Confused? Dig Deeper Under the Surface of the Overall Market

By Tom Madell

In case you hadn't noticed, the stock market has become highly volatile lately, with most of the action on the downside. This is highly likely chipping away at your overall stock portfolio returns. But you probably haven't noticed something going on beneath the surface which might have important implications for managing your portfolio going forward.

Over the short term, highly volatile stock performance is associated with stocks continuing down rather than up. But research seems to suggest that over the longer term, one cannot necessarily conclude that we will be in for poor stock market performance ahead. In fact, as stocks undergo a correction or even a bear market often accompanied by high volatility, the astute in-it-for-the long-haul investor may be able to pick up stocks considerably cheaper than they were just months before. And since lower stock prices can, and often do, spring back after a relative short "white knuckle" ride, investors who choose to sell stocks into a downturn to reduce the apparent increase in risk, may actually be selling when stocks are in fact better situated than they were when they were on the rise.

But beyond the overall market losses in net asset values accompanying a stock downdraft creating more reasonably valued stocks, there may be another less visible opportunity, one that tends to favor the performance of certain types of stock funds/ETFs over that of others. That is what seems to be happening now.

As I reported in the April Newsletter, funds/ETFs with an emphasis on Large Growth stocks have been outperforming those with a Large Value emphasis over the span of the last 10 years. But historically, such outperformance is unusual. In fact, many studies have shown that Value stocks tend to outperform Growth over the long run, although each category can have spells of superiority for lengthy periods. Exactly when Value will return to its historical dominance is anyone's guess although there lately have been some signs that this may be starting to happen. In 2016, Value funds did interrupt the otherwise dominant performance of Growth, but since then, Growth again swamped Value in 2017 and continued to do so up until recently this year.

However, things may now be changing. Over the last 4 1/2 months, Large Growth funds, on average, have sunk from market leaders to correction territory defined as a 10% drop from a previous high. Large Value funds have fallen too but about 6% less than Large Growth (according to data on Morningstar.com, as of 10/29).

While this period is not at all long enough to come to any strong conclusions, it has been quite a while, namely since the 4th Qtr. of 2016, since Growth funds have trailed Value funds over even a 3 month calendar quarter. So if the current trend continues, it could well mark the resumption of the 2016 outperformance. So, even though neither group has done well since mid-June, your portfolio would have dropped considerably more if invested in Growth funds. If such results were to continue at the same magnitude over an entire year, the degree of Large Value outperformance would be in the range of about 15%.

This reversal seems to be reflected in the performances of two of the main stock indices, the Dow Jones Industrial average (DJIA) and the NASDAQ. The DJIA, while somewhat balanced in what it owns, has closer to a Value orientation than a Growth one, while the NASDAQ, on the other hand, is definitely tilted toward Growth. Over the last quarter, an ETF mirroring the DJIA, SPDR Dow Jones Industrial Average ETF (DIA), is down about 3% while one tied to the NASDAQ, Invesco QQQ Trust (QQQ), is down about 8%.

More specifically, looking at the Vanguard Growth ETF (VUG), its biggest allocations are to Technology stocks and secondarily to Consumer Cyclical stocks. The Vanguard Value ETF (VTV) has its heaviest weighting in Financial stocks and what are considered more defensive, less risky sectors. But over the last 3 months, Technology and Consumer Cyclical stocks have been near the bottom in performance among the 11 market sectors while defensive sectors such as Health Care, Utilities, and Consumer Staples have been near the top. And Financial stocks have done a bit better than Technology stocks.

All the recent volatility accompanied by rising interest rates, along with Growth stocks having performed so well until recently, may be leading investors to now move toward the above defensive sectors.

Combine this with the fact that, according to an article on Marketwatch.com, Value stocks outperformed Growth stocks over 4 straight years from 2002 to 2005, the last time the Fed was continually raising rates, as they have 8 straight times since Dec. 2015 with 4 more increases projected by the central bank into mid-2019.

The likely underlying explanation then for the shift from Growth to Value is this: Value stocks tend to be more stable than Growth stocks and capture higher dividends than Growth stocks, thus serving as a ballast against lower stock prices. This compares to Growth stocks whose major appeal is price appreciation rather income generation. In the kind of market environment outlined above, it seems natural that more investors will return to favoring Value funds over Growth funds

Further, according to the above cited article, faster inflation also favors Value stocks. And a potential trade war with China could also cause prices to rise and to keep the Fed in an aggressive rate raising mode.

So, while you may choose not to reduce your overall allocation to stock funds as a result of the above factors, you may want to follow what the above data seems to show and just move some of your funds in the direction the market seems to be now showing a preference for.

Key Takeaways from this Article

With the stock market still near historic highs, and so many unsettling things going on in the U.S. and the world right now, everything will need to continue to fall into place on the positive side for stocks to perform as well as they have up to now. In short, there appears to be a greater risk than a reward potential in stocks than previously going forward. While I am not advocating a significantly lower allocation than before to stocks at the present time for long-term investors, if your allocation to stocks has grown over the last year or two as a result of stocks' extraordinary performance vs. your bonds and cash, one may want to bring these allocations back down to your previously defined levels.

Likewise, if your allocation to Large Growth oriented funds has risen a lot while your allocation (if any) to Large Value oriented funds hasn't, you may want to consider making some adjustments. But we'll still need to see if the current superior performance of Value over Growth is for real or just a temporary phenomenon. But from my perspective, it appears to be the former with potentially years of outperformance lying ahead.

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