Growth stocks are at risk of topping out, according to Bank of America Merrill Lynch analyst Stephen Suttmeier—and value stocks are well positioned to stage a comeback.
To determine the relative value of growth and value stocks, Suttmeier divided the Russell 1000 Growth index by the Russell 1000 Value index (.RUI). This price ratio has been climbing this year, reaching a high only exceeded by the level reached during the dot-com bubble.
When will value overtake growth? Suttmeier turned to the ratio's Relative Strength Index, or RSI, for some clues. The RSI, used to measure price momentum, is calculated by dividing a security's average gain during up periods with its average loss during down periods over a specific time frame.
A RSI value of over 70 generally indicates that a security is becoming overvalued and primed for a pullback. This has already happened in the most recent 14-week RSI for the Russell 1000 Growth/Value ratio. The RSI for this ratio has been pulling back from around 80 earlier this year to 58 as of last week, breaking a support level last seen in mid-2017, Suttmeier wrote in a note yesterday.
This could signal a potential momentum breakdown for growth stocks, according to Suttmeier. In the past when the RSI hit a level this low—in September 2014 and January 2016—it has been followed by the outperformance of value stocks for at least a year.
The opinion was echoed by Michael Wilson from Morgan Stanley.
The forward price/earnings ratio on the S&P 500 (.SPX) is now above fair value, according to Wilson, especially with the recent rise of the 10-year Treasury yield to above 3%. "A temporary overshoot is reasonable, but downside risk on valuation is more likely in the face of higher rates," he writes.
But instead of an overall downturn, Wilson believes the current rotating bear market in the U.S. will end with growth stocks and small-caps underperforming. Defensive sectors such as health care and consumer staples have already been the market leaders since early June, while growth sectors such as technology have been lagging. Wilson noted that last week, momentum strategies saw their worst week of performance since early March 2016.
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