2020 was one of the most volatile years on record as measured by the daily average Cboe Volatility Index (VIX), encompassing both the Covid-19 induced bear market and the subsequent run of momentum-driven growth stocks. Momentum stocks, particularly those with exposure to secular trends accelerated by the pandemic, thrived as the dominant theme during 2020 from a factor perspective and indeed, the [1]Russell 1000 Dynamic Growth index was up 54.6%, beating the Russell 1000 Defensive Growth index by almost thirty percentage points.
Large growth stocks have outperformed large value stocks, with few exceptions, since the Global Financial Crisis. The growth bias in the market has been fueled by a subpar economic growth environment and low interest rates with little inflation. More recently however, the growth bias has been characterized more narrowly in stocks such as “FAANG+M” (an acronym for many of the most popular growth stocks: Facebook, Apple, Amazon, Netflix, Google and Microsoft), which have achieved an unprecedented concentration level in the Russell 1000 Growth index. This narrow market concentration has also disproportionately impacted valuation. In addition to high absolute price to earnings ratios, large growth relative to large value price to earnings ratios are at record levels this growth cycle.
The backdrop described above has resulted in many conversations with Clients about the possibility of a market rotation towards more economically sensitive value stocks. Certainly, the preconditions seem to be in place – namely the significant relative underperformance of value to growth, the attractive valuation profile of cyclical stocks relative to the high absolute valuations of secular growth stocks, and elevated sentiment and growth concentration in the large cap indices. The catalyst for such a rotation is assumed to be better economic growth as vaccines are rolled out at the same time as additional stimulus hits. Pent-up demand combined with improving consumer confidence and mobility and abnormally high savings could contribute to boom-like conditions, eventually pushing up inflation and longer-term interest rates (steeper yield curve).
The traditional play book would suggest a value rotation is in store that would favor early-cycle beneficiaries of rising interest rates and commodity prices such as banks, energy and industrial stocks, at the expense of the secular growth winners of the past several years. And it would not be surprising if some of the more fully-valued, over-owned secular growth winners that have done so well and now represent a significant percentage of the large cap indices become donators of funds to be reallocated to these more cyclical areas. This does not mean the secular growth winners will necessarily decline in value. In fact, considering how the pandemic has not only accelerated many of the secular growth tailwinds they enjoy, but also served to enhance their competitive moats, we would expect many of them to continue rising in step with earnings growth. Rather, it may simply mean a period of underperformance versus more unloved and undervalued cyclical stocks, resulting in a rationalization of position weightings within the concentrated large cap indices. Within the growth indices we would expect this dynamic to lead to a rotation from growth at any price towards growth at a reasonable price.
Our process has already been steering us in this direction within our Clients’ portfolios over the past six months. By exercising our discipline, we have been actively selling or trimming some of our more fully valued secular growth holdings and replacing them with more attractively priced cyclical growth stocks that have equal or better near-term earnings growth prospects. This is precisely the type of active management that should be rewarded in the period ahead with market valuations full, investor complacency high, and stock correlations likely to fall. And as noted earlier, we experienced a spike in volatility in 2020. Typically, such spikes have not been a one-year phenomenon – at least looking back over the past thirty years. If indeed we are entering a period of heightened volatility, that should accrue to the benefit of actively managed strategies over passive ones as active managers exploit the stock price fluctuations for alpha generation.
Our process, which covers four consecutive decades of outperforming the S&P 500, combines the best elements of growth and value – resulting in a strong core equity option that tends to sidestep speculative frenzies in either style environment. Investing in high quality growth stocks at reasonable prices has allowed our Clients to participate in growth markets with a margin of safety that reduces volatility in challenging environments – with risk and diversification controls that augment our downside protection. We anticipate a greater balance of both secular and cyclical growth opportunities that favor both quality and valuation – a market environment that should provide a nice tailwind for our Clients.