Dangerous to buy the dip on growth stocks

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However, since late 2021, that has sharply reversed, with the growth index lagging the value index by about 40 per cent. Some of the highest-profile growth stocks that peaked during the COVID-19 lockdown period, such as Peloton and Shopify, fell by more than 90 per cent.

After this shake-out, any smart investor who is remotely contrarian will sniff potential bargains. However, before piling into heavily sold growth stocks, it’s worth looking at some background and what made the growth stocks perform so strongly in the first place.

Much depends on the macro factors

First, the background: growth stocks smashed value in the late 1990s until the bursting of the dotcom bubble, and then underperformed for more than a decade. So these cycles can go for a long time. Much depends on the macro factors at work.

Those macro factors, in particular inflation, help explain why growth did so well over the past 10 years. When inflation is declining, it will normally mean interest rates and bond yields are also going down. It is also well established that lower inflation helps to support higher price-to-earnings ratios, which is what happened through to late last year.

Further, lower bond yields will help support higher share price valuations. When analysts do a discounted cash flow valuation on a company’s shares, they will typically base their discount rate on the 10-year bond yield (plus or minus a bit for risk). The lower the discount rate, the higher the current value of future cash flows, meaning the higher price you’re prepared to pay for the shares today.

When inflation started rising sharply, those tailwinds reversed into mighty headwinds. The US 10-year bond yield shot up from lows of about 0.5 per cent to a recent peak of 3.2 per cent, radically transforming the valuation equation for growth stocks, which has been clearly reflected in plunging share prices.

Over the past 10 years, every time the growth stocks suffered a setback they quickly bounced back, conditioning investors to buy the dip. What might be different this time is the outlook for inflation. If inflationary pressures persist, that will continue to be a headwind for growth stocks.

Not wise to bet against technology

It’s frustrating to be told the arguments for persistent inflation are pretty equally stacked, but that’s the case. For example, the increase in globalisation that helped reduce costs over the past 20 years may well be reversing as companies reassess the benefits of more robust supply chains.

Also, the very low unemployment level in both the US and UK has led to wages growth settling at about double the pre-COVID-19 level.

Similarly, if Europe follows through on cutting its reliance on Russian gas and oil, that could affect energy prices, plus resources could be diverted to building more renewable energy generation.

On the other hand, the more renewable energy capacity that gets built, the lower energy costs will be, reducing the cost of production. Further, over the past 50 years betting against technology has not been wise and technologies such as AI and 5G could be transformative.

The upshot is nobody can be certain where inflation will be in a year or two, meaning there is no certainty on whether growth stocks will bounce back as in the past.

There are definitely bargains, and there may well be a bounce back from oversold levels. But for sustained performance, smart investors would be well advised to hedge their bets by retaining a balance between growth and value stocks.

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