Key Take-Aways

• The recent shift in policy by central banks fundamentally changes the investing landscape as liquidity wanes and investors are forced to re-evaluate their strategies
• Growth stocks enjoyed a long period of outperformance as interest rates stayed low and liquidity was strong over the last 10-years. Now with liquidity shrinking, value stocks are poised to outperform. 
• Investors can take advantage of the shifting market landscape by adding a value tilt to their portfolios using ETFs such as VTV, RPV, or SCHD
• Platforms such as M1 Finance enable individuals to easily tailor a portfolio that suits their needs and allows them to say invested over the longterm

Note, stocks mentioned in this article are for illustrative purposes only, they are not recommendations to buy or sell any security. Please talk to your preferred financial advisor before taking any investment actions.

Without a doubt 2022 has been rough on stocks, with once herald darlings such as FB, NTFLX, and others making 52-week lows seemingly every other week. As a whole, the stock market, measured by the S&P 500 is down a little over 10% YTD (as of 04/23/2022) and down roughly 11% from its 52-week highs. All this to say that stock market investors have been taking it on the chin as of late. To make matters worse, bonds have provided little safety with the Vanguard Total Bond Market ETF BND down 9.9% YTD. 

So what gives?

Unless you have been living under a rock, you’ve likely heard that inflation is running hot throughout the United States and other major economies. Elevated pricing pressures formed in a near-perfect storm of conditions that existed either before, during, or after the global pandemic. The primary factors boil down to the prolonged period of low to negative interest rates, historic money printing, supply chain disruptions due to labor and geopolitics, and energy markets on edge due to Russia’s invasion of neighboring Ukraine. In the U.S. these factors have pushed consumer inflation to its highest level in decades, with the CPI for Q1-2022 averaging 7.97% year-over-year—far above the U.S. federal reserve stated target of 2% to 3%. In response, the Federal reserve has pivoted from ‘transitory’ inflation to full-on inflation-fighting mode, and that brings us to the pain we are currently witnessing in global markets. 

Higher Rates

Since the financial crisis of 2008, central banks throughout the world had been using a variety of monetary tools aimed at creating loose economic conditions such as low rates, and quantitative easing aka bond-buying. This near-decade-long period of loose monetary policies quickly became an issue when governments started printing historic sums of money in response to the 2020 pandemic. Until recently, the result was a calm and rising stock market, but now central banks are peddling the other way and instead of providing liquidity to the global economy they are slowly turning off the spigot.

It officially kicked off in March of 2022 when the U.S. Federal Reserve increased rates by 25 basis points (or a quarter of 1%), marking the first rate hike since December 2018. Looking to May, the Federal Reserve has hinted at hikes as large as 50 basis points. On top of this, the U.S. central bank is looking to taper off its massive balance sheet by ending bond purchases and allowing existing bonds to roll off its balance sheet and not reinvest the funds. All of this creates an environment of declining liquidity.

A Shifting Environment

Higher interest rates are the primary tool of the Fed to rein in inflation, however, it’s a balancing act to avoid pressing too hard and dipping the economy into a recession ie a hard landing. Over the last 13 rate hike cycles in the U.S., the Federal Reserve has only managed a soft-landing (increasing rates without hurting the economy) 3 times, while causing a hard landing 10 times. Though the odds are not in our favor, we can’t let that stop us from putting our money to work. Instead, we need to adjust our strategy to maximize the probability of success. 

Bond Pain

Over the last 30-years, stocks and bonds have been largely negatively correlated and thus bonds provided a perfect dance partner for stocks. However, as highlighted by the below chart, the last 30-years have been marked by an unprecedented decline in interest rates, and accommodative bond-buying action by central banks whenever the markets sense turmoil. Since 1992 the yield on the U.S. 10-year has steadily declined from 7.32% to a low of 0.55% in July 2020. Since July of 2020, rates on the 10-year have sky-rocketed to just shy of 3% causing the havoc we’ve seen in bonds.

Given the fact that central banks are actively working against liquidity, we cannot expect the same benefit from bonds. Broadening our view of stocks and bonds to the last 100-years shows several instances where bonds and stocks both experienced pain at the same time, serving the 60/40 portfolio plenty of pain. 

