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Growth stocks: risk or opportunity?

The essential

The ratio of growth stocks to value stocks in the MSCI World (MSCI Growth / MSCI Value) has surpassed its mid-2012 highs. The decline in oil prices and oil securities only reinforces this trend.

Historically, cycles favouring growth stocks have always ended with exaggerations— and the subsequent fall was all the more dramatic. There are other ways to take advantage of low rates, with dividend strategies. If we wish to follow the trend, it would be wise to balance technology securities (mostly american, providing greater USD exposure) with sustainable high dividend yield securities. However, it would be better to avoid biotechnology and social networks, which are already well on their way to becoming bubbles.

 

 

 

 

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The ratio of growth stocks to value stocks (MSCI Growth / MSCI Value) hit new highs recently at the global level (see chart n°1). This trend toward growth stocks that began in 2007 (Lehman crisis) was cut short in mid-2012 (speech by Mario Draghi). The decline in oil prices is breathing new life into growth stocks relative to value stocks. Should we be following this trend?

Why growth stocks are returning to favour

Two arguments are key to focusing on growth stocks:

  1. low infl ation maintains low interest rates, which sustains the valuation of long-maturity assets,
  2. the scarcity effect of growth given that it is sought-after.

The decline in oil prices, which began in June 2014 and accelerated from September- October onwards, only strengthens these two arguments from a macroeconomic perspective. It also adds a fairly inevitable sector argument: consumer discretionary— which, in theory, should benefit—has a significant presence in the global index of growth stocks, ahead of technology and health care securities (see table). Incontrast, oil securities follow financial securities as the most over-represented in the Value index. We may add that, in general, the impact of a drop in oil prices on consumption is more rapid than producers' capacity reductions.

This trend is occurring on all continents

In the US, the country leading this cycle, infl ows are driven by economic growth outpacing the other regions of the world (+2.7% expected in 2015 versus +1.9% on average for industrialised countries); it is even possible that the growth of infl ows may outpace profi t growth. Not much is needed now for the overall market valuation to surpass the 18x trailing earnings threshold (the PER recently reached 17.8x), above which it may be considered to have entered a bubble (see the March 2014 Cross Asset article: Equity markets: should we fear a new bubble?"), as was the case in 1987 and in 1996-2000. As we can justify a domestic growth premium in the US compared to the rest of the world, this trend could persist and concentrate in the highest-growth sectors. Meanwhile, some sub-segments of the "growth" theme are already in bubble territory, such as securities related to social networks and biotechnology (see chart N°. 3).

At this point in the cycle (phase iii in our roadmap—see Discussion Paper: "The short investment cycle: our roadmap"), it is fairly standard that if economic growth is buying time, which corresponds to our scenario, growth stocks win out. This is one of the themes that we discussed in the November issue on the outlook for 2015. The drop in oil prices has reinforced our conviction in this regard. The situation is also a strange reminder of the end of the 1990s, when the appeal of the US benefited technology securities and buoyed the dollar while keeping interest rates low.

It is interesting to note that elsewhere, the search for growth also comes out ahead if we consider the recent trend in the MSCI Growth/Value ratio by region (see chart N°. 4). This is the case in the emerging markets, Europe and Japan. Among these three investment regions, the Japanese case stands out the most, because strategies based on the search for value have historically always held sway. This clearly demonstrates that after more than 20 years of normalisation of Japanese valuations, change is afoot. Return on equity is finally increasing, encouraged by Abe's policies, which suggests this trend will continue. Taking a closer look at the composition of the MSCI Growth index in Japan, we see that it is replete with technology and industrial securities—essentially export securities that benefit from a low yen. We now better understand this trend. International securities also appear to be a major theme for the coming year.

Take emerging markets, accustomed to rapid growth: the search for value was popular from 2000 until 2008. Since then, with economic growth in these countries slowing, the trend has gradually shifted back toward growth stocks. That being said, this universe generally breaks down by region or country rather than by sector or style. Being a producer or consumer of commodities is a particularly clear divide. The steep drop of currencies also indicates prudence on countries with the most fragile fundamentals, particularly in terms of external debt. For the moment, we maintain our preference for Asia, which has not been undermined by these recent developments.

Finally, in Europe, the return to this theme is understandable given the halving of GDP growth potential compared to the pre-crisis period in 2007 (1.2% in our central scenario, compared to 2.3% from 1987 to 2007). Note that in Europe the consumption segment of the MSCI Growth index is more defensive than elsewhere (consumer staples and health care account for 39% of the MSCI Growth index, although consumer discretionary still accounts for 19%). Given a position further back in the cycle than the US and the ECB's QE, the reflation theme makes sense: it involves financials and consumer discretionary. In other words, securities that are both Value and Growth.

In the end, the fact that new highs in the MSCI Growth/Value ratio are being reached sends a strong positive signal on this theme in general, but possibly more so in the US than elsewhere. It should be noted that global growth is clearly driven by the US.

A strategy not without risk

We note that, in the past, cycles favouring growth stocks in general always end in "exaggeration" mode. This was the case in 1980, 1987, 1992-93 and 1999-2000. There is no reason that this time will be an exception to the rule. That is the upside. The downside is evident in chart N°. 1: the greater the rise, the harder the fall. Since the end of the 1970s, the highs reached by the MSCI Growth/Value ratio have always ended up reaching lower lows than the previous cycles!

Insofar as investors are convinced by arguments in favour of "secular stagnation", growth stocks should benefit. The trend in oil prices has reinforced this theme, and this could persist. But we should remain vigilant. Everyone knows that pinpointing a peak is delicate, even if initial signs are apparent. In 1987, the MSCI Growth/Value ratio peaked at the beginning of May, but the crash did not occur until October. In 2000, the ratio reached a major peak in March—the drop did not really take shape until September.

It also appears interesting to complement this strategy with a more prudent approach consisting of capitalising on sustained low interest rates in another way, by simply focusing on companies' dividend yield and their sustainability. Indeed, yields offered by equities are now higher than government bond yields and even sometimes corporate bond yields. Recall that before August 1958, this yield hierarchy was the norm, which was logical: shareholders are the last to be reimbursed in the event of bankruptcy. Strong post-war growth, then the abandonment of the fixed exchange-rate system, the rise of financialisation and leveraging of economies reversed this original hierarchy. As sustained low growth scenarios (secular stagnation) gain credibility and yield becomes scarce among fixed-rate investments, focusing on yield securities makes sense.

Conclusion

The context of sufficient yet contained overall growth and of low inflation is favourable for risky assets and encourages maintaining low interest rates. The decline in oil prices strengthens this scenario. The MSCI Growth/Value ratio is benefiting, surpassing its highs from 2012. We should note that oil securities suffering from this situation are among the value stocks, while the decline in inflation expectations encourages selecting long durations. Although this phenomenon applies generally, the theme appears strongest in the US. We should reiterate, though, that even though cycles favourable to growth stocks always end with exaggeration, these securities are not without risk. If we wish to follow the trend, it would be wise to balance technology securities (mostly american, providing greater USD exposure) with sustainable high dividend yield securities (another way to benefit from low rates). However, it would be better to avoid biotechnology and social networks, which are already well on their way to becoming bubbles.

 

 

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2015-06-01

 

 

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Biotech is already on the path to being a bubble

 

 

2015-06-04
Eric MIJOT, Strategy and Economic Research at Amundi
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