April showers bring May showers bring June….more showers? If you had to predict the weather in Michigan this Spring, it would have been pretty simple: 65-75 degrees with rain. You would have been correct about two-thirds of the time. The investment world has had a similarly persistent trend for the past six years: stocks up with growth stocks beating value stocks. The following table shows the returns for stock indices highlighting this trend from June 30, 2013 through June 30, 2019:
Generically speaking, growth stocks are companies that are experiencing high growth in earnings. They generally trade at higher multiples of those earnings (and thus are more expensive) than their value stock counterparts. Value stocks don’t have the same earnings growth expectations, but they are usually less expensive and pay higher dividends. In the long-run, their total returns should theoretically be similar, though some studies suggest value stocks outperform.
This kind of discrepancy happens from time to time (in both directions). I believe it is happening today because we have been in a prolonged, relatively slow growth recovery. There are a handful of stocks that have been able to show earnings growth in this environment; this has made them very attractive. They’re being labeled as sure things with growth rates that will surely continue for the foreseeable future. They are being touted as a lock if ever there was one — even more of a sure thing than rain next Tuesday.
Alas, investing is never that clear cut. It is important to understand the dangers of falling into this trap, especially in today’s world. When President Trump uses tariffs as the preferred tool of choice to punish foreign governments for misdeeds, he creates an environment of chaos and uncertainty. Companies dependent on a free flow of supplies amongst different countries have to rethink their global supply chain. This kind of environment causes growth to slow even further and drastically increases the odds of a recession. The sure thing growth stocks will probably still be able to grow their earnings through this, but that won’t be enough to sustain their price levels.
A good example of this occurred in the not-too-distant past. Microsoft during the 1990s was a classic growth story. If you recall, the internet was kind of new and Microsoft created an operating system that made it easy to connect. It also took over the word processing and spreadsheet world, and an entire network of consultants built their businesses around Microsoft products. The company enjoyed tremendous growth: 37% earnings growth per year! It was as much of a sure thing as many of the growth stocks today. The stock price climbed even higher than earnings did forcing the Price/Earnings ratio (a measure of value) up to 72 from 20 at the beginning of the decade. As in interesting aside, Amazon’s PE ratio is 70 today.
During the next decade, the US economy suffered two recessions. Perhaps not surprisingly, Microsoft continued to grow its earnings throughout this difficult period, though at a much more pedestrian 8% clip. Despite the growth in earnings, the stock fell nearly 50% as the PE ratio fell from 72 down to 10!
Bringing things back to today’s environment, the following table adds more information to the return table listed above.
What we have seen over the past six years is a pretty good growth environment for all companies as all of the indices listed have had decent earnings growth. The stock price for each has risen even faster than earnings growth, and thus the PE ratio expands. However, this multiple expansion has been somewhat concentrated in the growth names. Thus, the outperformance in these names is almost completely attributed to this multiple expansion.
There is an industry expression that highlights the dangers of multiple expansion. It is called the greater fool theory. The Greater Fool Theory suggests you can continue to make money in stocks even if the stocks are expensive if you can find at least one fool to buy it for a higher price. This works until there are no more fools. The last fool holding the bag loses. This is what happened to many of the tech names (Microsoft included) during the 1990s. While we are not quite at those extremes, the signs are pointing in that direction.
Timing markets is notoriously difficult, and some would say futile. Markets can continue to rise much longer than seems plausible. The NASDAQ in 1999 doubled despite the high valuations at the beginning of the year. However, there are a few things you can do to protect yourself if we are indeed heading toward another Y2K climax. First, it doesn’t hurt to have some cash on hand. Second, reduce exposure to cyclical names; and particularly in this environment, companies that rely on a global supply chain will minimize your risk. Finally, tilting the equity portion of your portfolio towards the value spectrum would be prudent. We’re not expecting a 2008 disaster even if our economy does fall into recession. Perhaps a little rain and a couple of thunderstorms. We’re used to that by now. Eventually, the sun will rise, and we may even one day this summer need to use the sprinklers again.
Anthony J. DiGiovanni, CFA
Chief Investment Officer