The Long and Short of It: Investing in the New Climate

Frothy. Too hot. Overvalued. There are plenty of adjectives used to describe the current market environment now that the broader indices are sitting at or near all-time highs.

The S&P 500's forward price-to-earnings (P/E) ratio currently stands at about 25. To put this into perspective: The S&P 500 hasn't been this overvalued since the dot-com bubble in 2000 when the index had a P/E ratio of 23.4.

The concern is the divide between the S&P 500's price and its earnings. The S&P 500's price increased dramatically in 2020, as the index ended the year more than 16% higher. Earnings, on the other hand, declined significantly. According to FactSet, the S&P 500's earnings are expected to decline by 13.7% in the calendar year 2020, which is the most significant earnings decline since 2008.[1]

Several market pundits have noted that the excessive amount of stimulus to combat the pandemic-induced economic downturn drives high market valuations. The Federal Reserve's near-zero key interest rate policy through 2023 is supporting these record-high valuations.

No matter the reason for the record-high stock valuations, it is the environment that we're currently living in and is inspiring investment firms to rollout some creative investing strategies.

Take GMO, for example. Jeremy Grantham's investment firm introduced a twofold investment strategy: long value stocks and short expensive, overvalued growth stocks. GMO applied a similar approach back in 2000 to profit from the dot-com bubble, and it's betting on similar results when the growth stock bubble bursts.[2]

The reasoning is that value stocks have underperformed growth stocks for more than 10 years. The divergence between growth and value stocks was particularly pronounced in the past year. In 2020, the iShares Russell 1000 Value ETF (IWD) only rose 1.7% versus the 38.3% gain from the iShares Russell 1000 Growth ETF (IWF).

Investors have poured into growth stocks in the past year. At times, many individual investors didn't even consider the fundamentals backing the growth stocks' valuations. They were simply fearful that they'd miss the market's next leg higher and jumped on board without a second thought. This, according to GMO, is a sign of a bubble.

GMO is betting the bubble will burst, and value stocks will return to favor. But the firm doesn't see merely investing in value stocks as the most profitable strategy. It wants to profit from value stocks rise, and growth stocks decline. Enter the long value, short growth strategy.

Unfortunately, while GMO's strategy sounds like a win-win, the reality is that this type of plan can be hard to employ for individual investors. And it's not necessarily the right strategy for all portfolios, as each investors' financial goals and investment timeframe are different. There is no "one size fits all" approach that works for everyone.

Nicollet Investment Management agrees that there are merits to having a blend of value and growth stocks in your portfolio. But attempting to time the market by doing the "twist" with long and short strategies could hurt you more than it helps. So, before you make any changes to your current holdings, give us a call to discuss the role of value and growth stocks in your portfolio.

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[1] https://insight.factset.com/sp-500-cy-2020-earnings-preview-largest-year-over-year-earnings-decline-since-2008

[2] https://www.institutionalinvestor.com/article/b1pl17cn1sbqwc/GMO-Has-a-Plan-to-Profit-From-a-Growth-Stock-Bubble