Because Markets Change

Last quarter, we looked at major market shifts between international and domestic markets in the last decade. This quarter, we’re examining another common market rotation between growth and value styles.

Growth & Value

Markets change. They don’t usually change as rapidly as they did in 2011, but they do change. Looking back, it’s fairly easy to identify distinct periods when certain areas of the market led other areas of the market.  Typically, these cycles of market leadership fall into one of three broad categories: international or domestic regions, small- or large-capitalizations, and growth or value styles.  The tech boom in the late 90s was part of a strong growth trend – and the tech bust was marked by a rotation back into a value trend. The rise of emerging markets in the mid-2000s was part of a six-year international cycle.  

Although market leadership rotates between these different areas of the market, major market cycles share certain characteristics. Through the example of growth and value leadership cycles over the past 35 years, we can learn more about market leadership cycles and how we can attempt to take advantage of these trends in our portfolios.

Market Cycles Last Years
Previous periods of growth or value leadership have lasted many years. Value led growth for nearly 10 years starting in 1977 and ending in 1986, despite a few short reversals. After some back and forth in the late-1980s, a strong growth trend developed in 1989 and lasted roughly four years. Then value took the lead for four years before growth dominated in a long six-year run.

These long lasting trends aren’t limited to growth and value rotations. Domestic and international cycles and small- and large-cap cycles also tend to last many years. The recent international trend lasted six years from 2002 to 2007.

Reversals are common  – even during the strongest leadership cycles. Although value outperformed growth for the seven years from 2000 through 2007, you can see that growth led briefly in 2003. Growth has led value since 2007, despite a brief reversal in 2008 when value led.

35 Years of Growth & Value Cycles

The chart tracks the three-year rolling returns of growth and value indexes from 1977-2012. Source: FundX

Cycles Happen Concurrently
Although we’ve focused specifically on growth and value cycles in this example, market leadership isn’t limited to just these two choices – and there are times when market leadership trends overlap. The chart shows that value outperformed growth from 2004 to2007, but the bigger trend during this period was internationals, as measured by the MSCI EAFE Index, which outperformed both domestic growth and value.  

Within growth and value, there are further classifications. There are different strategies and capitalizations. In this example of market leadership rotation, we looked at all capitalizations of growth and value, but there are periods when large-cap growth leads small-cap growth. The tech boom in the late 1990s, for example, was part of a large-cap growth trend.

Forecast or Follow Market Changes?
Although we know that markets change and these cycles last years, we still can’t know in advance what area of the market will lead next.  Although historically, growth has tended to outperform value in periods of advancing markets, market leadership doesn’t follow a set pattern. There is no way to forecast future market cycles. Some investors opt to hold both growth and value funds in their portfolios. This means that during the years when growth is leading, only part of that investor’s portfolio will participate in the growth trend. And when value is leading, only part of that investor’s portfolio will participate in the value cycle.

Our Upgrading strategy aims to take advantage of market leadership cycles. By investing in mutual funds and exchange traded funds (ETFs), we can easily change the portfolios of the FundX Upgrader Funds when markets change. When internationals were outperforming in the mid-2000s, the fund portfolios were invested in international funds.  As the international trend subsided, our fund portfolios sold out of international funds.

Recently, growth has begun to lead value and we’ve been led to buy more growth funds and ETFs. If the trend continues, we’ll gradually increase our exposure to growth, and if the market changes, we’ll change too.

Figures assume reinvestment of capital gains and dividends, but do not reflect sales charges or taxes, which would lower these figures. Past performance is no guarantee of future results. Historical performance represents index performance and does not reflect the performance of any FundX Upgrader Fund. Current performance of the FundX Upgrader Funds is available on page 22 .  Growth is shown using the MSCI US Investable Market Growth Index. This index represents the growth companies of the MSCI US Investable Market 2500 Index.  Value is shown using the MSCI US Investable Market Value Index.  This index represents the value companies of the MSCI US Investable Market 2500 Index. The MSCI EAFE Index (Morgan Stanley Capital International, Europe, AustralAsia and Far East) is an unmanaged index of over 1000 foreign common stock prices including the reinvestment of dividends. It is widely recognized as a benchmark for measuring the performance of international value funds.You cannot invest directly in an index. Growth stocks typically are more volatile than value stocks; however, value stocks have a lower expected growth rate in earnings and sales.