phenomenon continues, the lowest hanging fruit for new internet-based companies has been picked.
Either way, growth has clearly had a phenomenal run, a run that places it among the top four periods over the last 90 years. But as we all know, momentum trades can go on for a while. Calling a top is very difficult, but the headwinds are mounting for growth-oriented investments. Whether this recent correction for growth stock valuations is the beginning of a shift in the trend is impossible to know, but history suggests it’s likely.