The relationship between the yields on short- and long-term bonds is normalizing after being more topsy-turvy earlier in the year. That’s a positive signal for the economy, and it that means select groups of stocks will benefit.
The “yield curve” is a term to describe the difference between the yields on short- and long-term bonds. Normally, the longer-term yields are higher to compensate bond investors for the risk of inflation over time, so the yield curve would reflect a positive number. But right now, longer-term yields are below short-term yields. That’s because the Federal Reserve has lifted short-term interest rates to cool economic demand and the rate of inflation.
The yield on the
10-year Treasury
is at about 4.51%, while the
2-year Treasury yield
is at about 5.07%. That’s a negative 0.56% differential for the yield curve.
The difference was even steeper earlier this year. In early March, the yield curve hit a low of just over negative 1%. Since then, the bond market has gotten more optimistic that economic demand may not sink that much over the long-term.
To be sure, concerns about the economy aren’t completely going away, but the 10-year yield has risen substantially in the past several months. After all, many areas of the economy have recently seen growth since the same time last year, and the recession that people had been taking about hasn’t arrived.
In this scenario, value stocks are likely to perform well enough, as long as the yield curve continues to improve. Value companies are more mature in their life cycles, so their profits are more influenced by changes in economic demand. In contrast, high-growth firms are still scaling their businesses, so their financial results are more influenced by the rate of adoption of their products and services.
Already, the
Vanguard S&P 500 Value Index
exchange-traded fund (ticker: VOOV) has performed decently, gaining just over 2% since early March, while the
Russell 2000 Growth Index
down is a touch since then.
“While yield curves are biased steeper…being long value…will make sense,” writes 22V Research’s Dennis DeBusschere.
Still, there are some growth stocks that are worth owning for the long-term even if value also rallies. The good ones aren’t the smaller, less profitable ones on the Russell 2000. Those stocks are risky because some of the companies may still need to raise money and borrow at an elevated cost. Those stocks also trade at high price-to-sales multiples, some close to 10 times sales, so they’re vulnerable to large drops.
Larger “growth at a reasonable price,” or “GARP stocks,” are better bets, DeBusschere says.
These GARP stocks are companies that are not only profitable already, but they’re still growing earnings faster than the average company. It isn’t likely that the real economic growth that would accompany an improving yield curve would be much higher than low single digits in the next few years, according to FactSet, so some GARP stocks can still perform even better than some value stocks.
Netflix
(NFLX) is an example that fits the description. It’s still seeing streaming adoption internationally, and it’s adding advertising into some subscription plans at home. It should expand profit margins as sales increase, and analysts forecast annual earnings per share growth of about 23% over the next three years. It trades at just under five times sales estimates for the next 12 months.
Alphabet
(GOOGL) is another example. It’s seeing higher cloud adoption with the advent of artificial intelligence. It’s is also using AI in advertising, where it could raise ad rates as the platform drives better results for brands. Analysts are looking for 10% annual sales growth for the next three years and low teens EPS growth. The stock trades at about five times sales.
Both tech stocks are up more than 20% since early March.
The market has become a tricky one to navigate. All of these stocks have a strong shot to perform well over the next few years.
Write to Jacob Sonenshine at [email protected]
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