The Tell: Value rotation on pause or dead in the water? Goldman, Morgan Stanley debate

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Value investors have had reason to cheer in recent weeks as inexpensive stocks have outperformed those with faster-growing earnings and sales by a healthy margin.

During the past three months SPDR S&P 500 Value ETF SPYV, +0.05%  has outperformed both the S&P 500 index SPX, -0.06%  and the SPDR S&P 500 Growth ETF SPYG, -0.10%, with value falling just 0.4%, versus a 1.5% decline for the S&P 500 and a 2.5% loss for growth.

But the trend has been running out of steam during October — value has fallen 0.1% month-to-date versus growth’s 0.2% decline — helping instigate a debate over which factor will treat investors more kindly during the final quarter of 2019 and beyond.

Goldman Sachs analysts, led by David Kostin, argued in a research note published over the weekend that the recent rotation into growth will appear, in hindsight, to be another in a series of false alarms, because a future slow-but-steady U.S. economy will ultimately play to the favor of growth stocks.

“Investors currently pay a record-high premium for stocks with stable earnings growth versus firms with volatile growth,” Kostin wrote. “But as economic activity slows, stocks with volatile growth tend to experience earnings weakness and falling valuations, and investors gravitate towards stocks with more stability,” he added, warning that investors lured to value stocks by their relatively low prices will be burned in the coming quarters.

Goldman economists expect the U.S. economy to grow at roughly 2% annually, the sort of mediocre growth rate that typically has led to outperformance of the growth factor. “Historically, value stocks have fared best during periods of very strong or very weak economic activity,” Kostin wrote. “During periods of modest economic growth, investors have typically assigned a scarcity premium to growth stocks that are able to generate idiosyncratic growth in excess of the economy.”

Goldman Sachs Investment Research

But what if economic growth in the coming quarters will be worse than just middling? Mike Wilson, chief U.S. equity strategist at Morgan Stanley has been predicting that a sharp economic slowdown awaits the U.S. economy as the effects of tax-cut stimulus wains and businesses work off excess inventory and cut costs.

Overoptimism about economic growth has caused investors to become too bullish on earnings growth as well, he argued in a Monday note to clients, and has lead investors to overpay for growth stocks that will ultimately fail to deliver the rising earnings that are supposed to define them.

“In the first and second quarters of 2019, value saw modestly positive earnings growth while growth saw earnings shrink,” he wrote. “Despite this, consensus is still very optimistic on growth’s earnings prospects in 2020.”

Morgan Stanley Research

He argued that growth stocks are trading at historic highs relative to their projected earnings, while earnings growth actually has been higher for value stocks since 2017.

Morgan Stanley Research

“Investors are still piled into growth names, hoping the earnings growth picture improves,” Wilson wrote. “However, both the last-twelve-month numbers and the next-twelve-month numbers suggest that growths earning’s superiority is on hold for now.”