By Mark Hulbert 

It's the conventional wisdom that growth stocks and value stocks go in and out of favor along with the market cycle: Growth shines in bull markets, especially in its latter stages, while value takes the lead in bear markets.

As plausible as this pattern appears to be, however, it has held up less than half the time over the past 90 years. This is especially important to keep in mind now, given widespread concern that the bull market may be coming to an end -- if it hasn't already. Investors should think twice before betting that value stocks will help protect them from the full brunt of a bear market.

Value stocks are those that are trading for the lowest prices relative to their underlying net worth. The metric most often used to determine where a stock falls on the value-growth spectrum is its ratio of price to per-share book value. Value stocks are those with the lowest such ratios, while growth stocks have the highest.

Current examples of value stocks within the S&P 500 include several in the energy sector, such as Baker Hughes, Loews Corp. and Mosaic Co., which produces phosphates and potash. The price-to-book ratios for these companies range from 0.87 to 0.94, according to FactSet, in contrast to a 3.16 price-to-book ratio for the S&P 500. Two stocks near the growth end of the spectrum, meanwhile, are Amazon.com and Netflix, both of which sport price-to-book ratios above 20.

No consistency

Since the 1920s, there has been no consistency in the relative performance of value and growth in either bull or bear markets.

In bear markets before 1970, for example, the 50% of stocks nearest the growth end of the spectrum outperformed the 50% at the value end by an annualized average of 3.8 percentage points. In the bear markets of the subsequent four decades, however, it was just the opposite, with value beating growth by an annualized average of 10.7 percentage points. The current decade appears to be reverting to the pre-1970 pattern, with value lagging behind growth in both the 2011 and 2015-16 bear markets. (These results are calculated using data from two professors, Eugene Fama at the University of Chicago Booth School of Business, and Kenneth French at the Tuck School of Business at Dartmouth College.)

As you can see from the accompanying chart, a similar picture of value and growth's relative performance emerges in bull markets as well. Value came out ahead of growth in bull markets up through the 1980s, but has been inconsistent since then. It is well behind growth in the bull market that began in March 2009, for example.

Why do so many persist in nevertheless believing that growth leads in bull markets and value in bear markets?

One reason is that memories of the internet-stock bubble are still fresh in many investors' minds. The internet stocks that soared in the late 1990s, during the inflation phase of that bubble, couldn't have been further away from the value end of the spectrum. From the beginning of 1997 through March 2000, the growth-stock category beat the value category by an annualized average of 7.7 percentage points. It was just the reverse during the bear market that was precipitated by the bursting of that bubble, with value stocks beating growth by an annualized average of 22.8 percentage points.

But, to repeat, value and growth's experience in the late 1990s and early 2000s is more the exception rather than the rule. So we're on shaky ground extrapolating its experience into the future.

So plausible

Another reason why many continue to believe that value leads in bear markets is because theories as to why this should be true are so plausible. A stock that is trading for a lower price relative to its intrinsic worth presumably is less likely to fall as far in a bear market than one that is trading for a high price. In a bull market, in contrast, growth stocks should come out ahead since investors are less worried about downside risk.

This belief has a long and distinguished history, tracing at least as far back as Benjamin Graham, author of the classic "The Intelligent Investor" and erstwhile mentor to Berkshire Hathaway Chief Executive Officer Warren Buffett. Graham famously argued that stocks trading for low enough prices relative to their net worth provide a "margin of safety" against a downturn.

What basis?

It is true that, before the 1970s, the average value stock had a much lower beta than the average growth stock. It therefore wasn't a particular surprise that value stocks fell by less in bear markets. But, since then, there have been significant periods in which value stocks had higher betas and, sure enough, that is when they fell by more than growth stocks during bear markets.

Right now, according to FactSet, there is hardly any difference in the average betas of growth and value stocks, as judged by the 50% of stocks within the S&P 500 with the highest price-to-book ratios and the 50% with the lowest. This suggests that both groups could easily fall by more or less the same amount in the next bear market.

The investment implication: If your current equity exposure level is higher than you can tolerate during a bear market, then you should reduce that exposure level now rather than hope that a shift to value stocks will lessen your losses.

I hasten to add that this discussion doesn't mean that you should avoid value stocks. There no doubt are many good reasons why such stocks might be compelling investments. The point of this discussion is more limited: Don't invest in value stocks in the hope they will be a good defensive strategy in a bear market.

Mr. Hulbert is the founder of the Hulbert Financial Digest and a senior columnist for MarketWatch. He can be reached at reports@wsj.com.

(END) Dow Jones Newswires

July 08, 2018 22:24 ET (02:24 GMT)