by Peter Jones, CFA
Senior Vice President
Research and Portfolio Management
In the last few days, the powerful rotation from growth stocks to value stocks, highlighted in our colleague Alex Harding’s article last week, continued. As a reminder, value stocks are those with cheaper valuations and higher dividends, while growth stocks are those with more expensive valuations and brisk top line growth. Just three weeks into the third quarter, value stocks have outperformed growth stocks by more than 7%, bucking the trend we’ve seen since the beginning of 2023. Market participants continue to debate whether this rotation is sustainable or whether growth, and more specifically “The Magnificent 7”, will re-assert their leadership.
In recent years, value and small-cap stocks have outperformed when investors see an increasing probability that inflation will be defeated, the Fed will cut rates quickly and economic growth will accelerate. To that end, economic and company news this week seemed to support the notion that this rotation could be sustainable. On Thursday, second quarter GDP was announced, coming in at a robust 2.8% annualized growth rate. This growth represents a meaningful acceleration from 1.6% in the first quarter and is well above the 20-year average of roughly 2.0%. Bottom line, the second quarter GDP growth confirms that we are nowhere near an economic recession which helps the narrative for value and small-cap stocks.
Inflation and Fed policy was also helpful for the sustainability of the market rotation this week. The Fed’s preferred measure of inflation, personal-consumption expenditures (PCE), moderated once again (chart below) and is ever closer to the Fed’s stated target of 2%.
At 2.6%, not only is PCE nearing the Fed’s target, but the annualized rate in the last three months is even lower at 2.3%. With the Fed’s preferred measure of inflation nearing its target, the Fed has an “all clear” to begin cutting interest rates this fall. PCE data this week has many investors wondering if we will see three rate cuts before the end of 2024. Value and small-cap stocks are more sensitive to interest costs, and relief from the Fed supports a continued rotation to these cohorts.
When it comes to company news, “Magnificent 7” constituents Tesla and Google reported their second quarter earnings - neither of which were well received by investors. For Tesla, discounts, rebates and incentives used to spur demand for electric vehicles caused margin pressure and profits missed Wall Street expectations by 7%. As a result, the stock declined 12.3% on the earnings news. For Google, although profit growth continues to stand out for the company, the YouTube segment missed revenue expectations. The 50% appreciation in the stock price in the last year created a high bar for Google to impress investors and the stock plunged 5% with their earnings announcement.
While the evidence to support a rotation to value stocks continues to build, the profit momentum among the “Magnificent 7” stocks remains undeniable. As shown in the chart below, Amazon, Google, Facebook and Nvidia are all expected to grow earnings by more than 56% this quarter. As for the other 496 companies in the S&P 500? Only 5.7% (chart below). So long as profit growth continues its rapid ascent, it is hard to bet against the “Magnificent 7”.
Takeaways for the Week
Value stocks continued their sharp outperformance vs. the “Magnificent 7”
Second quarter economic growth exceeded forecasts, growing a healthy 2.8% on an annualized basis
The Fed’s preferred measure of inflation, personal-consumption expenditures, continue to moderate towards the 2% objective