A common debate among investors is whether growth or value stocks represent better investments at any given point in time. While you may believe, as Warren Buffett (Trades, Portfolio) does, that there is no real difference between growth and value, that is not a sentiment shared by large parts of the market. As such, it can be helpful to put yourself in the mindset of someone who does separate those two concepts, if only to understand where the money is flowing. A recent note from Morgan Stanley (MS, Financial) argues that, right now, value stocks offer more upside than growth stocks.
Late cycle expansion
The note begins by acknowledging this yearâs stock rally has been primarily driven by the Federal Reserveâs reversal on monetary policy. With that in mind, the bank reckons the earnings growth may be running out of steam:
âAs the global stock market rally continues seemingly unabated, it has started to take on a slightly different complexion. With the Federal Reserve abruptly pivoting on its monetary policy earlier this year, investors have assumed that additional interest rate hikes are on hold indefinitely. We agree. With that policy change, however, there are still signs that the economy and earnings growth will be slower than normal this year.â
The key issue is that while earnings have been expanding, there has been a corresponding lack of improvement in underlying economic fundamentals. This disconnect is evidence that the market is entering a late cycle expansion, which Morgan Stanley defines as âa period when there is limited slck in things like the labour force and other things necessary to grow without disruptive inflationary pressures.â
âSuch periods can be attractive for equity markets, but they also tend to favor certain kinds of stocks that exhibit one of two qualities. They are either secular growers or defensive businesses. Secular growth companies are businesses that donât need a strong economy to generate extraordinary earnings growth. Today we find such businesses in ânew economyâ areas; things like software, digital services and payments. Defensive businesses are things like regulated utilities or consumer staples. Over the past year, the stocks of these kinds of businesses have done extremely well and outperformed the major averages.â
The issue, however, is these stocks have gotten increasingly expensive. As the report points out, this has made investors look for returns in cyclical stocks in lower-quality areas like banks, energy and industrials. This investor overreach has made the rally take on a more speculative character.
âIn other words, after the good stuff has been picked over, investors are forced down the quality curve, the late cycle rally becomes more speculative. Perhaps we have to look no further than Bitcoinâs near 40% rally in the past month to see just how speculative this rally is getting. We think itâs a sign of exhaustion, and a time to be a bit more careful.
Our advice: trim stocks that have rallied the most this year, and look to areas that are less appreciated. We think this continues to favor value over growth stocks and international over the U.S.â
Disclosure: The author owns no stocks mentioned.
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