Gunning for Growth

Karyn Mccormack

Growth stocks are back in vogue.

Brian Gendreau, investment strategist for ING Investment Management points out in his most recent research note that the Russell 1000 growth index has risen by almost 7% since Apr. 20, when the S&P 500 index hit a low. Meanwhile, the Russell 1000 value index has risen 4.8% and the S&P 500 has gained 5.4% since that date. In fact, Gendreau says, growth stocks have been beating value stocks during the entire second quarter, reversing a trend that has lasted for most of the last five years.

This is not just a fluke, says Gendreau, who kindly sat with me this morning for a video interview. He argues that growth stocks will continue to beat value stocks, based on three indicators. First, the yield curve spread has been flattening, which is typical in economic expansions. The spread between the yield on 10-year and 2-year Treasury notes was recently around 44 basis points, down from a peak of 259 basis points in August, 2003, he notes. A narrowing of the yield curve spread has historically favored growth stocks, Gendreau says.

The second indicator is high capacity utilization. Though this measure of factory usage declined in April to 79.2%, it's above the low of 74.4% reached in December, 2000 (one month after the end of the last recession) and very close to the average value of 80.5%. Growth stocks usually outperform when capacity utilization has been high, Gendreau says.

The third sign is earnings yield. Gendreau says the trailing p-e ratio of the Russell 1000 value index is 17.2, while the p-e of the Russell 1000 growth index is 23.8. This puts the ratio of their earnings yield (value over growth) at 1.36, down considerably from its value at the end of 2004. He notes that while the earnings yield of the Russell 1000 value index has been rising, the earnings yield on the Russell 1000 growth index has been climbing even faster.

This implies that valuations of growth stocks have been getting more attractive, Gendreau explains. "In the past, growth stocks have outperformed when the ratio of earnings yields on value relative to growth have been low."

The bottom line, Gendreau says, is these indicators have been signaling a rotation into growth stocks for two months in a row, and point to the outperformance of growth for the first time since February, 2000.

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