What Delayed The Shift From Growth To Value Stocks For So Long?

Spurred in part by the massive surge in index fund investing and bolstered by the role tech companies have played in the remote-work world, growth stocks have reigned for an unusually long period of time.

Until the reality of Covid hit like a ton of bricks in February, investors couldn’t go wrong where ever they decided to place their money. Sure, the market rotated between pockets of big winners and small winners, but, for the most part, everyone was a winner.

“The concept of a market rotation has never really gone away, but the markets have been on a one-way winning streak for the past 10 years,” says Peter Davies, CEO of Jigsaw Trading in Bangkok. “It didn’t really matter too much what you invested in; chances are it would rise with everything else.”

Sure, these subtle swings between sector to sector, industry to industry and even global region to global region didn’t quite add up to anything of significance. Today, however, the markets appear to be on the cusp of a massive rotation. And this is something you should know about immediately.

What is rotation? “Market rotation is when money stays in the stock market but moves from one style, sector, or attribute to another—for example from growth to value,” says Greg McBride, Chief Financial Analyst at Bankrate.com in Palm Beach Gardens, Florida.

Perhaps the most significant rotation in the last generation occurred in the 2000/2001 timeframe. In merely scanning the broad market indices, it looks as though the entire market came crashing down following its March 2000 peak. But that overall number hides what was happening behind the index curtain. In looking at the underlying stocks, you would have seen one of the most unambiguous and abrupt rotations ever witnessed.

“Historically, rotations have been long lasting, at times a decade or longer,” says Chris Kampitsis, a financial planner at the Barnum Financial Group in Elmsford, New York. “A common example of this is the late 90’s when growth and technology stocks were in such favor that a bubble formed. When the bubble popped, a rotation occurred, and value stocks came into favor the following decade.”

When charting growth and value stocks, the seesaw motion between the prominence of one or the other has been a regularly occurring phenomenon. That growth has been in an uncharacteristically long cycle of outperformance is highly unusual. However, don’t be fooled. Nothing lasts forever.

“Value and growth tend to have prolonged periods of disparate performance relative to each other,” says Chris Carter, Portfolio Manager at Navalign Wealth Partners in Los Angeles. “Growth has been outperforming for over a decade due to technological disruption, structural shifts and low interest rates but eventually value will take the lead.”

Why have growth stocks been so dominant? Perhaps a better question might be “What has been holding back traditional value stocks?”

“It’s been quite a while since we’ve seen a prolonged rotation from growth stocks to value stocks,” says Ken Johnson, Investment Strategy Analyst at Wells Fargo Investment Institute in Charlotte, North Carolina. “Value stocks largely consist of Financial and Health care firms both of which have struggled, up to more recently. Financial firms have been loaded with regulatory restrictions and their earnings growth has been stifled by a flatter yield curve and low interest rates. Health care firms have been overwhelmed with political uncertainty specifically as it pertains to the future of the Affordable Care Act and pharmaceutical drug prices.”

In fact, you may have found yourself ridiculed for suggesting investments that don’t fall into the growth category.

“Growth companies have outperformed value companies for so long that it has been a very contrarian view to move from growth to value,” says McBride. “The outperformance of growth reinforced the appeal of growth, often at the expense of value, for many investors. But any time there is a near-universal sentiment in markets, the market has a way of humbling investors sooner or later.”

While it’s tough to predict exactly when that “humbling” will occur, it’s often quite apparent what can trigger it.

“Growth stocks had been on a tear for years, driven by fast-growing and high-earning tech companies,” says Chris Davis, Investing Specialist at NerdWallet. “And when the pandemic hit, the ‘stay-at-home’ stocks like Zoom and Netflix
NFLX
had all the more reason to keep going up. A rotation is a signal that investors see some kind of change on the horizon. The confidence in growth stocks over the past decade may suggest investors just didn’t see any reason to flee those high-flying tech companies. Now, maybe they do.”

