Calls for the impending collapse of growth equities, particularly tech stocks, are getting louder as the market marches higher and the share of the biggest tech players grows larger. Recent investor concerns have focused on frenzied retail trading, high trading volume generally, and the dramatic rise in valuations since late March.
I agree that valuations among the tech leaders are at expensive levels relative to their history. I also concede that the growth segment of the market has taken on some speculative characteristics of late. However, what to do about it is another matter entirely. Go into cash at 0%? Rotate into bonds yielding 60 basis points? Move into more defensive equity sectors? Shift from growth- to value-style investing?
My answer is to not wholesale exit the market, but rather to reassess equity exposures and seek to balance portfolio risk in light of current conditions. This may mean, among other things, reducing your growth-stock exposure somewhat and selectively increasing your stake in value stocks. In today’s environment, I believe there are many strong value-oriented companies that may be attractively priced because they have been unfairly punished along with weaker cyclical companies.
That being said, overall, I continue to favor growth stocks over value stocks for the medium to longer term. Why? In my view, growth-driven companies should continue to garner a premium in a low-growth, low-yield world post-COVID-19.
Tech still has legs…
Figure 1 highlights that tech-stock valuations, while indeed lofty by historical standards, may not be quite as rich as they appear. Price/earnings (P/E) ratios have lagged the appreciation in the tech index because earnings have been so strong. In short, the technology sector has thrived in the era of COVID-19 and (I believe) is likely to continue to post strong earnings going forward due to ongoing structural demand for data, storage, cloud computing, e-commerce, and artificial intelligence.
…but is not without risks
But investors should be cognizant of the risks associated with the sector. For example, regulation continues to loom over the high-profile mega-cap names and will likely remain a source of headlines. Higher interest rates, while not likely anytime soon, could also trigger a correction (as falling rates have been a driver of elevated tech-stock valuations). Even without these headwinds, the tech sector could still experience a near-term correction following its unprecedented rise this year.
I would suggest three actions for investors to consider taking now:
- Stay long tech, but less long: In terms of risk management, trim tech exposure, but remain overweight the sector.
- Balance your equity “style” risk: Rotate some of that growth exposure to value to better balance portfolio risk.
- Seek out industrial leaders: Look for reasonably valued industrial companies with resilient top-line growth, strong margins and free cash flow, and the power to take market share from rivals.
What’s the main risk? If the economy’s nascent recovery falters amid a global resurgence of COVID-19, a deeper, longer recession could ensue, potentially taking equities down with the broader economy. In that case, I would expect “safe” assets like government bonds and higher-quality credit to fare well, while value-oriented equities would likely struggle more than their growth-oriented counterparts.