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For Years, Growth Stocks Were Fun and Fantastic — Until Now

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As stocks hit record after record in the past decade, investors didn’t much care if a stock was cheap or expensive. What mattered most was: Is it growing quickly?

If the answer was yes, the stock was in high demand, almost regardless of the price. Investors were ravenous for companies able to add customers and deliver fat growth. So they were willing to pay premium prices for an Amazon or a Netflix. Left behind were stocks in more staid industries, even if they looked like better bargains by several measures.

Suddenly, though, the siren song of high growth has gone dissonant. As markets tumbled in recent weeks, the stocks that were soaring the highest have fallen the fastest. Worries about interest rates and global trade are raising concerns about the companies’ future growth. Plus, high-growth stocks had further to fall given how much more expensive they had grown versus the rest of the market by various measures.

So far this month, high-growth stocks in the Russell 3000 index have plummeted 11.3 percent, versus 7.7 percent for their lower-priced counterparts known as “value” stocks, as of Wednesday. It’s the biggest such monthly gap in performance in a decade.

If the long run of dominance is indeed over for growth stocks, the stakes could be huge. It would mean pain for investors who went all-in on the sexy, high-flying stocks that so dominated cocktail-party conversations.

Even investors with more-vanilla index funds would take a hit. The supercharged performance for high-growth stocks means companies like Amazon, Facebook and Google’s parent have swelled in market value. Those three, plus Apple and Microsoft, make up more than 15 percent of the S&P 500 index by themselves. So, movements in their stock price have more influence on S&P 500 index funds than smaller stocks.

Perhaps more ominous is the market’s track record. The last two times the pendulum swung sharply between dominance for value and growth stocks occurred around two of the most dramatic implosions in the stock market’s history: the 2000 dot-com crash and the 2007 onset of the Great Recession.

To be sure, many investors say the market can shift from one led by growth stocks to one led by value stocks without cratering. And the market has given head fakes before, where it seemed like value stocks were about to regain leadership, only to fade back again. But many investors nevertheless see a reversal as inevitable, simply because high-growth stocks have become much more expensive than value stocks.

“We know that this condition is more indicative of a mania of some sort, though we couldn’t tell you when it ends,” said Barry James, president and portfolio manager at James Advantage Funds and an investor who prefers what he calls “bargain stocks.” ”But when it ends, it ain’t pretty.”

To see how strong the fervor has been, consider the stocks in the Russell 3000 Growth index, which includes Facebook, Visa and Home Depot. It was trading at 28.97 times its earnings, as of the end of September. That means investors essentially were willing to pay nearly $29 per share for each $1 in earnings per share that the companies produced in a year.

Stocks in the Russell 3000 Value index, meanwhile, were trading at a more modest price tag of $16.46 for each $1 in earnings per share. The prices were so different because earnings for the first group were rising at nearly triple the rate for the second.

The high price-to-earnings tags for growth stocks make them vulnerable as interest rates rise. The Federal Reserve has been gradually raising interest rates over the past two years, after keeping them at ultra-low levels following the recession.

When rates rise, bonds pay higher amounts of interest and suddenly look more attractive to investors than riskier stocks. Higher rates can also slow economic growth and increase borrowing costs for companies, which taps the brakes on their earnings gains. That’s why price-to-earnings ratios often drop for stocks when interest rates are rising.

And over the last month, it’s often the stocks with the highest price-earnings ratios that have been hit hardest. That means growth stocks.

Beyond that, some of the hottest areas among growth stocks are facing their own challenges. Internet giants are under increasing government scrutiny not only in the United States but around the world, which further threatens their growth.

Of course, growth stocks have appeared ready to cede their crown at other points during this bull market. In 2016, for example, value stocks did better as a group, only to fall behind growth stocks again in 2017.

One point in favor for growth stocks is that revenue for many of them has become more stable, in the form of recurring revenue rather than one-time purchases, which makes their growth more durable.

Growth stocks also don’t look anywhere near as expensive as they did in 2000, the last time they gave up long-term leadership to value stocks. At the time, the dot-com bubble had sent companies, even those with no profits, to astronomical prices.

Michael Liss, a senior portfolio manager on four mutual funds at American Century that focus on value stocks, has heard that argument a lot. He doesn’t buy it.

“That’s the thing people say: It’s not as crazy,” he said. “But does it have to get to the worst-possible situation ever, or worse than that, for it to be out of control? No, if you take out the tech bubble, this is crazy,” he said, citing how much more expensive high-growth stocks have become than the rest of the market.

“This is way outside the bounds.”

© The Associated Press. All rights reserved.

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