Growth stocks have had a good run – so much so that the FTSE 350 low-yield index is at an 18-year high relative to its high-yield counterpart in price terms. This raises the question: are growth stocks now overvalued?
I suspect not, but they do face some big risks.
To see this, we first need to know what drives the performance of growth stock relative to value. My chart summarises one answer. It shows how a handful of factors have tracked annual changes in the FTSE 350 low-yield index relative to the high-yield index in the last 20 years.
The strongest of these factors is valuations. Growth stocks outperform after their yields have been high relative to those on value stocks, and underperform after their yields have been low. This is as you’d expect.
Also, growth stocks tend to do well when Aim stocks outperform the All-Share. Again, this is no surprise. Growth stocks, like Aim, tend to do well when investors’ sentiment is improving.
Thirdly, growth stocks do well after the yield curve (measured by the gap between 10- and two-year gilt yields) has been upward sloping. Again, this is probably due to investors’ sentiment. An upward-sloping yield curve predicts better economic times, and as these materialise so sentiment improves. Such an improvement is not discounted in advance because people are bad at foreseeing that their future tastes will change.
Inflation expectations – as measured by the gap between 10-year yields and their index-linked counterparts – also matter. High expectations predict good returns on growth stocks, and rising inflation expectations are also associated with growth stocks outperforming. This might be because inflation expectations are cyclical – they rise as the economy improves – and so are associated with improvements in investors’ sentiment. One caveat to this, however, is that rises in retail sales (other things equal) are associated with growth stocks underperforming.
These factors suggest that on reasonable assumptions – no changes in yields and a 5 per cent rise in the All-Share and Aim – growth will very slightly outperform value over the next 12 months.
The main reason for this is simply that growth stocks are not yet overvalued. The dividend yield on the FTSE 350 low-yield index, at 2.1 per cent, is actually slightly above its post-1997 average. Much the same is true if we look at traditional growth sectors. Yields on tech and media companies are slightly above their post-1997 averages, while yields on healthcare stocks are around their average.
Valuations, then, are not (yet) a big problem for growth stocks in general (although they might well be for one or two particular ones).
There are, however, risks to them.
One comes from investors’ sentiment. The fact that Aim shares have recently done unusually well relative to the FTSE 100 warns us that sentiment is now quite high. This means there’s a danger of it mean-reverting downwards. As it does, growth stocks would suffer.
A possible trigger for such a decline would be slower economic growth: investors’ sentiment is often cyclical. A disorderly Brexit would be one danger here.
Another risk is higher real bond yields. Historically, growth stocks have been very sensitive to these; other things equal, a one percentage point rise in 10-year index-linked gilt yields is associated with growth underperforming value by 14 percentage points. This is common sense. Higher real yields mean that expected future cash flows are discounted more heavily. Growth stocks (by definition) offer more of these than value stocks, so they suffer more as yields rise. A big reason for their good performance in recent years is that real yields have fallen.
In this sense, those of you who think there will be a bursting of the 'bond bubble' should be especially wary of growth stocks.
While these are not overvalued, there are therefore dangers to them. Valuations are not everything.
