Growth is outperforming value due to interest rate expectations

Growth and Value Stocks

According to analysts, growth stocks have the ability to outperform the broader markets or a particular subsegment for a certain period. These types of stocks can be found across different market caps such as small, mid, and large.

Growth companies are deemed to have a high probability of experiencing significant expansion in the upcoming years. This could be due to their promising products or product lines expected to generate substantial sales, or they may have better management and operational practices than their competitors, which could potentially give them a competitive advantage in their market. Typically, growth companies retain earnings and reinvest them back into the company.

Value stocks are generally larger and well-established companies whose stock is trading below its perceived worth, based on certain financial benchmarks or ratios used by analysts. Value stocks typically trade at a discount to various ratios such as price-to-earnings, book value, or cash flow ratios. For instance, a company may be trading at a discount to its book value and may be regarded by many analysts as a promising value play. Value stocks generally tend to pay dividends.

Stocks may be undervalued for various reasons, such as negative public sentiment that may drive the stock price down due to personal scandals of key figures or unethical behaviour by the company. However, if the company's financials remain strong, value-seekers may consider this an ideal entry point, assuming that the negative sentiment is temporary, and the stock price will eventually recover.

The Time Value of Money

As growth companies are inclined to retain and reinvest their earnings back into the company, their expected dividend stream is pushed back into the future. This means that growth companies are more sensitive to interest rate movement than value companies due to inherent time value of money characteristics i.e., a dollar today is worth more than a dollar in the future. The opportunity cost increases as interest rates rise and decreases and rates decline.

Growth vs Value Indexes

Source: www.tradingview.com

The top chart shows the relative strength between the iShares Russell 1000 Growth ETF (IWF) and the iShares Russell 1000 Value ETF (IWD). The candlestick chart beneath is the relative strength chart between the NAS100 and US30.

Both charts have charted a higher trough followed by a higher peak and are in uptrend. I.e., the IWF is outperforming the IWD and the NAS100 is outperforming the US30.

Interestingly, the correlation coefficient (bottom indicator) between both relative strength charts is an astounding 98%. I.e., the NAS100 can be categorised as a growth index and the US30 is a proxy for a value index.

NAS100's Outperformance Coincides with Lower Yields

Source: wwww.tradingview.com

The Failure of Silicon Valley Bank and Signature Bank in March led to a noteworthy decline in the US 2-year yield (red down arrow). At the same time the relative strength of the growth-based NAS100 noticeably increased against the value-based US30 (up red arrow).

The minutes of the Fed's March meeting included a presentation from staff members with a projection for a mild recession starting later this year and a recovery coming in 2024 and 2025. As such, the US 2-year yield has remained much more subdued at 3.94% than its early March high of 5.08%.
Given the time value characteristics of growth, this has aided the uptrend in NAS100's relative strength over US30.

Moreover, yesterday's headline CPI release showed April's rate of inflation at 4.9% y/y, falling below 5% y/y for the first time in two years. Progress is being made on the inflation side, prompting the CME FedWatch Tool to give a probability of more than 90% that the Fed will pause in June. It also suggests a 25bps cut in September. If true, and subject to correction, the growth side of the market will likely continue to outperform the value side.

Summary

• The iShares Russell 1000 Growth ETF is outperforming the iShares Russell 1000 Value ETF.
• The NAS100 mirrors this outperformance over the US30.
• The outperformance coincides with notable US 2- year yield decreases in March.
• The US 2-year remains subdued.
• This is supportive of growth over value, given growth's time value of money characteristics.
• The Fed's March minutes suggest a small recession towards the end of 2024.
• Inflation has declined below 5% y/y for the first time in 2-years, helping to moderate yields.
• Any cuts in interest rates will tend to continue to support growth's outperformance over value.