• Wealth Management

5 Reasons Growth Stocks Could Be Vulnerable

As the business cycle ages, the fastest growing companies face increasing risks.

The bull market in stocks reached its 10-year anniversary last month, helped in the first quarter by the Federal Reserve, which adopted more accommodative monetary policies after last December’s stock market swoon. U.S. growth stocks, dominated by tech leaders, were the biggest winners.

Rather than celebrating, however, I’d like to wave a yellow flag. With the business cycle aging, earnings growth slowing and investors crowding into just a handful of market leaders, growth stocks seem vulnerable. I think investors should diversify into more value-oriented investments, which may hold up better if the stock market corrects later this year.

Below are five main reasons why investors may want to scale back on growth holdings:

  • Valuations seem high. The top 20% of companies with the fastest sales growth in the S&P 500 have an average price-earnings ratio (a common measure of valuation) that is nearly double the overall market’s p-e of 17.3. The 50 fastest growers have a multiple three times that of the overall market. Valuation levels this high are comparable to what we saw in 1999, just before the tech bubble burst. 
  • Interest rates could rise. Since stocks are often valued in comparison with the interest earned on a Treasury note, higher interest rates can make stocks look less valuable, causing p-e ratios to fall. I think real interest rates have bottomed recently and may rise this year if global growth continues to improve more than expected or inflation rises.
  • Technical market factors are concerning. Many hedge funds are invested in high growth sub-sectors, such as software, information technology and Internet retail. These sophisticated institutional investors could move out of growth stocks quickly if the positive momentum turns. Another technical factor: growth stocks have been more volatile relative to the overall market recently, finds Morgan Stanley Chief Cross-Asset Strategist Andrew Sheets in a recent analysis. In contrast, the downside volatility of value style stocks is near an all-time low, he notes. That suggests that in a correction, value stocks may not decline as much as growth stocks.
  • The regulatory backdrop is changing. Some of the biggest winners in the stock market have benefitted from business models that rely on proprietary technology platforms for social networking and streaming media. These platforms may face new restrictions around privacy and the nature of the content they distribute. Such restrictions could increase costs and slow growth.
  • The IPO market is reawakening. With a new crop of fast-growing companies going public, some investors could cash out holdings in familiar growth stock winners to free up cash to buy IPOs. This year’s IPO pace is already running at nearly three times last year’s pace.

Alongside these risks to growth stocks, are other challenges, including slowing earnings growth and an aging business cycle. While the Fed’s policy pivot has extended the bull market in growth stocks—and it may last a while longer—investors should consider adding positions in value-oriented active managers, which could perform better than growth managers when the market corrects.

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