- Growth stock leadership has reached an extreme level
- Recovery in the energy and financials sectors would lift value indices
- Stability in oil prices and the dollar could be favorable for value stocks
Growth leadership may be long in the tooth
The investment universe is full of dichotomies, and one of the most familiar to equity investors is the shifting leadership of growth and value stocks. This relationship has reached a notable milestone, and investors looking at equity allocations should consider the wide valuation dispersion in today’s market.
A growth run for the record books
The current bull market for growth stocks is approaching the 10-year mark — the longest period of extended growth outperformance on record, and considerably longer than the previous record of 6.5 years. This outperformance has driven equity prices to record highs (Source: Bloomberg) and has also created wide valuation dispersions within the S&P 500 Index.
At the close of 2015, the average price-earnings (P/E) multiple for the S&P Index was approximately 17x earnings. The most expensive quintile of S&P 500 stocks measured by P/E ratios had a trailing P/E of 55x. The so-called FANG stocks — Facebook, Amazon, Netflix, Google* — were in this leadership group. Meanwhile, the P/E for the cheapest quintile was a mere 9x, a valuation caused, in part, by the energy selloff. To put these valuations into historical context, at the height of the 1999 tech bubble, the most expensive quintile had a P/E greater than 63x, and the cheapest quintile had a P/E of 9x (Source: Bloomberg).
The opportunity in wide valuation spreads
Historically speaking, the past 10 years of growth outperformance have been an exception to a long-term rule: Value has historically outperformed growth more often. If history is a guide, reversion to an extended period of value leadership could be approaching. At the same time, the wide valuation spread — the difference between the cheapest and most expensive stocks — presents a significant investment opportunity for long-term investors.
As we anticipate a transition to a value-driven equity market, it is essential to keep an eye on two sectors — energy and financials. If oil prices have bottomed out, as many believe, it is likely they will continue to recover, and earnings of businesses tied to the energy sector will follow suit. For financials, a combination of macroeconomic factors has contributed to the sector’s extended sluggishness. These stocks have struggled since the initial shock of the global financial crisis and continue to trade at attractively low valuations today. This sector is certainly worth watching, particularly if macroeconomic conditions improve.
The intrinsic value of a value approach
Beyond the lengthy run of growth outperformance and the compelling wide valuation spreads in the market today, it is also worth noting the intrinsic worth of undervalued equities. A stock priced below its intrinsic value is like a beachball held under water: When temporary pressure is removed, it can rise to a new level. When lower valuation stocks are trading at a significant discount to the market — as many are trading today — historically they have gone on to outperform the market.
To date in 2016, we have seen a subtle shift in leadership, as value has outperformed growth across all market capitalizations. If the U.S. dollar, oil prices, and China’s economy continue to stabilize, investors could see the end of the growth outperformance that has defined the past decade. It may be time to review portfolio diversification across equity styles.
* These companies may or may not be current fund holdings. Please see putnam.com for more information.
Standard deviation is a measure of volatility that reflects the dispersion of a set of returns relative to an investment’s mean, or average, return over time. It is often used as an indicator of investment risk. Larger standard deviations mean larger dispersion from the mean. In a given set, two thirds of returns fall within one standard deviation of the mean, while 95% fall within two standard deviations of the mean.