August 10, 2021:
Back in late January, we argued that US growth stocks had become a full-scale bubble.
Since then, some of the high-flying investments we wrote about have done quite poorly. Tesla and Gamestop both peaked within days of our article; they are down 21% and 56% respectively. An index of companies that have gone public via “SPAC” (a newly popular type of IPO that is faster, less regulated, and more expensive for investors) peaked a few weeks later and has now declined by 33%.(1)
But while there are pockets of weakness, the large scale bubble in US growth stocks remains intact.
In our March article, we explored the outcomes of past bubbles, and described how we are investing given the current opportunities and risks. We outlined three aspects of our approach:
- We are avoiding the bubbly areas of the stock market and focusing on areas that are still priced for good prospective returns. (Yes, they are out there!)
- We are leaving some room to add more stock exposure in case the bubble bursts and causes a widespread selloff among non-bubble markets.
- We are including alternative investments that will benefit from any convergence of growth stocks and value stocks, regardless of overall market direction.
Below, we will go into a little more detail on that third item.
The current opportunity in value vs. growth
“Growth stocks” are generally defined as the more expensive half of the market, with “value stocks” making up the other half. (We aren’t crazy about this terminology but we’ll save that for a footnote).(2)
The companies in the “growth” half of the market are more expensive because investors have higher expectations for their future earnings. They have correspondingly lower expectations for the “value” companies’ earnings. This makes perfect sense; some businesses have brighter prospects than others, and it’s only natural that investors would be willing to pay more for them.
It makes less sense for investors to pay dramatically more for growth stocks, to the extent that future earnings are unlikely to grow enough to justify the price. But that is exactly what’s happening right now.
This chart shows the ratio of how expensive value stocks are compared to growth stocks. When the line is high, value stocks are more expensive compared to growth stocks, and when it’s low, value stocks are relatively cheaper and growth stocks relatively more expensive.
The ratio has tended to stay within a range over the decades shown here, with a couple of extreme outliers. The first was during the tech stock bubble of the late 1990s, which saw growth stocks become extremely expensive compared to value stocks. The bursting of that bubble was followed by a scorching outperformance for value stocks over the following years, bringing the ratio back up to (and then above) normal.
The second outlier is right now. The recent plunging of the ratio means that growth stocks have become nearly as overvalued as they were at the peak of the 1990s tech bubble. As happened after that bubble, we think it’s very likely that the ratio will return to a more normal level.
The blip up at the end of that chart could possibly be a sign that this normalization has already started to happen, but we aren’t depending on that. This is not a market timing call, nor is it a prediction of where we are in the market “cycle.” Justifications like that are too speculative and unreliable. Our confidence lies in the premise, which is supported by market history, that what is severely out of whack will, at some point, return towards normal. We don’t know what the timing will be, but from these levels, we see a lot of potential upside for value relative to growth over the long-term.
Whether or not the return to normal is already underway, we don’t expect that ride to be a smooth or easy one. For reference, here’s a close-up of value’s path to its dramatic outperformance vs. growth after the bursting of the tech stock bubble:
Despite an 85.6% outperformance by value stocks over this period, value experienced some pretty major drawdowns relative to growth (some of the worst ever, in fact). At each temporary reversal of the trend, there were those arguing that the trend was over. Sticking with value-vs-growth trade took a lot of fortitude, but the eventual rewards were well worth it.
We are seeing something like this right now. After a nice run of outperformance for value, there has been a reversal over the last few months, and pundits have again started to argue that the value’s outperformance trend is over. But looking at the huge valuation disparity in the first chart, we think this is unlikely. Pullbacks like this are no fun to endure, but we think the eventual rewards for doing so will be substantial.
Investing in value-vs-growth
We’re investing in the value-vs-growth theme in two ways. A big one is that our stock exposure is heavily concentrated in value stocks, with relatively little in growth stocks.
Additionally, in almost all accounts we have alternative investments with exposure to the “convergence” of value and growth. These investments will do well if value does better than growth, regardless of the direction of the overall market. So even if the market is declining, as long as value stocks are declining less than growth stocks, the convergence strategy will be profitable. The same goes for value doing better than growth in a rising market.
Of course, this investment suffers if growth stocks outperform, as in the last few months. But while that could continue for a while, we think the eventual outcome is very likely to be a significant outperformance by value stocks, to the benefit of our convergence strategy. This part of our portfolios gives us access to value stocks’ likely long-term outperformance, but without taking overall stock market risk.
As we did in January, we still feel that the evidence points strongly towards the existence of a growth stock bubble that will, as bubbles must, eventually burst.
But we don’t know what that will look like: when it will begin, how long it will last, or how much it will impact the broader economy and the non-bubbly areas of the markets. This is why we are taking a multifaceted approach which includes the value-growth convergence strategy, a strong tilt towards the better-priced areas of the global markets, and leaving some room to add stock exposure should valuations improve. We think this strikes a good balance between positioning for the opportunities that are available today, and those that we think might be coming down the road.
1 – Source: stockcharts.com (TSLA, GME, and SPAK as of 8/6/2021)
2 – The philosophy and approach we use is called “value investing,” which means that we look at all areas of various markets and seek out those investments that are inexpensive (or at least reasonably priced) compared to their own historically normal levels.
Because “value investing” shares a word with “value stocks,” people often conflate the two, but they really have nothing to do with each other. A value investor might prefer value stocks, as is the case today – but at other times, value investors might recognize that growth stocks are the better deal. (This was the case, for example, before the Financial Crisis in 2006-7). It all comes down to how expensive growth and value stocks are at any given time, compared to their own histories and to each other.
Aside from the confusion it causes, the term “value stocks” is just misleading. Value stocks may be a good value at times, but at other times they are overpriced, which is the opposite of being a good value. It would be better if they were called “low-growth stocks” or something like that. But, the world calls them “value stocks,” so we have to go along with it.