Market Extra: Value stocks were poised for glory in 2023, then it all slipped away as AI euphoria took over. Here’s what to expect next.

The seven stocks were on pace to log annual advances of between 48% and 210% on the year so far, fueled by expectations that the Federal Reserve is done raising interest rates to curb inflation and amid continued investor enthusiasm about AI. 

Similarly, the Russell 3000 Growth Index
XX:RAG,
which tracks Russell 3000
RUA
companies with higher price-to-book ratios and higher forecasted growth values, has jumped nearly 34% so far in 2023.

It has outpaced the Russell 3000 Value Index
XX:RAV,
which includes stocks with lower price-to-book ratios and lower expected growth potential, by nearly 30 percentage points, which would mark the largest yearly outperformance for growth stocks since 2020, according to Dow Jones Market Data.

The price-to-book ratio is a way to gauge if a stock is overpriced or undervalued. It measures a company’s value, based on its stock price, relative to its book value, or what would be left if a company’s assets were liquidated and debts repaid.

A short time ago, things looked different. In 2022, the Russell 3000 Value Index outpaced the Growth Index by nearly 20 percentage points, the largest outperformance on record based on data back to 2000, according to Dow Jones Market Data.

That was largely because the 2022 bear market handed growth stocks their worst calendar year in decades, driven by the Fed’s sharp interest-rate hikes, recession fears and other headwinds, including Russia’s invasion of Ukraine.

“In 2022, you had rates going up significantly, so any long-duration ‘growth-y’ type asset that is not promising cash flow till far off in the future was severely discounted,” said Mark Travis, president and chief executive at Intrepid Capital. 

Value stocks, however, can offer a higher dividend relative to the S&P 500
SPX,
and allow investors a way to avoid “exorbitant price-earnings multiples,” he said.

Value stocks usually trade at a lower market price than what the company’s fundamentals, such as earnings, dividends and operating costs, may otherwise indicate. 

“What a value stock is trying to do is to give people exposure to the equity market without the volatility that comes with a long-duration instrument,” Travis said.

Until the past 15 years, value also had a record of outperforming growth, when looking from 1970 to the 2007-2008 global financial crisis. But growth stocks prevailed from 2008 until the 2020 pandemic, which prompted central banks worldwide to cut interest rates to historic lows in an effort to revive their economies.

Many central banks also expanded their balance sheets, effectively flooding financial markets with “cheap money,” until a spike in U.S. inflation to a 40-year high led to tighter monetary policies. After the Fed began raising interest rates in March 2022, it increased borrowing costs and weighed on corporate earnings.

“The growth component was, you could buy almost anything that promised you something way off in the future, whether that’s a bond or a stock, from basically 2010 to 2020 — that game is now over,” Travis told MarketWatch via phone on Wednesday. 

But that hasn’t necessarily been the case in 2023. Even with the Fed’s policy rate being held at 22-year high, technology growth stocks have been setting up for a strong finish. 

See: Investors beware: ‘Magnificent Seven’ are starting to resemble ‘Nifty 50’ stocks that got crushed in the 1970s market crash

Still, Nicholas Colas, co-founder at DataTrek Research, said the relative performance of U.S. growth and value stocks may remain volatile in 2024 since there are “high levels of uncertainty” around economic growth, monetary policy and long-term interest rates. 

“Recent trailing 100-day price returns suggest no reason to slant a large-cap portfolio towards either growth or value as we start 2024, but small-cap value looks overextended,” Colas said in a Wednesday note. 

The chart below shows increased volatility between growth and value stocks since 2020:

Meanwhile, the short-run cost to portfolio performance of getting the “value/growth trade” wrong has doubled since 2020 in both U.S. large and small caps, Colas said.

“Many investors tilt their portfolios in one direction or another, so they should prepare for another year of wondering if their style will prevail over any given 4–5 month period,” he said, but adding that there isn’t a compelling reason to choose between large-cap value and growth stocks in early 2024. 

U.S. stocks finished lower on Wednesday with the S&P 500 and the Dow Jones Industrial Average
DJIA
posting their third straight sessions of losses. The Nasdaq Composite
COMP
finished 0.6% lower.