Commentary January 14, 2022 at 07:44 AM Share & Print
What You Need to Know
- Research Affiliates and Vanguard strategists think so, due to rising inflation and interest rates.
- But rising inflation hasn’t yet pushed bond yields above key levels.
- The overvaluation of growth stocks is another key factor.
It’s too early to tell if value stocks will outperform growth stocks this year, but if interest rates continue to rise along with rising inflation they very well could, according to Chris Brightman, CEO and chief investment officer of Research Affiliates, a financial strategies research firm specializing in asset allocation and smart beta.
“It will be one catalyst or another that creates the mean reversion from today’s absurdly stretched valuations between value and growth stocks,” “Inflation causes rising interest rates and rising interest rates could be the catalyst for the correction in the stock market.”
The stock market action of the new year suggests that is starting to be the case, he said. “We’re barely into January 2022 and the relative performance in the first week or so shows that high-flying growth companies with high multiples are underperforming.”
Indeed, the Russell 1000 Value Index of large-cap value stocks gained 1.12% year-to-date through Thursday, compared with a 5.90% decline in the Russell 1000 Growth Index. The Russell 2000 Value Index of small-cap stocks lost 0.27%, compared with a 7.5% drop for the Russell 2000 Growth Index.
In 2021, however, only small-cap value stocks, not large-cap value securities, outperformed their growth counterparts. Large-cap value stocks underperformed because they excluded the high-flying FAANG — Facebook (now Meta) Amazon, Apple, Netflix, and Alphabet (formerly Google), Brightman said.
Inflation indicators have been showing substantial increases. On Wednesday, the U.S. government reported that its consumer price index rose 7% last year, its biggest jump since 1982. On Thursday it reported that producer prices climbed almost 10% (9.7%) in 2021, the steepest rise since 2010.
Interest rates, in turn, are climbing to their highest levels in two years, but the 10-year Treasury yield is still under 2% and the two-year Treasury yield is under 0.95% — currently near 1.75% and 0.95% respectively. On an inflation-adjusted basis, those yields are still negative.
As they climb further, high-flying growth stocks — also known as long-duration stocks, which are expected to to deliver a higher proportion of their cash flows in the distant future — will underperform value stocks, Brightman said.
“Value stocks aren’t priced nearly as much based on future growth prospects,” he said.
Value vs. Growth Stock Forecasts
Research Affiliates is forecasting an estimated annualized compound nominal return of 8% for the Russell 1000 Value Index and negative 4% for the Russell 1000 Growth Index over the coming decade.
Its annualized 10-year forecast for the EAFE Value Index, which excludes the U.S. but includes Europe, Australasia, and the Middle East, is 10%, more than twice its forecast for the EAFE Growth Index, and for Emerging market value stocks 13% versus 5% for emerging market growth stocks. The expected real returns, adjusted for inflation, are 2.6% lower for each.
Vanguard, too, favors value stocks over growth stocks. “We expect value stocks to outperform by as much as the historical equity risk premium over the next decade, mostly because of a decay in the overvaluation of growth stocks,” according to its 2022 market outlook.
“Value stocks remain 30% undervalued over growth,” said Kevin DiCiurcio, senior investment strategist at Vanguard, in a recent webinar. He expects value stocks will outperform growth stocks over the next decade because of long-term inflation and rising real rates, cumulative corporate profit growth rates and equity market volatility.
Vanguard is forecasting 10-year median annual returns of 4.1% for U.S. value stocks versus 0.1% for U.S. growth stocks and 6.2% for non-U.S. stocks.