The case for value
Reasonable valuations could provide an upside surprise.
March 2024, From the Field
The U.S. stock market has recently produced very strong returns in aggregate, narrowly led by the seven mega-cap stocks known as the “Magnificent Seven.” Driven by the strength of the Magnificent Seven, which accounted for more than 47% of the Russell 1000 Growth Index as of February 20, 2024, growth stocks have significantly outperformed value stocks.
This uneven market advance has many investors wondering if we should expect growth stock dominance to continue or if a broader market rally, led by value stocks, could be on the horizon.
One reason to be skeptical of continued growth stock dominance is the huge valuation gap that growth stocks currently enjoy over value stocks. As of February 20, the P/E of the Russell 1000 Growth Index was 12.2x higher than the P/E of the Russell 1000 Value index, which measures in the 86th percentile of all month-end observations since January 1998.
However, since this elevated valuation gap has persisted for some time, we should not
necessarily expect the gap to mean-revert quickly. But it does indicate that growth stocks currently enjoy high earnings growth expectations, while expectations for value are quite reasonable. Consequently, it will be much easier for value stocks to surprise markets to the upside going forward.
The stark difference in expectations is particularly noticeable at the sector level, where sentiment for financials and energy sectors are notably depressed while technology sentiment is meaningfully elevated. This can be illustrated by comparing each sector’s share of the S&P 500 on a market-cap basis versus on an earnings basis.
As of February 20, financials—which are heavily represented in the value index—accounted for 20% of the S&P 500’s earnings but only 13% of its market cap. Similarly, energy—another sector heavily tilted toward value—accounted for 8% of S&P 500 earnings but only 4% of the market cap. Meanwhile, information technology—which is extremely growth oriented—accounted for 19% of S&P 500 earnings but 30% of the market cap.
Both the financials and energy sectors face headwinds that could be fading over the near to medium term. In the case of financials, a steepening yield curve could drive profits higher if the Fed cuts short-term rates. In the case of energy, peaking oil rig productivity and/or further elevation of tensions in the Middle East could push oil prices higher.
Another potential tailwind for value relative to growth is higher real interest rates. Real interest rates, defined as the rate of interest minus the rate of inflation, were extremely low during the post-financial crisis period from 2008 to 2019, famously known as the “New Normal.” But an examination of history reveals that the near-zero real rates of that period were actually very abnormal. And the dynamics that held rates so low for so long—most
notably extremely accommodative monetary policy—appear unlikely to continue going forward.
If real interest rates do, in fact, revert back to normal levels, it would mean both bad news and good news for stocks overall but could favor value stocks.
The bad news is that stock valuations are generally lower when real rates are high. We can see this dynamic at work by plotting the P/E ratios versus the 10-year real rate over that past 10 years. This reveals a fairly notable negative correlation.
But the good news is that higher real rates are typically accompanied by higher economic growth, which in turn should mean higher company earnings. So while the P/E ratio may go down, it does not mean that stock prices need to go down because the “E” could be moving higher. And this could be even better news for value stocks because while P/Es have tended to fall when real rates have been higher, they have tended to fall by much less than growth stock P/Es do.
There is also some good news for growth stocks. Excitement about artificial
intelligence has recently made growth stock valuations somewhat impervious to
the impacts of higher rates, as investors hold hope that the future earnings
boost from artificial intelligence could outweigh the impacts of a higher rate environment.
The bottom line is that while value stocks have trailed growth stocks considerably over the past year, there are reasons to believe this dynamic could shift going forward. As a result, our Asset Allocation Committee has recently moved to an overweight position in U.S. value equities.
Key Insights
- U.S. growth stocks have significantly outperformed value stocks over the past year, but we believe this dynamic could shift as near-term challenges fade.
- T. Rowe Price’s Asset Allocation Committee has moved to overweight U.S. value stocks, as earnings expectations appear to leave room for an upside surprise.
Written by
Tim Murray, CFA
Capital Markets Strategist Multi-Asset Division
Over the past year, U.S. growth stocks have significantly outperformed value stocks, driven by the so-called Magnificent Seven.1 Given this uneven market advance, many investors may wonder if growth stock dominance will continue or if a broader market rally, led by value stocks, could be on the horizon.
Elevated valuations for U.S. growth stocks reflect high earnings growth expectations for the sector. More subdued earnings expectations for value stocks leave room for an upside surprise. This difference in expectations is particularly noticeable at the sector level (Figure 1).
Low expectations for financials and energy sectors
(Fig. 1) S&P 500 Index sector weights versus share of index earnings
Data represent the 12-month period ended February 20, 2024.
Past results are not a reliable indicator of future results. Actual outcomes may differ materially from forward estimates.
Sources: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. S&P 500 Index. GICS. See additional information.
* The “Magnificent Seven” stocks are Apple, Alphabet, Amazon.com, Meta, Microsoft, NVIDIA, and Tesla. The specific securities identified and described are for informational purposes only and do not represent recommendations. Not representative of an actual investment. There is no assurance that an investment in any security was or will be profitable.
(Fig. 2) Real rate impact on stock valuations
Data represent the 10 years ended January 2024.
Past results are not a reliable indicator of future results. Actual outcomes may differ materially from estimates.
Sources: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. Bloomberg Finance L.P. and Russell Indexes.
See additional information.
NTM = next twelve months*
The artificial intelligence excitement began in late 2022, with the launch of ChatGPT.
On a sector-weight basis, expectations for the extremely growth‑oriented information technology sector are meaningfully elevated relative to the tech’s share of S&P 500 Index earnings. Meanwhile, sentiment toward the financials and energy sectors—both heavily tilted toward value—is notably depressed.
Despite near-term challenges, a steepening yield curve could drive up profits in the financials sector if the Federal Reserve cuts short‑term rates. Peaking oil rig productivity and/or further elevated tensions in the Middle East could push oil prices higher, boosting energy earnings.
U.S. value stocks also could benefit from higher real (after inflation) interest rates. The near-zero real interest rates seen from 2008 to 2019—the post-global financial crisis period commonly referred to as the “New Normal”—were actually quite abnormal relative to historical norms, and a repeat of the extremely accommodative monetary policy that held rates so low for so long appears unlikely going forward.
While stock valuations, represented by price-to-earnings (P/E) ratios, have tended to fall when real rates are high, value stocks typically have fared better than growth stocks in such environments (Figure 2). Still, it is important to note that recent excitement about artificial intelligence has made U.S. growth stock valuations seemingly impervious to the impact of higher interest rates.
U.S. value stocks have trailed growth stocks considerably over the past year, and we believe this dynamic could shift. As a result, the Asset Allocation Committee recently moved to an overweight position in U.S. value equities.
From the field
After the Fed pivot, what’s next?
With cooling expectations, investors wonder when and how far U.S. rates will fall in 2024.
1 The “Magnificent Seven” are Apple, Alphabet, Amazon.com, Meta, Microsoft, NVIDIA, and Tesla.
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