Why do some investing styles appear to come in and out of favor? It’s not as simple as investors might think.
Recently, value stocks have had a good couple of quarters, following eight quarters of being outperformed by growth stocks. Will this value cycle have some staying power? Before we go too far, let’s examine how the two styles are determined.
At the risk of oversimplifying things, index providers say that low price-to-earnings ratio (P/E) stocks are value stocks, and high P/E stocks are growth stocks. Unfortunately, index providers do not measure P/E relative to the stocks’ industries. Rather, they just lump them all together and draw a line between low and high P/E. This can result in systematic biases in sector exposures for value and growth indexes.
A key example: Because information technology (IT) companies are typically faster growing than firms in other industries are, many IT stocks are not considered value. As of mid-March 2017, the Russell 3000 Growth Index had 32% of its sector exposure to IT while the Russell 3000 Value Index had 10%. That’s a 22-percentage-point differential.
Meanwhile, in the financial services sector, the Russell 3000 Value Index had 28% in financials while the growth index only had 3%. As for energy sector exposure, the growth index had only 0.53%.
These sector biases in value and growth indexes go a long way in explaining why one style might be in favor over the other. It’s not that the style—value or growth—is in or out of favor; it’s because a sector is in or out of favor.
Here are some examples of how a sector position influenced growth and value’s respective fates, throughout history.
- Lack of exposure to IT meant value underperformed during the Tech Bubble build-up in the late 1990s.
- Exposure to financials helped value outperform growth from 2000 through 2007, while growth was slow and the Federal Reserve (Fed) was hiking interest rates.
- However, that same exposure to financials meant value underperformed during the financial crisis.
Stocks do matter, but sector biases are also significant.
When does one style tend to do better than the other does?
Below, you can see the quarterly relative performances of the value and growth categories. When the shaded region is above the axis, that’s when value outperformed growth. When it’s shaded below the axis, growth outperformed value.
First observation: Half of the time between 1979 and 2016, growth beat value, and half the time value beat growth. While the cycles were quite irregular, there are some notable patterns. The first is that the average cycle is six quarters, although that average includes a lot of variability. The longest growth cycle was 12 quarters during the boom of 1988 through 1991. The longest value cycle was 15 quarters long from 2002 through 2006, while the Fed was hiking rates.
Second observation: A growth cycle’s length has tended to be positively correlated with the length of the subsequent value cycle. In other words, a short growth cycle was typically followed by a short value cycle; and a long growth cycle was typically followed by a long value cycle. We just got done with an eight-quarter-long growth cycle, so maybe that could provide a good first guess as to how long the value cycle (which we’re two quarters into) might last.
Third observation: Broadly rising markets have tended to favor growth over value, so value has tended to be a bit more defensive. This makes sense as traditionally “defensive” sectors like utilities, telecom, and consumer staples typically have greater representation in value indexes than in growth indexes. More cyclical sectors, like industrials, consumer discretionary, and information technology typically have greater representation in the growth indexes.
Better growth has been shown to help all stocks, but growth stocks in particular. Some of this could be an extrapolation-tendency of investors, where they think better growth begets better growth. Value has tended to do well when growth is scarce, which is a good way to describe the 2000 to 2007 period. It was a period of growth, but meager growth.
How growth and value have fared in different economic climates
I researched how combinations of economic growth and inflation conditions have favored certain styles, using monthly returns of four Russell indexes. Since inflation is correlated with interest rates, I took into account that periods of rising inflation were also periods of rising interest rates. Going back to 1979, falling inflation has been typically good for value stocks, while rising inflation has been relatively better for growth stocks. Falling inflation has typically meant falling interest rates, which can be good for rate-sensitive sectors that are significant parts of the value index.
|12-1979 through 2-2017||Inflation rising||Inflation falling|
|Growth above trend||Growth/Large cap||Value/Large cap|
|Growth below trend||Growth/Capitalization unclear||Value/Small cap|
|1993 through 2017||Inflation rising||Inflation falling|
|Growth above trend||Growth/Large cap||Style unclear/Large cap|
|Growth below trend||N/A||Value/Small cap|
Since 1993, the results were more mixed. Good growth with rising inflation has statistically been associated with large caps and growth performing relatively better than small caps and value. Below-trend growth with falling inflation was statistically associated with small cap value performing relatively better. These are tendencies and not iron laws of investing; things tend to change all the time.
A case for diversification
Considering the ambiguity in which style does better at what point in time, maybe it just makes sense to stay diversified. However, as measured by the trailing 30-day correlation, growth and value stocks are highly correlated. During the Tech Bubble Burst, they became less correlated, with value performing relatively better—although investors may have missed out in the bubble’s build-up. In the financial crisis, correlations dipped as investors were relatively better off avoiding financials. In the wake of the 2016 presidential election, value was the place to be, but mainly thanks to financials and energy.
Given the high correlation between growth and value stocks, picking the right style is less of an issue than picking the right sectors.