Stock-market volatility appears to have returned with a vengeance over the past several days. Though you wouldn’t know it from looking at the daily closing levels for the major market indices, there have been some wild swings in certain sectors. In particular, the technology-heavy Nasdaq fell 8.3% from an intraday high of 14,175 on February 16th to an intraday low of 13,004 during this week’s Tuesday session. The abrupt weakness in the Nasdaq, and technology stocks more specifically, still looks like just a blip if you look at a longer-term chart. And it appears as though a rebound is afoot today. But it was looking a little dicey on Wednesday. Something spooked investors who have ridden on this gravy train for many years now.
As noted, the Nasdaq is weighted very heavily toward technology stocks. Another index with a heavy weighting in technology (about 45%) is the Russell 1000 Growth index, which we will refer to as “RLG” to reflect the iShares ETF that tracks the index. As you’ve probably heard, growth investing has been outperforming value investing for many years now. Over the past ten years, an investment in the RLG has produced a total return, including dividends, of 378% compared to just 183% for the Russell 1000 Value (RLV). But there have been numerous times when that trend looked like it might reverse. We are in one of those periods right now. In the chart below, you can see that the RLV has outperformed the RLG by over 6% for the year-to-date period (excluding dividends). In fact, as of the time of this writing, the RLG has given back the lion’s share of its previous gains for the year while the RLV is still up over 8%.
So is this just another head fake? I’m thinking maybe not this time. The biggest factor causing the rotation from Growth to Value is the sharp increase in interest rates. While short-term rates are largely controlled by Fed policy, it is harder for the central bank to directly control longer-term interest rates (even though the Fed continues to buy $120 billion in bonds each month). The yield on the 10-year Treasury bond has risen sharply from a low of about 0.50% last year and 0.92% at the beginning of 2021 to about 1.39% today. This move in interest rates has increased the attractiveness of value stocks relative to growth stocks for a number of reasons:
- Left-for-dead companies that struggled mightily during the downturn suddenly appear poised to thrive in an environment with GDP growth of 6% or more (as some economists are now predicting for this year); investors seeking the most bang for their investment buck may therefore flock to these kinds of companies as the economy improves;
- Technology, Consumer Discretionary and Communication companies are vastly overrepresented in the RLG. As with any investment, these stocks can be valued by determining the present value of their future cash flows. As interest rates increase, the value of cash flows to be received many years in the future decreases. Another way to say this is that the opportunity cost of owning expensive stocks increases when interest rates on bonds and other fixed-income securities rise;
- The increase in long-term interest rates, even as short-term rates stay low, has resulted in a “steepening of the yield curve”; banks and other financial companies, which are far overrepresented in the RLV, are able to earn higher net interest income when the yield curve steepens, and especially as deposit costs remain at close to zero;
- Higher commodity prices should help energy and materials (commodities) companies, which are overrepresented in the RLV;
- Industrial companies, which have a higher relative weighting in the RLV as well, stand to benefit from an acceleration in global economic activity.
The days of simply piling into the market leaders regardless of valuation may be drawing to a close. Investors must now recognize that there are alternative opportunities out there, including both heretofore underperforming stocks as well as incrementally more attractive bonds. A powerful economic rebound combined with rising interest rates and higher inflation, if that indeed transpires, will change the investment backdrop in a meaningful way. If you’re a trader, you must adapt to the new reality. If you’re a long-term investor like us, it feels like a good time to own high-quality companies with great balance sheets and reasonable valuations.