NEW YORK (Reuters) - One undeniable fact has underpinned the latest leg of the long-running U.S. bull market: Paying up for growth stocks at any price paid off, hugely.
Paying a premium for shares of fast-growing companies like Amazon Inc (AMZN.O) and Google parent Alphabet Inc (GOOGL.O) over those viewed as good value for the money has been a recipe for success for more than five years. Growth stocks have beaten their value rivals by a margin of more than two-for-one in that span.
In the last month, the wheels have fallen off that profit vehicle. The Russell 1000 Growth Index .RLG, which features stocks that trade at high prices relative to their earnings, has sunk more than 10 percent so far in October, its poorest performance since the financial crisis. In that same period, the Russell 1000 Value Index .RLV is down just 7 percent.
That shift was cast into sharp relief last week after major revenue shortfalls reported by both Amazon and Alphabet triggered the largest drops in their stock prices in years. Nasdaq .IXIC, stacked with growth names from the tech sector in particular, is in a full-fledged correction - the term for a fall of at least 10 percent from the most recent peak.
Heading into the month, the gap in performance between the Russell’s growth and value indexes hit the widest level in at least 40 years. Previous instances of such a widening led to a comeback in value stocks, which include names such as JPMorgan Chase (JPM.N), Exxon Mobil (XOM.N) and Johnson & Johnson (JNJ.N), and has fueled rotation speculation.
“When the rotation started to go back the other way, sort of reversion to the mean, value went on to outperform growth for several years. It was a longstanding reversion-to-the-mean kind of a trade,” said Phil Orlando, chief equity market strategist at Federated Investors, in New York.
The S&P 500 .SPX is now down about 9 percent from its Sept. 20 high, with some of the year’s best-performing and heavily weighted sectors, such as technology .SPLRCT and consumer discretionary .SPLRCD, contributing to the decline.
Both of those sectors have fallen for three straight weeks and include growth stocks such as Amazon, and Alphabet, leading some market participants to believe a full-blown rotation into value stocks is under way.
Technology accounts for a weighting of nearly 35 percent in the Russell 1000 growth index, followed by an 18.8 percent weighting in consumer discretionary, according to FTSERussell data.
Even with the recent downturn, growth stocks remain expensive on a forward price-to-earnings ratio basis, making the argument for value stocks more persuasive given investor concerns that have fueled the sell-off.
Steve DeSanctis, equity strategist at Jefferies in New York, said there are sound reasons to own value stocks now.
“We are starting to see earnings accelerate faster for value than for growth, and if GDP is going to be north of 3 percent, we should see a pretty good earnings backdrop,” DeSanctis said.
Third-quarter gross domestic product reported on Friday came in at a 3.5 percent annualized growth rate.
Still, questions remain over whether the shift to value will be a full rotation as the bull market enters its late-cycle stages, or merely a temporary defensive play during a selloff, similar to what happened earlier this year when the S&P 500 tumbled into correction territory in February.
One thing distinguishing the current environment from earlier this year is that the Federal Reserve seems more determined than previously to keep pressing interest rates higher, said Julian Emanuel, chief equity and derivatives strategist at BTIG, in New York. That has resulted in higher yields on U.S. Treasury securities.
“Investor psychology has shifted to the idea that long-term yields are rising. When that happens it’s an implicit negative for high-multiple stocks, which tend to reside in the growth category,” Emanuel said.
Along with the Fed’s raising rates, investor concerns have included a slowing China and a stronger dollar, which in turn hurts emerging markets and corporate earnings for large multinational companies.
“The Fed is saying we are moving ahead, steady rate hikes. That in the face of the weak global issues is what has people spooked and what has value outperforming,” said Alec Young, managing director of global markets research at FTSE Russell in New York.
Still, investors may be missing out on gains by moving too heavily into value now, should the pendulum swing back before the cycle starts to end.
Not all market participants are convinced the end is near for growth stocks.
“If you think value’s going to outperform, you’re thinking more at the end of the cycle,” said Scott Wren, senior global equity strategist at Wells Fargo Investment Institute in St. Louis, Missouri. “As far as consistent meaningful outperformance by value, that’s not going to happen until we’re halfway through the next recession.”
Reporting by Chuck Mikolajczak and Sinéad Carew; Editing by Leslie Adler