Stocks’ Value Season Hasn’t Arrived Yet

Is a leadership shift underway? Value stocks—those whose price is low relative to others’ using metrics comparing prices to things like earnings or sales—outperformed in September. This has some pundits proclaiming a new value leadership trend is at hand, arguing growth stocks’ supposed decade-long leadership is over. However, we believe this is premature and ignores actual leadership changes since this bull market began.

The relationship between value and growth stocks, overall and on average, is cyclical. Value stocks typically (but not always) perform best coming out of bear markets and recessions. They tend to be in economically sensitive sectors—moving with the business cycle. Hence, markets usually punish them disproportionately when recession hits. At the bear market’s bottom, pessimism overshoots by miles—depressing prices to irrationally low levels and loading a spring that launches them higher as recovery takes hold. Many value companies are also small, so this overlaps with small cap’s tendency to outperform early in a bull.

But value can also have short bursts of outperformance later in the cycle, too. While value led after 2008 – 2009’s recession, it also outperformed for months in 2012 – 2013 and 2016. Temporary deviations from the prevailing trend—so-called countertrends—happen often and tend to fool many investors. Rather than try to time them, ask if there is a valid reason for value to outperform for a meaningful length of time. Given where we are in the market cycle, we don’t think there is.

In a maturing expansion, growth stocks usually do better. Growth stocks cluster in sectors driven by innovation, spurring new products and services in growing markets. They generally aren’t as sensitive to the economic cycle—better able to grow through soft patches as well as acceleration. Relative to value stocks, they often enjoy faster earnings or revenue growth, higher margins, more sustainable profits longer-term or some combination thereof.

These growth characteristics overlap quite a lot with other categories that shine as bull markets age. Mega cap stocks—those bigger than the broader market’s weighted-average market capitalization—usually perform best as the bull persists and market breadth narrows. The longer the bull wears on, the more the percentage of stocks outperforming the broad market tends to fall—a narrower share of big stocks move capitalization-weighted indexes higher. “Quality” also becomes more attractive. Quality can be measured in different ways—there is no set definition—but it generally refers to managements’ effectiveness and the strength of companies’ product and services lineups. Large growth stocks feature prominently in both categories.

In a bull’s later stages, investors usually bid these stocks higher. Warming optimism allows “multiple expansion”—financial industry jargon for rising P/E ratios. That augurs well for growth, mega-cap and quality stocks, which typically sport higher valuations, meaning investors are willing to pay more for earnings. These aren’t your bargain-basement stocks.

Value’s recent relative rally looks sentiment driven—just one month’s blip so far—and smaller than many that have occurred throughout this cycle. We doubt this one will be the start of a long-lasting trend. It is important to look beyond the last month. Value underperformed when stocks pulled back in August, likely tied to recession fears that stoked volatility. It is normal for what lags on the way down to lead on the way up. But seizing on such wiggles is myopic. Countertrends occur frequently. Sentiment driven style shifts don’t usually last long—fundamentals tend to win out in the end. Today, we think those favor the largest stocks, which tilt toward growth. For investors, discipline is best. Stocks look forward. Reacting to the recent past likely invites whipsaw that can take you further from your long-term financial goals.

In our view, a mid-cycle slowdown keeps sentiment in check—a pause that refreshes for the bull’s next leg up, in which  growthier, high-quality, mega-cap stocks should lead. We think investors tilting their portfolios towards them will likely benefit.