I wanted to write this article weeks ago but was too busy. However, as we have seen time and fortunes have moved on and as such this is very prescient.
I have been talking about recency bias and the over valuation of technology stocks a lot this year.
We have had the longest period of outperformance for growth stocks as far as I remember, almost 10 years to be precise. Yet history has shown us that Value not Growth gives the better returns over a longer time.
What has happened in the last 10 years?
Declining interest rates favour growth stocks due to an expansion of the fair price/earnings ratio (PE) however rising interest rates tend to favour value stocks.
Why is this?
Growth stocks tend to be priced to perfection and at some time they stop growing as fast as in the past. Now we have the simple calculation for P/E which is the earnings divided into the price to give you a P/E ratio. This is then used to compare the P/E ratio vs its peers. As growth stocks have higher growth than value stocks, this PE ratio is higher. What we need to know is if the current P/E ratio justified?
While the P/E ratio is a very simplistic method for investing what we really need to know is the sustainable growth rate of the company/industry and the required rate of return to justify that P/E ratio.
This is the key point which I hope will help people understand the risk in owning growth stocks at this moment.
A metric to calculate the required rate of return is the expected return above the risk-free rate (rate of return on a government bond). It then becomes obvious that if interest rates rise then the expected fair P/E ratio is lower. If growth slows from 25% p.a. to 20% p.a. then the fair P/E ratio is even lower. This is a double whammy; rising interest rates and slower growth demands a much lower fair P/E ratio.
Value, on the other hand, is buying a stock/market/sector at or below its fair market value. Eventually, the market will reflect this with higher prices as such that is why historically value has always outperformed growth.
We are now seeing huge volatility in the markets and I suspect we are now seeing a major shift from growth stocks towards value. This trend is likely to continue for many years.
Human psychology sadly hates selling losers, hates changing its mind, and loves to follow the past expecting this to carry on into the future. Another major issue is that an advisor would have enormous difficulties telling a client that they should be investing into an underperforming asset from the past, while the press is extolling the growth stories of all those tech companies.
If you want to relax, just diversify your portfolios, as one sector goes up and up into over valuation, you will continue to take bits of profit away and add it to an underperforming sector. The underperforming sector will eventually become a leading performing sector. This way you will have a more consistent performance, less volatility, less stress and still reach your goals.