The valuation performance disparity between value and growth has become extreme in our view, with the Russell 2500 Growth Index outperforming the Russell 2500 Value Index by 25.4% year to date, and 65.85% since year end 2016. This is in stark contrast to a more normalized performance period, such as year end 2009 to year end 2016 when value out-performed growth by a modest 50 basis points, up 143.29% vs. up 142.8%.1
Russell 2500 Growth and Value total return 12/31/2009-07/21/2020. Source: Bloomberg
In our opinion, growth’s outperformance has largely been driven by quantitative easing and stimulus programs. The Fed has lowered its fed funds rate to zero, and the yield on the 10-year treasury has fallen from 2.44% to 0.60%.2 These stimulus actions, have created what investors describe as a “Fed put”, or an underpricing of risk assets. These tail winds disproportionally benefitted riskier investments versus those that offered a more balanced upside/downside protection tradeoff, as low-cost loans were readily available, if needed, to offset unanticipated cash shortfalls.
Yield on 10-year treasury, 12/31/2016-7/21/2020. Source: Bloomberg
Growth investors may be assuming that this period of low rates is permanent, and if so, may be erroneously applying these low rates in discounted cash flow models. Dividing by a lower interest rate over time increases the projected price of a security, potentially leading to overly aggressive price targets. With the U.S. federal deficit increasing from $23.2 to $26.5 trillion dollars year-to-date3, and likely continuing to grow with additional stimulus actions, it is our view that 10-year treasury rates are unsustainably low. Thus, we think even a modest increase in rates would negatively impact growth stock valuations.
Total U.S. Public Debt Outstanding, trailing 12-months. Source: Bloomberg
We believe growth investors are now struggling to support price targets. Coincidently, earlier this week, Blackrock’s senior quantitative researcher asserted that “Investors should scour alternative data for trading signals and end their obsession with valuation metrics.4” Searching for alternate factors or ‘signals’ to justify continued growth style investments is concerning.
In our view, valuation always matters. With extended growth stock valuation levels, cratering treasury yields and skyrocketing U.S. Debt levels, we would recommend investors begin the rotation away from growth back to value. What are you waiting for?
1 Russell 2500 Value and 2500 Growth index returns from Bloomberg.
2 10-Year Treasury yield history from Bloomberg.
3 U.S. Treasury Public Debt Outstanding sourced from Bloomberg.
4 Blackrock quantitative opinion from Bloomberg article published 7-21-2020 “https://au.finance.yahoo.com/news/blackrock-quant-sees-stock-valuation-123918083.html”
All views/opinions expressed herein are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. These views/opinions are subject to change without notice. The information and material contained herein is of a general nature and is intended for educational purposes only. This does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities. The Russell 2500™ Value Index measures the performance of the small to mid-cap value segment of the US equity universe. It includes those Russell 2500™ companies that are considered more value oriented relative to the overall market as defined by Russell’s leading style methodology.