Growth or Value? The Yield Curve May Provide the Answer

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Includes: IVE, IVW
by: Jonathan Selsick
Ken Fisher , Forbes columnist and CEO of Fisher Investments, in his book The Only Three Questions that Count, provides an excellent rationale as to how the yield curve can predict whether value stocks or growth stocks will outperform one over the other.
The theory goes like this: Companies that have access to new capital will be more likely to increase their earnings, and shareholder value. When the yield curve steepens, value companies have better access to capital, and should outperform growth companies. When the yield curve flattens, growth companies have better access to capital, and growth should outperform value.
How does it work?

On the one side we have banks. When the yield curve is steep, banks have an incentive to lend, since they can borrow short term money at low rates and lend it out longer term at higher rates. When the yield curve is flat or inverted, they cannot make money lending, but they can make money by helping companies raise capital, through stock issuance.
On the other side are the companies that need capital to grow; either value companies (defined as companies that trade at a low p/e ratio / high earnings yield), or growth companies (defined as companies with a high p/e ratio / low earnings yield). Value companies prefer to raise capital by issuing debt and growth companies prefer to raise capital by issuance of new stock. Fisher gives an example of a value company, trading at a 5 p/e (20% earnings yield), that can borrow at 7%,and buy back their own stock at a 20% return, increasing earnings. The growth company that trades at a 50 p/e (2% earnings yield) can issue stock at 2% cost of capital, and buy treasuries at 5% to increase shareholder value.
So when the yield curve is steep, banks will lend money and value companies will borrow it. When the yield curve is flat, or inverted, value companies may still wish to borrow money, but banks will not lend money because they cannot make a profitthey have to borrow at say 8%, and lend it out at 7%. However they will be glad to help growth companies raise capital, and growth companies can create added value since their cost of capital through stock issuance is generally below Treasury yields.

The chart below (), shows how this has played out for the past 12 years.

The chart looks at two ETFs, [[IVE]] (large cap value) and [[IVW]] (large cap growth), and maps their momentum relative to the SPY. A momentum reading of 5 (green), means it is strongly outperforming the SPY, and a momentum of 1(red), means it is strongly underperforming the SPY. The chart also shows the momentum of SPY itself, and the two recession periods are highlighted in grey in the date column. The middle column is the slope of the yield curve, calculated by subtracting the federal funds rate from the 10 year Treasury bond yield (GS10-FF); the higher the number the steeper the yield curve. A negative number implies an inverted yield curve. The right hand column notes the significant yield curve and momentum changes.


Observations

It seems that Ken Fishers theory has proven true, for the most part, but with a lag between the time the shape of the yield curve changes, and the time each style outperforms. For example, in 2006, value had been dominating; in July the yield curve became inverted; value continued to outperform for another 12 months, and then growth took over and dominated for the next 12 months.

Note that Fishers theory is not one of those clean cut theories that adheres to a strict formula or timeline, but in general , it works, and is based on sound reasoning. Since the average annual difference between growth and value returns over the past 10 years has averaged 12% per year, it is a valuable tool in portfolio allocation. Momentum on its own is a powerful tool, but if you can rationally explain the momentum, like Fisher does, then that adds to its value.
Presently the yield curve is steep, and based on the Feds accommodative policy, looks like it will remain steep for an extended period. As expected, value is presently outperforming growth and should continue to do so, until the curve flattens again.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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