As you know, lots of things move in cycles. There are business cycles … seasonal cycles … weather cycles … cycles in nature (the ebb and flow of animal populations) and so on.

There is also a long-term cycle in the relationship between value stocks and growth stocks.

Sometimes, for years at a time, value stocks outperform growth stocks. In other market periods, the opposite happens: Growth stocks will outperform value stocks, sometimes dramatically — and sometimes for years on end.

You can see this in the chart below, which represents the performance relationship of value stocks versus growth stocks. It shows a spread between the Russell 1000 Value ETF (symbol IWD) and the Russell 1000 Growth ETF (symbol IWF).


The Russell Value ETF is heavy on blue-chip value names like Johnson & Johnson, Berkshire Hathaway, and Exxon Mobil. The Russell Growth ETF is oriented to fast-paced growth stocks with high multiples.

The blue arrow shows the multi-year period when value stocks strongly outperformed growth stocks (roughly between 2001 and 2007). The red arrow shows the decade-long period where growth stocks outperformed and value lagged behind. The brown exclamation point marks the beginning of 2017, when value fell off a cliff (in relative performance terms) compared to growth.

Why do these cycles occur? It comes down to factors like market psychology (fear vs. greed), economic growth, and the availability of cheap money (low-cost financing).

In the period between 2001 and 2007 when value stocks sharply outperformed, the dotcom bubble had just burst. The United States experienced a euphoria blow-off top, followed by an explosion of scandals (Worldcom, Enron, Tyco) — and right after that, the 9/11 attack on the World Trade Center.

All of this fear and uncertainty (which came right after the dotcom bubble) led investors to crave the shelter of value stocks. Safe blue chips — big, strong names with fortress balance sheets — were like an investor’s security blanket. At the same time, growth investors had a dotcom hangover.

And so, value stocks went into a period of outperformance that lasted for years.

Eventually, though, the tide began to turn (as it always does).

After the U.S. housing bubble burst and the 2008 global financial crisis, growth stocks were so beaten up that it was hard for them to get any cheaper … and central banks flooded the markets with stimulus to stabilize markets, which was great for small caps and companies that could grow quickly.

This led to a long, extended period where growth stocks picked up the baton and started to outperform relative to more conservative value stocks.

At the beginning of 2017 — note the exclamation point on the chart — value stocks started to dramatically underperform growth stocks. You can see it the way the line falls sharply on the chart.

We know why this happened too: because of political expectations.

In November 2016, when Republicans won control of the U.S. government by the strongest margin since the 1920s, markets immediately anticipated the stimulus of deregulation and tax cuts.

And deregulation and tax cuts are what the markets got … leading growth stocks to have runaway outperformance in 2017 and 2018, as value stocks got left in the dust.

So, what does this mean for you as an investor? To answer that, remember that markets move in cycles.

There was a period where value stocks outperformed growth stocks for many years. The cycle then reversed. And it will reverse once again …

Studies show that markets follow a principle known as “reversion to the mean.” This means that, when prices and valuations get too far away from their long-term averages, they tend to come back.

Reversion to the mean is another factor that favors value stocks over growth stocks today.

Money managers are expressing worry and concern over the valuations of growth stocks. Some have pointed out that growth stocks are more overvalued now — relative to their historical averages — than at any point since the year 2000.

That means growth stocks are a like a rubber band stretched to the upside. The rubber band is in danger of snapping back. At the same time, unloved value names are primed to make a comeback.

If the cycle turns and value stocks start outperforming growth stocks once again, and the new cycle lasts for years (as the old cycles did), that could have a significant impact on investor portfolios.

There are moves you can make to take advantage when the shift happens — like changing the weighting of your portfolio toward more exposure to value stocks relative to growth.

When the transition fully occurs (from growth back to value), there are also possibilities to improve performance with ETF rebalancing strategies, like weighting a portfolio more toward IWD than IWF.

Then too, in our Ideas by TradeSmith service, we should be able to detect when this transition from growth back to value is really taking hold … and find ways for you to profit from it.

The value-versus-growth story is a quiet one relative to all the noisy headlines, but it’s one of the most important “big picture” transition shifts investors should watch for today.

As always, we’ll keep a close eye on what’s happening and what our indicators tell us. When something shifts, you’ll be the first to know.

Stay tuned,

Richard_Signature

Richard Smith, PhD
CEO & Founder, TradeSmith