According to analysts, the profits of companies in the S&P 500 will rise by an average of two percent this year. Since the beginning of 2019, however, the most important index for the US equity market has already risen by a good 20 percent. Around 90 percent of this performance is therefore not due to higher profits, but to an expanded valuation. A closer look reveals that growth stocks in particular have become more expensive. "The result is a valuation gap between the so-called growth stocks and the broad market that few capital market participants have seen before," says Marcus Poppe, portfolio manager at DWS Group.
The trigger for this asymmetric development is the gloomy outlook for the global economy. This finds its expression in the purchasing managers‘ indices worldwide. For example, the ISM index for the US manufacturing sector fell from its high of 60.8 points in August last year to the current 51.7 points. This means that it is only a breath away from the 50-point mark, which separates growth from shrinkage of the sector. With this decline, the sentiment indicator has also written the script for the flight of investors to growth stocks. The gloomier the economic outlook, the more in demand are securities from companies that continue to grow even during periods of economic weakness.
This pattern has already been observed in the past in the course of countless stock market cycles. However, there is one important difference this time: the growth rally, which was only briefly interrupted at the end of 2018 and which began after the purchasing managers' index had passed its zenith in August last year, catapulted the valuation difference to a level not seen since the beginning of the recovery in 2010.
But why was the rise so much stronger this time? A look at the 2008 financial crisis will help here. After this break, economic growth has slowed significantly. In the USA, for example, real gross domestic product has only risen by an average of 1.6 percent per year since 2008. Between 2000 and 2008, economic output grew by an average of 2.7 percent, from 1980 to 1999 it was even at 3.2 percent on average.
"An important reason for this weakening was the massive decline in the indebtedness of private US households following the bursting of the subprime bubble, which had put a severe brake on the consumption on credit of the previous decades," explains Poppe. In such an environment, the number of continuously and strongly growing companies is then significantly lower, so that investors have recently concentrated on a comparatively small number of shares and thus pushed their prices sharply upwards.
Now many investors are wondering whether the rally in growth stocks will continue or whether value stocks and cyclicals will experience a comeback. From a fundamental point of view, the further development of the trade conflict is likely to be decisive. For the capital markets, however, the Federal Reserve's monetary policy should be the most important factor.
If the Federal Reserve comes up with one or more preventive rate cuts, this could also lead to a rise in long-term interest rates if market participants expect a subsequent economic improvement. In this case, demand for value stocks and cyclicals could also increase again, which could trigger a sector rotation. However, if the economic environment continues to deteriorate and long-term interest rates fall even lower, there is unlikely to be a pronounced change of favorites. In our view, that’s the most probable scenario. In any case, a real regime change can only be expected after a recession.