Growth Stocks Hammered

Earlier we mentioned that the S&P 500 was down 10%, however, that only tells part of the story. Digging deeper, we see wide dispersion in returns among different types of stocks year-to-date. Dividing stocks broadly into either value or growth stocks allows us to truly appreciate the difference in returns. At a high level, growth stocks have been beaten down while value stocks have held steady or even increased.

The below chart shows that the difference in year-to-date returns between value and growth stocks is night and day. Value stocks overall are down just 1.2%, as measured by Vanguard’s Value ETF VTV and shown by the black line. On the other side, growth stocks are down 19% as measured by Vanguards Growth ETF VUG and shown by the blue line.  

The bear market in growth stocks has compressed the S&P 500 PE ratio from its 10-year high of 39.26 set in December of 2020 to 21.59 as of April 2022. Despite the carnage, there are clear lessons to be learned. 

How To Invest

The Setup

By now it should be clear that what worked over the last 10-15 years might not work as well in the next 10-15 years as the role of central banks throughout the world tapper off liquidity. What to do? Well if growth prospered and value lagged over a period marked by historic levels of liquidity, then the opposite may be true as liquidity retreats. The previous charts of value and growth stocks show in real-time the impacts of shrinking liquidity as investors are forced once again to evaluate the price they are paying for each marginal dollar of corporate earnings and the stability of those earnings. The below chart shows the relationship between VUG and VTV over the last 5-years with rolling 3-year Bollinger Bands, and we see that up until recently growth was vastly outperforming value. But investing is about looking forward, and the chart suggests that we can be in the middle of a market shift to where growth taking a backseat to value.  

The Trade

The recent divergence in performance emphasizes the importance of having a well-diversified portfolio at all times and avoiding becoming too heavy in either growth or value stocks. That said, going forward it may pay to have a value tilt to your portfolio as the relationship between growth and value mean reverts. Now given the recent horrid performance of growth compared to value, it may pay to slowly shift the balance towards value and accelerate following a period where growth jumps up and value stays steady as we saw in March 2022. 

As an example, if you were invested in 80% growth and 20% value, it may be beneficial to shift closer to a 50/50 mix between growth and value stocks—if at all possible, it would be best to do this not by selling the beaten-down growth stocks, but by investing new funds into value holdings. If you are using M1 Finance (which I recommend that you do), you can quickly achieve a more balanced portfolio by updating your pie to say 50% VUG and 50% VTV. If you wanted to bet a little heavier on this stat arb opportunity, you can tilt more towards value than growth—but I don’t recommend straying too far. 

Alternatively, if you are smart and already invested in a broadly diversified ETF like SPY or VIT but you want to increase your exposure to value stocks, you can do so by allocating a small percentage of your portfolio to VTV or RPV (both great value ETFs). For example, if you were 100% VTI (or SPY, VOO, etc.) you can shift to be 90% VTI and 10% VTV. This would modestly increase your exposure to value while still allowing you to keep an overall balanced portfolio. 

The Bottom Line

As central banks shift from being a tailwind to markets to being a headwind, investors must reassess their current strategies to reflect the shifting environment. If you were a high-growth-orientated investor, the recent carnage in growth stocks has hopefully inspired you to consider adding some value holdings to your portfolio, and hopefully, this article has shown you how you can easily add some value via Vanguard Value ETF VTV. 

Alternatively, if you were already riding a robust and diverse portfolio using ETFs like VTI, VOO, or SPY, there is no real need to stop doing what you are doing. Continuing to dollar cost average and taking advantage of the 10% retreat in equities is a fantastic idea, however, if you want to add some value tilt you can do that easily and in a diversified manner with a small allocation to VTV, RPV, or even SCHD. 

The single most important thing you can keep doing during this and other market downturns is to keep investing and to invest in a method that fits your goals and personality. Tools such as M1 Finance make it easy for you to create a portfolio that matches you and allows you to stay invested through the ups and downs of the markets. Over time, the discipline to withstand the storms is what will have the greatest impact on your financial success. 

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Main photo by Oren Elbaz on Unsplash