OCEAN CITY — U.S. equities have exhibited a wide divergence across style and size this year, and the dispersion in performance is likely to persist.
In this low-growth macroeconomic environment, we expect growth stocks to continue to outperform value stocks. However, investors should avoid pockets of the market where valuations have been bid up to unsustainable levels. On the other hand, they should be wary of value traps, as areas such as Energy will likely remain under pressure due to a lack of profit and sales growth in the near future.
This year, growth stocks have outperformed value stocks by roughly 7% in the large cap space, and 10% in the small cap space. This can be largely attributed to the Technology, Health Care and Consumer Discretionary sectors, which are much more prominent in the growth indexes, and have vastly outperformed the overall market. For example, the proportion of technology stocks in the Russell 1000 Growth Index is nearly 20% higher than that in the Russell 1000 Value Index. Companies in each sector have one major thing in common — they are benefiting from both cyclical and structural growth trends.
Whether it is the accelerating pace of innovation and the proliferation of connected devices, increasing longevity or U.S. consumers’ improving wealth, these sectors have benefited from these trends and should continue to going forward.
Despite its outperformance, growth appears more attractively valued on most fundamental measures. Although it has typically traded at a premium to value, that gap is below historical averages for most multiples. For example, the price-to- sales ratio of the Russell 1000 Growth Index is usually double that of the Russell 1000 Value Index, but is now only 50% higher.
In this yield-scarce environment, investors should also appreciate that the relative dividend yield for growth stocks is 0.6, above its historical average of just under 0.5. Additionally, growth tends to outperform value when profit growth decelerates, according to BofAML Global Research strategist Savita Subramanian. Her forecast for negative earnings growth in 2015 coupled with relatively attractive valuations bodes well for growth stocks.
Although equity valuations are important, in our opinion, investors should not look at price multiples in isolation. Even with cheap valuations, companies with no top- or bottom-line growth may continue to struggle. For example, the Energy sector screens as one of the cheapest on a price-to-earnings, price-to-book and price-to-cash flow basis; however, it is the only sector expected to have negative earnings growth this year, at -54% according to FactSet. This sector is weighted more heavily in the value indexes — less than 1% of the Russell 1000 Growth Index yet more than 14% of the Russell 1000 Value Index.
As the Federal Reserve gears up to begin raising interest rates, we see the spigot of cheap financing and abundant liquidity being slowly turned off. With volatility expected to rise as a result, small caps will likely underperform. We prefer high quality
companies in both segments, as investors will likely shift their preference to strong balance sheets and stable earnings and dividends as market volatility picks up.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)