By: Wayne Duggan
Recently investors are witnessing a market trend that has been extremely rare over the past 15 years: Value stocks are outperforming growth stocks, triggering sell-offs in some of the hottest innovative tech names in the market.
The Big Rotation
For more than a decade, growth stocks have left value stocks in the dust. Since the beginning of 2005, the Vanguard Growth ETF (VUG) has generated a 523% total return. In that same period, the Vanguard Value ETF (VTV) has generated just a 292% total return.
So far in 2021, however, that trend has reversed decisively. Through May 11, the VUG growth ETF was up just 4.6%, while the VTV value ETF was up 17.4%.
In the past 2 weeks, the divergence has accelerated. The VTV Value ETF is up 2.4%, while the VUG growth ETF is down 4.2%. The growth-heavy Nasdaq Composite is down 4.6%, while the value stock-heavy Dow Jones Industrial Average is up 1.3%.
Why It’s Happening
The biggest driver of the rotation from growth stocks to value stocks is fears over rising inflation. The Labor Department recently reported that the U.S. Consumer Price Index, a popular measure of inflation, was up 4.2% in April compared to the prior year, its biggest jump since 2008.
In a vacuum, 4.2% inflation isn’t necessarily a red flag given it’s comparing this year with pandemic levels in 2020. However, investors are growing increasingly concerned that the Federal Reserve will be forced to raise interest rates sooner than anticipated to cool off an overheating U.S. economy. In March, the Fed reassured investors that it will likely not need to raise interest rates through at least 2023. But the bond market is currently pricing in a 9% chance the Fed will be forced into at least one rate hike by the end of 2021, according to CME Group.
Rising interest rates mean a higher cost of capital for companies borrowing money to invest in growth. Higher interest rates are typically bad for the stock market as a whole, but they tend to hit unprofitable growth stocks much harder than profitable value stocks.
How to Play It
Traders looking to profit off the rotation to growth should identify traditional value stocks that have positive net income and relatively low price-to-earnings multiples and debt levels.
Unfortunately, thanks to the recent surge in value stocks, that’s easier said than done. Many traditional value stocks (such as industrials, consumer staples and financials) find themselves with elevated price-to-earnings and price-to-sales ratios.
At the very least, investors should consider taking some profits in the top-performing growth stocks in their portfolios.
Disclosure: The author holds no positions in the securities mentioned.
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