Growth stocks: A comeback or a dead-cat bounce?

Technology and growth stocks ranked among the big losers in the first half of 2022, but during the sultry weeks of summer, they clawed back part of their underperformance. Does this signify a genuine comeback, or are tech and growth stocks just coming up for air to take the next plunge? Although the medium-term outlook is constructive, the long-term potential of the growth investment style depends on what interest-rate regime will prevail in the future.

Catching a breath

Growth-stock devotees have been granted a respite in recent weeks. Instead of summer doldrums, technology stocks (which make up a large part of the growth-stock segment) have staged a vibrant summer rally. The Nasdaq 100 index has gained around 20% since mid-June. Meanwhile, an updraft has been wafting even in the most speculative nooks and crannies of the equity market such as biotech stocks and even meme stocks like GameStop and AMC. Altogether, technology and growth stocks have clawed back around half of their year-to-date underperformance relative to the broad market. However, their prior share-price declines had made a correction overdue. At their nadir, more than half of all stocks in the Nasdaq index were trading 50% below their all-time highs. Unprofitable (“disruptive”) growth companies had already been in a bear market since March 2021 and had registered peak-to-trough share price drawdowns ranging from 70% to 90%.

A genuine revival… | …or a dead-cat bounce?

Technology stocks relative to the broad market

Sources: Bloomberg, Kaiser Partner Privatbank

Interest-rate peak = growth bottom?

But the sudden comeback by growth stocks isn’t attributable to technical market factors alone. Moreover, we currently find ourselves in a regime in which different equity investment styles – i.e. styles focused on value stocks or growth stocks, for example – react very sensitively to changes in interest rates. This sensitivity is deducible from the high positive or negative correlation of the excess return (alpha) on specific baskets of stocks such as dividend aristocrats or the constituents of the Nasdaq 100 with (5-year) US interest rates. Hence, the main driver of the purported growth revival and the recent underperformance of the value investment style is the sharp pullback in the market interest-rate level at the long end of the yield curve. The yield on 10-year US Treasury notes plummeted from 3.5% in mid-June to intermittently as low as 2.6% in early August.

A market driven by interest rates | High correlation between equity alpha and bond yields

Correlation between equity alpha and 5-year US Treasury yield

Sources: Bloomberg, Kaiser Partner Privatbank

There are good reasons for the recent yield decline. One in particular is that inflation appears to have already reached its peak (USA) or is close to doing so (Europe) while the economic activity outlook is dimming and the threat of a recession is mounting. Elevated geopolitical risks round out the mix and increase the need for security (the kind provided by government bonds). Given this set of circumstances, it appears that long-term market interest rates likely have also already peaked in the current cycle. If that’s the case and if yields tend to stay rangebound around their current level in the near future, the growth vs. value performance relationship looks set to resume stabilizing because as recent months have shown, it’s mainly the change in the interest-rate level – not the absolute interest-rate level – that is driving the growth/value ratio (at the moment).

Falling yields… | …create a tailwind for growth stocks

Value vs. growth and 10-year US Treasury yield

Sources: Bloomberg, Kaiser Partner Privatbank

Constructive medium term, long-term question marks

The (relative) prospects for growth stocks are also constructive on a medium-term horizon, in our view. For one thing, from a valuation perspective, an analysis by Goldman Sachs reveals, for example, that the price-to-sales ratio of high-growth stocks in the USA has decreased from 14x to less than 4x (median since 1995). There definitely are some attractive bargains by now in the growth stock universe, as evidenced by a number of take-private transactions by private equity managers lately like Thoma Bravo’s recent takeover of cybersecurity specialist Ping Identity (at a 63% premium over the company’s last closing stock price). Moreover, the prospects for growth stocks are perhaps better than they may seem also in reference to economic activity because in a further downturn scenario in which the ISM purchasing managers’ index in the USA drops into contraction territory (below the 50-point level) and thus confirms fears of a recession, 12-month returns in particular for growth stocks are historically better than for value stocks, for example.

Growth at a mild advantage | Performance potential after an economic downturn

Scenario “ISM PMI drops below 50” scenario, historical returns since 1975

Sources: Bloomberg, Kaiser Partner Privatbank

Our interest-rate assessment in combination with the arguments laid out above prompted us to return our underweighting of growth stocks in our discretionary investment mandates to neutral in July. Our very long-term stance on growth stocks fundamentally remains bullish. We are staunch adherents of the theory that above-average, profitable growth should be compensated with an excess return in the long run and that stocks with a long duration (i.e. shares of companies whose revenue and earnings lie far in the future) accordingly outperform. If the world of the future resembles the one of the last decade, the long-term growth/value ratio uptrend could continue to persist. But the question of whether we are at a proverbial “historical turning point” also with regard to this topic is definitely a legitimate query. Deglobalization, demographic trends and the risk of persistently higher inflation rates are just a few of the factors that could cause us to find ourselves in a lastingly altered (interest-rate) regime in the future. In such a regime, growth stocks could potentially have a long way to fall relative to value stocks.

Uptrend (still) intact | Is there still a big drop height?

MSCI World Growth vs. MSCI World Value

Sources: Bloomberg, Kaiser Partner Privatbank