Stuyvesant Insight: Value to Outperform Growth

Below is a screenshot of the performance of the S&P 500 value index relative to the S&P 500 growth index:

There has been a dramatic underperformance of value year-to-date (-9.83% through May).  However, the RSI (measure of relative strength) and the MACD (measure of momentum) have perked up from deeply oversold levels and are trending higher.  Moreover, the value index began an outperformance phase in early June.  We expect this phase to continue.

Growth stocks' earnings increase at a stable rate.  As a result, investors will assign more certainty to earnings forecasts and will discount them further into the future when computing their present value.  This causes growth stocks to have a longer duration, a measure of risk used in computing certainty of cash flows.  An increase in bond yields results in an increase to the discount rate applied to the company's future cash flows, which has a disproportionately negative impact on the net present value of growth stocks.  Investors are less willing to pay up for growth stocks if their earnings aren't positively impacted by improving global growth and their valuations are more susceptible to rising interest rates.

The earnings ofvalue stocks are cyclical.  Their earnings accelerate during periods of strong global growth and decelerate during periods of weak growth.  As a result, investors discount their earnings over a couple of years, resulting in shorter duration securities.  Therefore, a period of rising yields, due to accelerating growth, tend to disproportionately favor both the earnings and valuation of value stocks relative to that of growth stocks.

These observations have supported the relative outperformance of growth to value this year.  Firstly, weakened 1Q17 domestic growth negatively impacted projected earnings of value stocks relative to growth stocks.  Secondly, the yield of the 10-year Treasury peaked in February at 2.60% and has since trended lower in a parallel fashion with the value-to-growth ratio:

Stuyvesant's June 3Q17 Investment Outlook highlighted that the path of least resistance for bond yields is up.  A powerful rally in yields has since ensued, catalyzed by hawkish international central bankers and strong global economic data.  We expect this trend will continue,  favoring the continued relative outperformance of value stocks.