October brought a significant drawdown across major U.S. equity indices. Fears over the potentially negative effects of tariffs and higher interest rates on global growth have been building for most of the year. We think the speed of interest rate increases (as opposed to their absolute levels) may have been the catalyst that spooked U.S. markets into correction territory, with technology bearing the brunt of the pullback. We are closely watching for additional risk-off signals. Credit spreads have widened, as is typically the case when volatility spikes. But, the fixed-income market isn’t showing signs of panic. The continued volatility in emerging markets bears watching. Against this mixed view of current market dynamics, we believe several factors support the case to sustain long-term U.S. growth equity allocations.
Earnings growth has been a major driver of market appreciation in U.S. growth stocks in 2018 and has generally contributed to their outperformance of broad U.S. equity markets over the past couple of years. Following October’s route, growth stock valuations are lower now than at the beginning of the year. They’re also slightly below their long-term average, making them reasonably valued from a historical perspective.
Information technology (IT) stocks were among the hardest hit during October, prompting some observers to suggest that today’s tech landscape is similar to that of the tech bubble. Beyond the typical fears that accompany a drawdown, there is little resemblance between IT sector fundamentals of today and those of early 2000. Today’s leading tech companies are highly profitable, have strong balance sheets, and continue to grow at faster rates than the overall market. Given the outperformance of IT stocks for most of 2018, it’s not surprising to see investors move to lock in gains at the first sign of trouble, which undoubtedly exacerbated the downside pressure on the group.
The S&P 500 IT sector has a growth rate 3% higher than the broad index.1 It’s normal for valuations of higher growth companies to be at a premium to those of lower growth companies. The average premium of the S&P 500 IT sector to the broad index in the past 30 years has been 30%. Today, it is a mere 7%, making it a relative bargain from a historical perspective.2 How can one explain the significant outperformance of this sector over the longer term? Approximately 89% of IT sector returns from March 9, 2009, through October 15, 2018, have been earnings-driven while only 11% were driven by multiple expansion.2 We think the greater valuation risks in the U.S. growth equity universe reside among slower growth constituents. These include dividend-paying stocks that have disproportionately benefited from investor thirst for yield in an era of ultralow interest rates that persisted throughout the 2008 financial crisis recovery.
Rates have risen at a fairly steady clip in 2018, which we believe contributed to October’s pullback. But, even at current levels, interest rates are still very low from a historical perspective. A study of valuation multiples during various interest rate environments shows that growth stock multiples have typically been expansionary as interest rates rise from low levels.3
Chart 1: S&P 500 Index next 12 months’ price/earnings (NTM P/E) ratio4 vs. 10-year yield
Rates have increased and appear to have moderated somewhat in November. But even if they trend higher from today’s levels, we don’t believe they will become a significant headwind for growth stocks until the 10-year yield approaches the 4% range. In sum, neither interest rates nor overall growth equity valuations are currently at levels that would trigger outsized worries of growth stock underperformance. We think growth stocks should remain attractive as long as fundamentals hold up.
Taking advantage of the sell-off
Volatility has often created a trading opportunity to add to positions in stocks with strong secular growth drivers whose relative valuations have gapped to attractive levels. For example, we had been consistently trimming our software positions as the sector got more expensive throughout 2018. As valuation gaps widened during the sell-off (which is typically more pronounced among smaller, less liquid stocks), we have been able to add back to some names that we believe have robust and sustainable growth opportunities and that we think are now underappreciated by markets.
There are a number of areas within the IT sector that we believe have particularly strong secular growth drivers and that may be somewhat insulated from macro headwinds that could materialize. In addition to certain opportunities in software, we are attracted to names within cloud, online, digital payments, and internet of things. In a separate three-part series, we have published a more in-depth look at these industries and what makes them attractive to us.
Optimistic about relative valuations
Even though growth stocks have outperformed value stocks since the end of 2016, we still believe there is a significant opportunity for growth stocks to put up competitive returns going forward. As the benefits from accommodative fiscal policy subside, we think U.S. gross domestic product growth will likely moderate back to levels where the growth premium will be relatively attractive. Additionally, we perceive a scarcity of growth stock opportunities within the investing universe, which could favor the companies we currently own and those we are seeking to add to our portfolio.
When differences in earnings growth are taken into account, historically faster-growing stocks had continued to have more attractive valuations relative to slower-growing stocks (Chart 2). One option investors could consider is moving away from lower-growth, bond-proxy surrogates and reward companies with attractive growth characteristics as interest rates continue to normalize. We think the combination of attractive valuations and strong fundamentals may bode well for the future of performance of our portfolios.
Chart 2: Price to earnings to growth (PEG) ratios of faster growth and slower growth stocks of the S&P 1500 Growth Index
Corrections and periods of volatility are a normal feature of markets, underscoring the need to maintain a long-term focus for assets designated for long-term investment. For perspective, consider that an investment in the Russell 1000 Growth Index one day before the collapse of Lehman Brothers in 2008 would’ve more than doubled in size as of October 2018. But beyond the risk of bad timing, a more important risk to investors is the paralysis that comes from being fearful of market volatility and staying out of markets altogether. It’s difficult to guess what markets will do in the near term. But, we think the fundamental backdrop is favorable for growth investors with a long-term perspective.
- Source: FactSet
- Source: Goldman Sachs Portfolio Strategy Research, October 17, 2018
- Sources: Federal Reserve, S&P, Thomson Financial, and Credit Suisse
- P/E is the price of a share of a stock divided by earnings per share, usually calculated using the latest year’s earnings.