In my January 20th, 2022, article on Seeking Alpha, I asserted that Value-focused ETFs, such as Vanguard Value ETF (VTV), were likely to be a better choice going forward than Growth-oriented ETFs, such as Vanguard Growth ETF (VUG).
Let’s look at how these two ETFs have done since that article appeared. Through July 31, 2022, VUG has returned -12.33%, while VTV has returned -4.58%, a plus 7.75% difference (both not annualized). (All returns cited in this article as charted on morningstar.com through July 2022.) We can assume that these two index fund returns closely resemble the average returns for the entire categories of Large Cap Growth and Large Cap Value funds, whether index ETFs or mutual funds or managed funds. Thus, so far, a good call, in spite of both categories not in positive territory.
But before I take a victory lap, let’s consider the following: Since 5/18/22, VUG has outperformed VTV +9.93 to +0.38. What’s going on here? Has Growth re-emerged to its over a decade-long leadership over Value? In fact, the entire market, as measured by an ETF such as Vanguard Total Stock Market (VTI) is up by 5.13% over the same period.
While two and a half months of returns can hardly be considered a long enough period to make such an assumption, we might be seeing a genuine turnaround, or, what investment professionals call a bear market rally, particularly for Growth funds. A bear market rally is a short-term uptrend within longer-term downturn, often called a sucker’s rally because the bear market doesn’t prove to be over.
What Some Important Research Shows
For years now, Fidelity Investments has been publishing research on where the US economy stands in the business cycle and how this affects different market sectors. The research assumes that the economy revolves through four identifiable stages of activity:
*Early Stage when emerging from a recession.
*Mid Stage marked by moderate growth.
*Late Stage when growth has reached a peak but starts slowing with inflation and interest rising and a tight labor market.
*Recession when growth contracts and interest rates may begin falling.
Where The Economy is Now
Growth began contracting in the first two quarters of 2022 with interest rates rising and a tight labor market. Although it is often difficult to exactly pinpoint the stage the economy falls in, especially near possible turning points, most would consider we entered the Late Stage of the economic cycle at the beginning of the year, as defined above. Interest rates are rising and unlikely to be anywhere near falling until perhaps 2023. Although there is some controversy, many experts, including Fed Chairman, think we are not in a recession.
During this Late Stage, as shown in the above link to the graphic representation, the Fidelity research suggests that the Energy sector is the single one most likely to outperform the overall market. This certainly has been true thus far this year. Secondary sectors typically showing a less consistent outperformance are Real Estate, Consumer Staples, and Utilities. The single sector most likely to underperform is Consumer Discretionary, with a secondary sector being Information Technology.
Here is how each of these sectors have performed year-to-date as measured by the Vanguard ETFs of the same name:
*Energy (VDC) +44.23
*Real Estate (VNQ) -13.63
*Consumer Staples (VDC) -3.10
*Utilities (VPU) +4.44
*Consumer Discretionary (VCR) -20.84
*Information Technology (VGT) -18.92
You can see the Fidelity research has been highly accurate in pinpointing which sectors have been the best and worst to own during the first half of 2022, with the possible exception of Real Estate.
According to Vanguard’s most recent portfolio breakdowns, the four sectors identified as outperforming the overall market by the Fidelity research in the Late Stage of the economic cycle compose 28.9% of VTV. The two sectors underperforming the overall market in the Late Stage of the economic cycle comprise fully 71% of VUG. On the other hand, VTV has only 10.66% of the worst performing sectors while VUG has only 6.71% of the best performing sectors. Neither fund has more than 3.25% in Real Estate making its performance inconsequential for either VUG or VTV.
The Fidelity research thus suggests that VUG’s heavy weighting in Information Technology (48.60%) and Consumer Discretionary (22.40%) may exert a significant drag on its return as long as we remain in the Late Stage with VTV better positioned for the stage than VUG.
Even once we enter the Recessionary stage, when interest rates may begin falling, the Fidelity research suggests that Consumer Staples may continue to outperform as compared to VUG along with Utilities, along with Health Care, which currently has a 21.4% position in VTV. However, Energy and Real Estate, along with Industrials, will likely be a relatively small drag on VTV.
For VUG, once we enter the Recessionary stage, Information Technology may continue to hurt returns, although Consumer Discretionary may neither help nor hinder its returns.
It appears that only once the economy begins to recover, following what many experts now assume will be an upcoming Recessionary stage, will the portfolio composition of a Growth fund such as VUG have a performance advantage over the typical Value fund, such as VTV. This may well be a long time in coming.
Suggestions for Action
Although the progression of stages of the economy may defy the precise order as implied by the Fidelity research (for example, assuming we are in the Late stage today, a recession may not necessarily follow if higher interest rates lead to a “soft landing” while avoiding a recession), this is not usually the case. Therefore, investors are better off assuming the cycle will proceed as defined over the longer term, ignoring short-term “blips” that may appear along the way.
While no economic and investment predictions can ever be completely relied upon, given the sound basis for the Fidelity research, investors may want to adjust their portfolios to more heavily weigh Value funds than Growth funds during the upcoming time periods ahead. This is consistent with the advice I have given in both my Jan. 20 article cited above and again in my Apr. 30th article.