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Value Stocks Shine as Growth Proxies Sag; Tug of War Between IWD & IWF Gets Hot

Value Stocks Shine as Growth Proxies Sag; Tug of War Between IWD & IWF Gets Hot

Diego Colman, Market Analyst

VALUE AND GROWTH STOCKS:

  • Value stocks have outpaced their growth counterparts in recent weeks, with the IWD ETF up 3.13% and the IWF ETF down 5.1% since the December FOMC meeting
  • Expensive names in the growth universe will struggle in the near term as the Fed transitions to tighter monetary policy and yields reprice higher amid soaring inflation
  • To capture upside potential in the value space, traders could bet on ETFs with this investment factor such as IWD or VTV

Most read: ARKK in Peril as the Fed Pivots to a Higher Interest Rates Regime

Value stocks have significantly outperformed their growth counterparts following the December FOMC meeting after policymakers pivoted towards a more aggressive monetary policy stance amid a heightened sense of urgency to quell inflation. Since the conclave, IWD (iShares Russell 1000 Value) has gained 3.13% and VTV (Vanguard Value) has rallied 3.19%. In contrast, IWF (iShares Russell 1000 Growth) has plunged 5.1% and VUG (Vanguard Growth) has sunk 5.6% (see chart below). This style rotation begs the question: will the trend underway continue or will it reverse? To understand the macroeconomic shift at play driving the market, it is important to provide context.

VALUE VS GROWTH ETFS

Value Stocks Shine as Growth Proxies Sag; Tug of War Between IWD & IWF Gets Hot

Source: TradingView

MONETARY POLICY

In recent weeks, expectations that the Federal Reserve will pull back support forcefully and raise borrowing costs multiple times in 2022 (at least three hikes) to curb mounting price pressures have bolstered U.S. treasury yields across the curve, fueling volatility and creating a hostile environment for growth stocks that rely heavily on low rates to justify their expensive multiples.

GROWTH STOCKS

Growth companies are frequently unprofitable and have speculative outlooks, but investors are willing to pay a premium to own them because they have an innovative business/product and have the potential to deliver better-than-average returns over the long run (long-duration cash flows). In a sense, these players concentrate on building up their future revenues at the cost of delaying profitability. However, when the cost of money rises, their future cash flows are worth less today when discounting them at a higher rate, compressing their valuations. Regularly, the U.S. 10-year yield is used in NPV models to price equities and this rate has soared from roughly 1.45% to almost 1.8% in the last 30 days, an atypical move larger than 2 standard deviations above the mean over a one-month period.

US 10-YEAR YIELD CHART

Value Stocks Shine as Growth Proxies Sag; Tug of War Between IWD & IWF Gets Hot

US Government Bonds 10-year yield chart prepared using TradingView

VALUE STOCKS

Value stocks sit on the opposite spectrum. These are mature companies that often pay dividends to lure investors. Their shares appear priced attractively relative to some measures of intrinsic worth (earnings, sales, book value of assets, etc.) and often trade at a discount with respect to the market when fundamentals are taken into account.

Value stocks have historically outperformed highflyers when monetary policy becomes less accommodative, and the 10-year yield begins to trend higher in response to elevated consumer prices and strong output. Companies in this category have a cyclical tilt (energy & financials, for example), so it makes perfect sense that healthy economic growth bodes well for their earnings. While GDP is seen decelerating in 2022, it is still expected to expand robustly, rising at an annualized pace of 4%, nearly twice above trend.

Related:Bond Market - What is the Shape of the Yield Curve Signaling for Cyclical Stocks?

INFLATION IMPACT ON VALUE & GROWTH STOCKS

Value companies have well-established businesses with consistent earnings, and, more importantly, pricing power, a quality that allows them to maintain or expand profit margins to some extent during inflationary periods. Growth companies, on the other hand, find it difficult to improve their margins significantly when consumer prices rise because they have few sales and do not make money anyway. Headline CPI accelerated in December to a four-decade high of 7% year-on-year, so it has become a problem for many firms.

VALUE VS GROWTH STOCKS KEY DIFFERENCES

Value Stocks Shine as Growth Proxies Sag; Tug of War Between IWD & IWF Gets Hot

Most read: Everything You Need to Know About Types of Stocks

OUTLOOK FOR VALUE & GROWTH STOCKS

U.S. Treasury yields are likely to reprice higher over the course of the next few months as the U.S. central bank prepares to raise interest rates and introduces quantitative tightening into the policy mix to achieve one part of its mandate: price stability. Expectations are mixed, but the 10-year yield could reach 2.25% by mid-year as a result of the pullback in support. The withdrawal of monetary stimulus will be a headwind for the longest-duration pockets of the market, leading to large reductions in equity length and accelerating the rotation into value in the short term. Another relevant observation: Fed's normalization cycles have been accompanied by increased volatility across asset classes.

Typically, value stocks hold up better when turbulence hits the market, and everything sells off. Conversely, when volatility increases, growth stocks are prone to large price swings, a risk that many investors often try to avoid.

A final point to keep in mind is economic growth. Although first-quarter GDP will be very anemic as a result of the omicron wave, activity should pick up appreciably as we turn the corner on the health crisis. Cases of COVID-19 driven by the omicron variant will peak in late January, according to some scientific models, and begin to decline precipitously shortly thereafter, following the same pattern seen in other countries such as South Africa and the United Kingdom. By the time this outbreak begins to subside, much of the U.S. will have been infected with the milder, but more transmissible strain. After spreading like wildfire, omicron may give natural immunity to a large part of the population, crowding out deadlier variants and bringing us closer to the end of the pandemic and the transition to an "endemic state."

Throughout the pandemic, value has outperformed growth when COVID-19 cases have been in decline. If markets follow the same playbook, value stocks could rule the roost and become a clear driver of alpha in the early stages of the year once confidence levels rebound, mobility rises, and the economic outlook improves on the return of regular order.

To capture upside potential in the value space, traders could focus on VTV (Vanguard Value Index Fund) or IWD (iShares Russell 1000 Value),two of the most popular and liquid ETFs that track this investment factor. A different, but also attractive, strategy could be to bet against growth proxies. To achieve this without getting into stock picking, traders could consider taking bearish positions in long-duration funds such as IWF (iShares Russell 1000 Growth), VUG (Vanguard Growth), or even ARKK (Ark Innovation).

In conclusion, while there may be reversals along the way after the theme gets overplayed from time to time, value remains in a better position to command strength over the next few months and at least through mid-year. The bullish thesis, however, rests on the assumption that the economy expands at a healthy clip and that the Fed stays on a tightening path to slow inflation but does not derail the recovery with aggressive measures.

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