For years, one of the most successful trades in the U.S. stock market has been to favor high-growth stocks over ones considered to be undervalued. At long last, this trend may be unraveling.
Value-based strategies could be poised for a comeback, as the overall economic environment becomes more challenging, with rising interest rates and a less-certain growth outlook. At the same time, the advance in growth-based plays is seen as overdone, as highlighted by recent implosions in some of the strategy's biggest outperformers, including Facebook (FB) and Netflix (NFLX).
"We think the turn is in," wrote Morgan Stanley in a Monday note to clients, saying that the "almost unprecedented" degree of outperformance by growth over value was poised to shift.
Thus far this year, the S&P 500 Growth index is up 10.8%, a move that is more than twice the 4.8% gain of the overall S&P 500 . Meanwhile, the S&P 500 Value index is down 0.2% thus far this year.
This trend has held across market capitalization sizes. The Russell 1000 Value index is up 0.4% thus far in 2018, below the overall Russell 1000 (up 4.7%) and the Russell 1000 Growth index (up 8.8%). The Russell 2000 index of small-capitalization shares is up 7.7%--the Russell 2000 Growth index is up 9.7% while its value index is up 5.4%.
This is hardly new to 2018. Value has been such an underperformer for years--not only relative to growth, but also to the broader market--that last year Goldman Sachs asked whether markets had seen "the death of value." The investment bank was just one in a chorus of voices sounding the alarm; Jeremy Grantham, the founder of asset manager GMO, suggested that many of the mostly widely used metrics in evaluating undervalued companies no longer held much weight for stock moves.
The following FactSet chart looks at the 10-year performance of the S&P 500 growth index (in green), and compares it with both the unadjusted index (red) and the value index (blue). The chart illustrates that growth has consistently, and significantly outperformed over the past decade.
"We appreciate the fact that fighting momentum can be a losing game but when things get this extreme and there is evidence of a turn, we have to go the other way," Morgan Stanley wrote.
While growth has done better for years, the degree to which it has been outperforming value has been unusually high of late. According to the investment bank, the difference hasn't been this extreme since the dot-com era.
Furthermore, the valuation difference between the large-cap growth stocks and their value equivalents is also at its most extreme since 2006. According to FactSet, the Russell 1000 growth index has a price-to-earnings ratio of 29.21, compared with the 17.98 ratio of the value index.
While growth overall has benefited from an environment with low interest rates and steady economic expansion since the financial crisis, it has particularly benefited as some of the market's biggest names have been growth plays. In particular, the FAANG group of stocks, which refers to Facebook, Amazon.com (AMZN) , Apple (AAPL) , Netflix, and Google (GOOG)-parent Alphabet (GOOGL), are all high-growth stocks.
While that group has led the market for years, including in 2018, the rally has recently shown signs of cracks. Both Netflix and Facebook tumbled after their most recent quarterly report, with Facebook suffering its biggest one-day drop ever and dropping into bear-market territory.
Facebook's plummet resulted in a rare week of pronounced outperformance by value instead of growth last week. The S&P 500 value index gained 1.44% over last week, compared with the 0.6% rise of the index overall. The growth index dropped 0.1%. That represented the biggest weekly outperformance by value over growth since December, according to the WSJ Market Data Group.
"Whether this is a blip or the start of something new, where investors rotate into value in an earnest way, remains to be seen," said Michael Mullaney, director of global markets research at Boston Partners. "However, the current environment feels a bit like the dot-com era, which was the last time that tech valuations in particular got a little stretched. When those pulled back, that led to a period of value outperformance that lasted for years."
Morgan Stanley espoused this view, saying that the outperformance of growth strategies wasn't justified by past and forecast earnings growth.
"Based on this spread widening over the past year, we think it time for a reversal. Either large-cap value stocks will go up more or large-cap growth stocks will simply come down and catch up with the rest of the market on P/E compression," it wrote. "We think it will be the latter but would not care if it is the former. Either way Value outperforms Growth and we think the spread can narrow by 10-15% over the next several months."
Morgan Stanley analysts referred to the outperformance by the value contingent last week as "a good start."