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The growth stocks puzzle

The growth stocks puzzle
January 20, 2015
The growth stocks puzzle

The reason to ask is simple. Long-term real interest rates have fallen sharply and are now negative. Such falls should make future cash flows more valuable; in fact, negative interest rates imply that they are more valuable than current cash flows. Because growth stocks, by definition, offer more future cash flows than value stocks, it follows that they should have benefited enormously from the fall in real yields.

But they haven't done so. Growth stocks - measured by the FTSE 350 low-yield index - have actually underperformed value stocks since the end of 2010. This is despite the fact that 10-year index-linked yields have fallen from plus 0.5 per cent to minus 1 per cent in this period.

Why is this? You might think it's just because growth stocks normally underperform: in the last 20 years the FTSE 350 low-yield index has given a total return of 6.4 per cent a year while the high-yield index has returned 8.8 per cent.

This isn't the whole story. If we look at annual changes in growth relative to value and in index-linked yields, we remove the downtrend in both. And doing so reveals something odd. The last five years have seen a positive correlation between growth relative to value and index-linked yields; falling yields have been associated with growth stocks underperforming. That's the exact opposite of what we'd expect given that a lower discount rate should raise the present value of future cash flows.

Such a positive correlation isn't unprecedented. But it is unusual; between 1990 and 2009 the correlation was negative on average, consistent with growth stocks outperforming when long-term rates fell.

So we have a puzzle: why hasn't the collapse in real yields triggered a boom in growth stocks? To put this another way, why have long duration safe assets done so well while long duration risky assets haven't?

One possibility is that equity investors think gilts are in a bubble and so are pricing shares on the basis of a higher 'shadow' discount rate rather than the actual rate.

Another possibility is simply that investors have become more risk averse. This explanation, however, runs into puzzles of its own. Increased risk aversion is incompatible with the fact that shares generally have risen a lot since the end of 2010. What's more, increased risk aversion doesn't necessarily mean that growth must underperform. Exactly the opposite happened in 2007-08; risk aversion rose, the market fell, but growth outperformed value.

If increased risk aversion does explain the lacklustre performance of growth stocks, it is aversion to a particular type of risk.

There's an obvious candidate here: secular stagnation risk. What we've seen recently is consistent with either a fall in expectations for long-term growth or increased uncertainty about long-term growth. Such a change would reduce bond yields, as investors seek insurance against weak long-term growth. And it would depress growth stocks because investors would fear that whatever individual merits these have are offset by low economic growth.

A decline in long-term growth expectations is entirely consistent with an improvement in the short-term economic outlook - something that has helped value stocks in the last two years.

It might be, therefore, that it's not just bond markets that are telling us we face the risk of secular stagnation. Stock markets are telling us this too.

And this matters for all stock-pickers. A bet on growth stocks is, in effect, a bet that markets will change their mind, and become less fearful of long-term stagnation. This might be a risky bet.