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Trouble Ahead for Growth Stocks?

- By John Engle

We are a month into 2019, but the year's outlook remains rather murky. A wavering Federal Reserve, mercurial (and divided) political leaders, trade war woes and signs of impending secular economic slowdown all contribute to an muddied, uncertain market in the year still ahead.

Despite the uncertainty, analysts at E-Trade Financial Corp. ( ETFC ) recently offered their market outlook. In a previous research note, we discussed one component of E-Trade's forecast: how economic policy could drive stock performance in 2019. But the brokerage firm's market outlook extends beyond the macro level. Indeed, it offers a few compelling ideas about what types of stocks investors should be focused on this year.

Large cap over small cap

E-Trade's forecast compares the relative fortunes of large cap and small cap stocks in 2018 and what last year's performance might signal for 2019. E-Trade comes down firmly in favor of large caps:

"At the onset of the current trade war, it was thought that tariffs would affect large, global firms more than small companies with US-focused operations. Nonetheless, small caps have underperformed large caps in 2018, and we appear to be late in the business cycle. If the economy slows, large caps could be better positioned to navigate more challenging long-term market conditions."

While more or less reasonable on a very surface-level basis, the argument that large global firms (generally large-cap stocks) would suffer inordinately worse during a trade war is somewhat lacking. Indeed, small caps, while not as globalized or international in their operations overall, tend to be buffeted by the same economics headwinds and have less scope for diversification -- or resources to ride out an economic storm.

Given all that, we are not terribly surprised that small caps underperformed in 2018. Therefore, we consider E-Trade's view that large caps may be better positioned to weather further troubles in 2019 to be reasonable, and far from counterintuitive.

Value over growth

E-Trade is on more solid footing when it addresses the relative merits of growth stock and value investing strategies. With economic storm clouds on the horizon, E-Trade recommends a retreat to value:

"Growth stocks have outperformed value shares for the better part of the past decade, including the past year. However, given the Fed's more restrictive monetary policy, it remains to be seen whether growth stocks can continue their pattern of dominance--especially since value stocks have the potential to outperform in more defensive environments that emphasize individual stock selection."

While growth stocks have enjoyed the boons of a decade of near-zero interest rates, tightening monetary policy and darkening economic prospects may take some of the air out of the zippiest growth companies.

We are all about value investing on this forum, but it is no secret that opportunities for true value plays have been increasingly scant in recent years. A bear market -- or simply a more normal secular bull market -- could reinvigorate the value strategy after spending years gathering dust.


2019 looks like it might prove to be an inflection point in the market cycle. Whether that means a recession, bear market, both, or neither remains to be seen. But what is clear is that volatility and uncertainty are back in force. E-Trade's guidance for the year reflects this situation quite aptly:

"While large-cap growth stocks led the bull run in previous years, in 2019 this could change if the market stops advancing in lockstep and assets become uncorrelated. In that environment, individual stock selection and a focus on company fundamentals could come to the forefront."

Making money in the market has been all too easy in recent years. That has bred complacence and led to softening of investors' strategic decision-making. The darker -- or at least more uncertain and volatile -- outlook for 2019 suggests that the days of easy returns are over.

Serious value investors should prepare for what lies ahead. As the wheel turns once more, it appears likely that value will once again be on the menu.

Disclosure: No positions.

This article first appeared on GuruFocus.