The Growth Vs. Value Trade Is At 1999 Levels
By Arcadia Research:
Over the last few years, we’ve seen an unprecedented divergence between Growth and Value as investors have seemingly left the latter to die while piling into a handful of high growth stocks. This certainly isn’t new behavior, but it’s recently been exacerbated and so I thought it would be a good time to reevaluate the risk/reward landscape within equities.
It’s true, much has changed since the Great Financial Crisis in 2008. Normal market functioning has essentially been suspended over the last decade as interest rates have been kept extremely low and central banks around the world have pumped record amounts of liquidity into the system. This is an important concept to understand because it’s considered to be one of the primary reasons for Growth’s dominance over Value during this time.
When all hell broke loose after the subprime mortgage bubble burst in 2008, the Fed slashed interest rates and launched a series of quantitative easing (QE) programs designed to increase the supply of money in order to resuscitate the economy. And while we can argue the pros and cons of monetary stimulus, one thing is certain — it did a phenomenal job of inflating asset prices over the last decade. Here’s a quick look at the Fed’s balance sheet, M2 (money supply), and the S&P 500.
However, asset prices aren’t necessarily an accurate representation of the economy. The whole notion of monetary stimulus is to jumpstart economic growth and then raise interest rates when growth finally starts to manifest itself in the form of inflation. The problem is that inflation has been nonexistent as growth has been slow and steady for the last decade, which has led to the popular belief that inflation is never coming back and thus interest rates will remain low forever.
This “lower for longer” narrative was supercharged by the coronavirus pandemic as the Fed was forced to slash interest rates to zero (again) and start another round of QE in order to combat a crashing domestic economy.
Value stocks are traditionally viewed as out-of-favor companies that usually trade at a discount to the broader market due to lower expectations about future growth. They’re usually more cyclical in nature (financials, energy, materials, industrials, etc.). So when COVID-19 reared its ugly head in the United States and subsequently eroded millions of American jobs and small businesses, market participants decided that mega-cap tech (FB, AMZN, AAPL, GOOGL, NFLX, MSFT, CRM, NOW) was the safest place to be, in addition to TSLA of course.
From a story perspective, the attraction of high growth software and internet stocks make sense. In a world where economic growth is absent and in-person interaction is severely limited, investors are wagering bets on the industries where growth is still present (or even benefiting). Why take the risk of buying a beaten down bank or energy company that’s inextricably tied to the economy when you can just buy FB or AMZN? Nowhere is this behavior seen more than in a simple chart of Russell Growth Index vs. Russell Value Index, which recently passed its record high in the tech bubble of 1999…
As a famous contrarian investor once told me, “the market will always try to make the most amount of people look stupid”. It was a simple statement, but it really stuck with me. With the massive outperformance of the Growth vs. Value have we reached a point of saturation? How far can these stocks go before reaching a tipping point?
Just to put some numbers behind this, the S&P 500 is up a little over 50% over the last five years while the tech-heavy Nasdaq is up over 100%. Facebook and Google have also more than doubled while Netflix is up 345% and Amazon is up a whopping 500%. Many of these stocks represent incredible companies with competitive moats in gigantic markets and so it makes perfect sense that they should significantly outperform the broader market.
For the record, I love the compounding growth stories in enterprise software and digital advertising. What’s not to like about an enormous total addressable market that’s expanding rapidly as new industries become disintermediated by technology? However, sometimes great companies aren’t great stocks solely because the stock is already priced for perfection and/or everyone already owns it.
Let’s use Netflix as an example. The stock posted massive gains this year as Wall Street declared it a “stay-at-home” winner causing both institutional & retail investors to gobble it up. Going into 2Q earnings, the market was expecting around 7 to 8 million net subscriber additions, which is undoubtedly the most important metric for Netflix bulls. However, when they announced 10 million net subscriber additions the stock sank precipitously in the aftermarket and while there were other factors contributing to the decline this just goes to show what can happen to crowded stocks when perfection is already priced in.
I happen to like Netflix. I’ve traded the stock multiple times throughout my career, but after seeing the number of Robinhood users holding NFLX climb from 160,000 to 210,000 in a matter of days after the stock rallied 75% in less than 3 months, I figured investors we’re getting a little too greedy.
However, human investors aren’t the only ones responsible for the Growth love affair. The systematic community also plays a significant role as Commodity Trading Advisors (CTA’s) and various types of quant funds scan the market in search of trends. For most of these funds, the predominant strategy is to correctly identify a trend and hop on the bandwagon until the trend breaks.
This is important because these funds trade completely without emotion and with a lot of leverage behind them. They don’t care if a stock has already rallied five hundred percent - If their algorithms suggest that a stock is going to keep grinding higher, they buy it.
The overarching point here is that the investment landscape has changed dramatically since the GFC due to unparalleled levels of monetary stimulus which has disproportionately benefited Growth stocks as economic growth has been slow while inflation has been MIA. This benefit was further exacerbated by COVID-19 which forced another round of monetary stimulus while convincing investors who were doubtful of a robust economic recovery to pile into defensive Growth. And now, the outperformance of Growth/Value is at 1999 levels.
To be clear, this is not a bearish call on Growth or more specifically mega-cap tech. I’m in no way suggesting that readers should open fresh short positions on [[QQQ]], but rather be mindful of who’s on the other side of the trade. At the end of the day, stocks go up when there’s more buyers than sellers and vice versa. What happens if there’s no one left to buy?
See also Hasbro (HAS) CEO, Brian Goldner on Q2 2020 Results - Earnings Call Transcript on seekingalpha.com