With the U.S. economy forecast to grow at or close to 3.0% for the rest of the year, it would traditionally be a good time to consider value stocks which tend to do well when economic growth and earnings are accelerating.
But that hasn’t been the case this year nor in recent years as the technology sector, along with other growth stocks, have outperformed their value counterparts. Through June 13, the Russell 1000 Growth Index is up 9.1%, while the Russell 1000 Value Index has declined by 1.1%. The divergence of the growth and value paths was also notable last year, with the Russell 1000 Growth Index up 28.4% in 2017, compared to just a 10.9% gain for the Russell 1000 Value Index.
Value stocks generally include stocks within the financials, consumer staples, materials, and utilities sectors, along with some energy firms. On the other hand, growth stocks namely comprise technology shares, some segments within health care, and consumer discretionary stocks. Value stocks are generally assessed based on their price-to-book value, price-to-earnings, and sales-to-price ratios. Factors for growth stocks include sales growth, forward-earnings growth and momentum – essentially, strong stock market performance.
Despite their lackluster performance this year, it would seem that value stocks have a few things going for them. Outside of the screening process market participants may use to track value stocks (such as the ratios mentioned above), other factors play a role in how the shares of these companies perform. This includes how strong the economy is, as well as sales and earnings growth. To some extent, the interest rate environment and the shape of the yield curve are also factors in market sentiment for financial stocks.
“Accelerating economic growth has historically helped the value style, a condition that is in place today,” LPL Financial noted in research published June 11.
U.S. gross domestic product (GDP) growth was 2.2% in the first quarter, revised downward from an initial estimate of 2.3% by the Commerce Department. But second-quarter GDP growth is forecast to be well above 3.0%, with economists forecasting that the economy will grow by 3.6% based on the June 2018 Wall Street Journal Economic Survey. And, in mid-June, the Federal Reserve Open Market Committee upgraded its annual GDP forecast for 2018 to 2.8%, up from its forecast in March of 2.7%.
Despite the higher forecasts for GDP growth, “the growth style of investing has continued to lead the equity market higher,” LPL Financial’s research notes. And accelerated earnings, which have also “historically provided a tailwind for value, has not worked recently.”
After a strong first quarter, it’s a mixed picture on the earnings front, depending on the sector within the S&P 500. Big energy and materials firms are forecast to report strong earnings in the second quarter with those two sectors leading the earnings charge. But big-name consumer staples and industrial companies may report year-over-year declines in earnings-per-share. As of June 8, the aggregate earnings-per-share forecast for companies within the S&P 500 is 19.0% year-over-year, according to FactSet.
The forecasted earnings surge for the energy and materials sectors is due partly to higher oil prices, unusually low earnings in the prior-year period, or the result of a business combination between companies that were standalone entities in 2017. After those factors are considered, information technology (IT) is forecast to be among the earnings’ leaders for the S&P 500. The IT sector is expected to report second-quarter earnings growth of 23.3%, according to FactSet.
Why the Underperformance?
Technology has led the market this year, and that is one of the reasons that LPL Financial believes value stocks are underperforming. The S&P 500 Technology Index is up 13.9% this year compared to 3.8% for the broader S&P 500.
Value’s underperformance can also be pegged to higher interest rates, which have affected high-dividend paying stocks in the real estate, telecom and utilities sectors, according to LPL Financial.
The FOMC raised short-term interest rates for a second time this year on June 13, and penciled in the potential for two more rate hikes this year (four in total for 2018), up from only three it had projected as of March.
LPL Financial notes that while higher interest rates would typically lift shares of the financial sector, long-term interest rates in the form of the 10-year Treasury note haven’t moved by nearly as much as short-term interest rates have. That has led to a flattening of the yield curve. The result for financials is a shrinking gap between the cost of funds they borrow at and the return on those funds from the longer maturity loans they make to borrowers. It’s worth noting that the S&P 500 Financials Index is down by nearly 1.0% this year through June 13.
Consumer discretionary shares have been another market outperformer this year, taking away some allure from consumer staples. The strength of online retailers within the sector has driven the S&P 500 Consumer Discretionary Index higher by 13.4% this year through June 13, while the S&P 500 Consumer Staples Index has fallen by 10.9%.
LPL Financial notes that some of these dynamics could continue. In addition, the market backdrop could also remain favorable for consumer discretionary shares, but less favorable for value plays in the energy sector if oil prices decline. The Organization of the Petroleum Exporting Countries (OPEC) and Russia are expected to boost output in July.
While taking all of these factors into consideration, value may still be poised for a comeback after the long outperformance of growth stocks.
“Although it is difficult to predict the timing of a turnaround, we would not be surprised if value stocks get some days in the sun this summer, supported by accelerating economic growth, attractive relative valuations, and potentially better financials sector performance,” LPL Research concluded.
Russell 1000 Growth Index:
Russell 1000 Value Index:
S&P 500 Technology Index:
S&P 500 Financials Sector Index:
S&P 500 Consumer Staples Sector Index:
S&P 500 Consumer Discretionary Sector Index:
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