March 5, 2021 glacierinvest

Growth stocks have noticeably underperformed over the past few weeks as interest rate increases have accelerated.

While painful to experience for growth investors, the drop shouldn’t come as a surprise after growth stock’s meteoric rise in 2020. The chart below is the ratio of the iShares Russell 1000 growth ETF (ticker: IWF) versus the iShares Russell 1000 Value ETF (ticker: IWD). The rise in growth relative to value last year rivals the first major leg down in growth relative to value after growth stocks peaked in March 2000 on the heels of the tech boom.

Not surprisingly, value stocks have benefitted at growth stocks’ expense, a reversion of the trend we experienced in 2020. In looking at the chart above, there’s potentially a lot of reversion to the mean that can still occur in the reversal of last year’s trend. Importantly, this reversion could go on for years. Growth stocks underperformed value stocks for nearly seven years after the internet bubble popped. That’s a sobering thought.

Since we can’t predict what’s going to happen, let’s examine some of the reasons why the current reversionary trend might continue and why it might not.

Why growth stocks could continue to underperform value stocks

A popular response is valuation. Growth stocks’ valuation levels are substantially, and arguably unjustifiably, higher than value stocks’ valuation levels. However, valuation is NOT a catalyst. Something has to occur to tip the balance of power. Valuation provides important context about how long a reversionary trend may continue. The greater the unjustified disparity in valuation, the longer the reversionary trend can last. See growth versus value March 2000 to July 2006.

Normalization is probably the most likely catalyst for growth to underperform value, at least for a period of time. The pandemic and the measures taken during the pandemic were transitory. While we may never fully return to the previous “normal”, the reopening of the economy will lead to value stocks regaining lost ground versus growth stocks, which appears to be what we’re observing now.

Looking past the normalization catalyst, rising interest rates could be a catalyst that enables the growth versus value reversionary trend to continue for a longer period of time. It’s difficult to say though because during the 2000-2006 growth versus value reversionary period, interest rates actually declined so rising rates don’t appear to be a requirement for this relationship to revert to the mean.

More likely, economic growth will be the catalyst that contributes to a more pronounced reversion to the mean. A recovery/reflationary environment should noticeably increase earnings and cash flow growth for value stocks whose businesses tend to be more cyclical. How long the recovery/reflationary environment lasts is anybody’s best guess but remember the chart above. There’s potentially a lot of reversion to the mean that could still occur.

Why growth stocks might outperform value stocks

I think growth stocks will likely underperform value stocks throughout the reopening of the economy and the normalization of life in general, whatever that may look like. Looking past the reopening of the economy, the obvious catalyst for a return to growth stock outperformance is lackluster economic growth. What and when the market collectively decides is lackluster is impossible to determine. Some important variables to consider include the negative impact high levels of government debt have been shown to have on GDP growth historically and what growth will actually look like once we get past the COVID shut-down quarters. Will growth look any better than it did prior to the pandemic? If not, will it be enough for value stocks to continue to outperform?

As you have hopefully taken away from this post, there are a lot of factors to consider in the growth versus value debate. We’ve only scratched the surface. It’s very difficult to predict what’s going to happen. Having a balanced portfolio diversified across asset classes, geographies and investment strategies is generally your best bet in counteracting this type of uncertainty, which by the way is quite pervasive throughout all investment markets.