Growth vs. Value: Who Wins in 2022?

Quietly, behind the scenes, we feel a massive shift is starting to gain momentum on Wall Street—and value investors may finally have their day in the sun.

When you look at the major indices' performance from the March 2020 lows, you'll probably question the prediction that value is gaining favor. The S&P 500 and NASDAQ have soared 109% and 128%, respectively, from the March 2020 lows, while the Dow has only climbed about 92%. Given that growth stocks dominate the S&P 500 and NASDAQ, it's easy to see that growth stocks have led the stock market's recovery from the pandemic-induced downturn.

But consider this: in December so far, the Dow has gained 3.6%, versus the S&P 500's 2.5% rise and the NASDAQ's relatively flat performance. Given that value stocks dominate the Dow, this may indicate that value stocks are starting to return to favor—and many market pundits claim the time for value is now.

Before we dig into the details of whether growth or value should outperform in the New Year, it's essential to understand the differences between these two buckets of stocks.

What Are Value Stocks?

The simple definition of a value stock is a stock trading below its actual worth. In other words, the stock is trading at bargain prices based on its projected performance. Value stock investors expect to make money as investors gain confidence in the company's performance and the stock's price returns to "fair value."

You have likely heard the term "cyclical stock" in conversations about value stocks, and that's because most cyclical stocks are categorized as value stocks.

Cyclical stocks tend to operate in industries with heavy ties to the health of the U.S. economy. They thrive when the economy is booming, especially after economic downturns, but see their business contract when the economy turns down.

Cyclical stocks benefit when Americans are more confident and have more disposable income, resulting in more spending on discretionary items. The most common cyclical stocks within the consumer sector are travel and leisure stocks like hotels, airlines, and restaurants, but also include larger purchase decisions like autos and housing-related items.

Another market segment often priced as valued are companies with profitable businesses but with low prospects for growth. These mature companies often get ignored by investors who seek more sexy stories. Value investors, however, carefully monitor these types of companies as they have good businesses and can become suitable investments if purchased at the right price.

Many cyclical stocks took a beating during the pandemic, especially hotels, airlines, cruise lines, and restaurants—and their now bargain-basement prices are tantalizing for many value investors. As an example, stocks like Norwegian Cruise Line Holdings Ltd. (NCLH), Marriott International, Inc. (MAR), Restaurant Brands International, Inc. (QSR), and United Airlines Holdings, Inc. (UAL) are up nearly 7%, 9%, 7%, and 6%, respectively, in December so far.

To further illustrate the recent rebound in value stocks: the iShares S&P 500 Value ETF (IVE) is up about 4% in December so far, while the iShares S&P 500 Growth ETF (IVW) is only up about 1.6%.

What Are Growth Stocks?

The simple definition of a growth stock is a stock offering strong and consistent growth potential. In our opinion, growth stocks are the most attractive stocks for investors by far. Growth is critical in assessing investments and an essential element of long-term returns. Even if a stock is bought at a premium price, if the company continues to grow, eventually, the investor should see a positive return on their investment.

However, over the market's cycle, the prices investors are willing to pay for growth can get out of hand. We all know the internet boom the market experienced in the mid-to late-1990's. In retrospect, it seems evident that the prices investors were willing to pay for internet stocks became silly.

We know with the benefit of 20/20 hindsight, the thesis underlying that internet boom was entirely correct: the internet would have a significant structural impact on every industry. The problem was not the thesis; the prices being paid became unreasonable. During that time, few high-flyers proved to be suitable investments because the market priced stocks for higher growth than was ultimately delivered.

So, when investing in growth companies, investors must be confident the company will grow at least at the rate implied in the current stock price.

Technology stocks are often considered growth stocks, but not all technology companies qualify—markets for technology change, and so do the stocks expected to grow. Once the benchmark for technology, IBM is now considered a value stock. IBM is a good business, they just do not show much growth. Cisco, one of the great growth stories of the 1990s, is now a value stock as its business is no longer in the epicenter of technology growth.

However, for the most part, we feel technology is the sector where investors continually find the best growth stories. So, it's not surprising that the tech-heavy NASDAQ rallied more than 20% in the first 11 months of 2021 when growth stocks were in favor.

That said, many of the growth stocks that led the market higher in 2021 are now starting to pull back—and pull back dramatically. As an example, NVIDIA Corporation (NVDA) dropped 8% in the first four trading days of December, and Zoom Video Communications (ZM) is down more than 10% in December so far.

The question now is whether value stocks will continue to outperform growth stocks in the New Year.

Who Wins in 2022?

In our opinion, the time for value may be at hand—and the reason is simple: two phenomena are working in value stocks' favor right now: inflation and interest rates.

We've talked a fair bit about the inflation situation in recent Nicollet Navigator articles, including How Much Cash Is Too Much Cash? and It's Beginning to Look a Lot Like… Inflation Is Here to Stay. The reality is inflation has reared its ugly head, and prices are set to remain elevated for the foreseeable future.

The Personal Consumption Expenditures (PCE) index, or the Federal Reserve's preferred inflation indicator, rose 5% in October. That marks the fastest pace in 31 years. Energy prices are driving the PCE higher, as they're up 30.2% year-over-year. Core PCE, which excludes food and energy, increased 4.1% to its highest level since January 1991.[1]

Now, when inflation sits at historically high levels, our central bank tends to step in to curb the inflationary environment by increasing interest rates. The Federal Reserve has eliminated transitory from its policy lexicon. All signs point to a more rapid ending of its bond-buying program, and there may be more rate hikes in 2022 than currently expected.

Historically, value stocks have served as defensive plays in a more inflationary environment. They are already undervalued and less susceptible to the potential pain of inflation and/or rising interest rates.

We feel that growth stocks tend to thrive in ultralow interest rate environments, as lower rates make growth all the more attractive. However, when rates start rising, that turns against growth stocks. If the Fed increases key interest rates in the New Year as most expect, many growth stocks will likely see some valuation compression. Since many value stocks tend not to have valuation premiums built into their price due to low interest rates, they could steal the show.

With that said, don't just toss your growth stocks out the window. It's important to remember to stick to your financial plan, as it is the key to achieving your financial goals—and growth stocks still may warrant a spot in your portfolio.

Give us a call at Nicollet Investment Management today, and we'd be happy to discuss your financial situation and plan to determine if it's well-positioned to help you achieve your goals in the current environment.

Please click here for important disclosures.

[1] https://www.cnbc.com/2021/11/24/key-inflation-figure-for-the-fed-up-4point1percent-year-over-year-the-highest-since-january-1991.html