“Maybe.” That’s the key word here. Yet, recent events may have signaled things are changing.

“Time durations for rotations are spurious-even faddish,” says Kelly Buckley, Managing Principal and owner of Spectrum Financial Alliance in Nicholasville, Kentucky. “For example, high capitalization, tech, growth company stocks are the beneficiary of Covid driven rotation. As we see the economy reopening (quickly, we believe, as soon as the FDA provides emergency vaccine authorizations and we believe this will occur within the next 30 days with two or more vaccines in phase 3 testing now) capital will rotate out of the clearly elevated valuation large cap tech growth universe into value-oriented bank stocks. Covid’s persistence has elevated and lengthened the rotation into the tech, growth world and as Covid begins to look beatable the rotation begins.”

Why might now be the time for value stocks? In part, it’s because of pent-up potential.

“Historically, value stocks have tended to outperform during periods of strong economic growth,” says Ann Guntli, V.P., Portfolio Manager at RMB Capital in Chicago. “But in the 12 years since the end of the Great Financial Crisis, value stocks have not kept up with growth stocks. GDP growth in the U.S. has also been below average for the past 12 years. Investors looked for growth from companies when growth from the economy was lacking. Looking forward to the economic recovery once the COVID-19 crisis is over, proponents of value-based investing are focused on the possibility that value companies and sectors will be key beneficiaries.”

Oddly—and here’s what makes rotation so tricky to predict—you can have a great deal of confidence in what exactly needs to happen to spur a move from growth to value stocks, but you just can’t know the timing for sure. When the flood gates open, however, it’ll be all apparent that shift has arrived.

“An effective vaccine is the sort of major event that forces investors to re-evaluate whether the investment climate has changed sufficiently,” says Steve Sosnick, Chief Strategist at Interactive Brokers
IBKR
in Greenwich, Connecticut. “While it shouldn’t have been a huge surprise that a vaccine was being developed, its efficacy was better than expected. A successful vaccine would go a long way to resuscitating the economy, so it was logical to see investors switch their focus to stocks that would benefit from improved economic activity. A stronger economy would eventually lead to higher long-term interest rates, so it was logical to see bank stocks outperform. The move was so violent because so much money has flocked to the beneficiaries of the ‘stay-at-home’ trade that when money flowed out of those stocks it was sufficient to boost smaller stocks quite substantially.”

This seems to be what took place the week of November 9th, when Pfizer
PFE
announced a Covid vaccine with a 90% efficacy rate. “Value stocks surged and stay-at-home stocks lagged, as investors bet Pfizer’s vaccine will allow the economy to finally reopen and recover,” says Carver.

This move may have been further reinforced when Moderna came out with a vaccine that has a 95% success rate. If you looked at the underlying securities in the market, you’d have seen a pronounced shift towards value stocks. And there was a good reason for this.

“It happened because many value stocks have become so undervalued in comparison to growth stocks that with the positive news of the efficacy of Pfizer’s coronavirus vaccine, investors didn’t want to miss out on the rotation and piled in,” says Robert R. Johnson, Heider College of Business Professor of Finance at Creighton University in Omaha. “Investors seemingly ignored the fact that coronavirus cases are climbing rapidly and the vaccine won’t be available for quite some time.”

The story remains a simple one. “A lot of the best performers during the pandemic have been work-from-home stocks and growth firms where their profit growth is further in the future,” says McBride. “A vaccine revives the appeal of the stocks that have been trounced during the pandemic and the bump higher in long-term Treasury yields undercuts the present value of future earnings, especially for those firms where the earnings are further down the road.”

It’s still too early to see if this shift to value stocks will last, but all indications suggest this long-awaited rotation has finally come.

“The Pfizer news gave investors some insight on the expected timeline of a COVID vaccine,” says Carter. “As a result, many economically sensitive sectors like financials, industrials and energy surged. The market has given us some head fakes with value rotation this year, but this could be the one that sticks.”

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