The relationship between short and long-term bond yields is in the process of normalizing, signaling a positive outlook for the economy. This normalization has important implications for select groups of stocks.
Understanding the Yield Curve
The yield curve refers to the difference between short and long-term bond yields. Typically, longer-term yields are higher to account for the risk of inflation over time, resulting in a positive yield curve. However, the current yield curve scenario shows that long-term yields are lower than short-term yields. This is due to the Federal Reserve’s efforts to cool economic demand and control inflation by raising short-term interest rates.
Currently, the 10-year Treasury yield stands at approximately 4.51%, while the 2-year Treasury yield is at about 5.07%. This creates a negative differential of 0.56% for the yield curve.
Improvement in Yield Curve
The yield curve disparity was even more pronounced earlier in the year, reaching a low of just over negative 1% in early March. However, the bond market has since become more optimistic about the long-term economic outlook.
While concerns about the economy persist, the substantial rise in the 10-year yield over the past few months indicates growth in many sectors. Contrary to expectations, the anticipated recession has not materialized.
Value Stocks Expected to Thrive
Given the current scenario and ongoing improvement in the yield curve, value stocks are expected to perform well. Value companies, which are in a more mature stage of their life cycle, depend on changes in economic demand to drive their profits. On the other hand, high-growth firms are still focused on scaling their businesses, with their financial results primarily influenced by the rate of adoption of their products and services.
One example of a value-focused fund is the Vanguard S&P 500 Value Index exchange-traded fund (ticker: VOOV). Since early March, it has experienced decent gains of just over 2%. In contrast, the Russell 2000 Growth Index has seen a slight decline over the same period.
According to Dennis DeBusschere from 22V Research, given the current bias towards steeper yield curves, investing in value stocks makes logical sense.
Growth Stocks with Long-term Potential
There are several growth stocks that stand out as worthy long-term investments, even amidst a rallying value market. However, it’s important to note that the smaller, less profitable stocks in the Russell 2000 pose a greater risk. Some companies within this category may still require funding and borrow at high costs. Moreover, these stocks often trade at high price-to-sales multiples, making them susceptible to significant drops.
On the other hand, larger “growth at a reasonable price” (GARP) stocks present better opportunities, as shared by DeBusschere.
GARP stocks are not only profitable, but they also continue to experience higher earnings growth compared to the average company. Considering the projected low single-digit growth in the economy over the next few years, as reported by FactSet, some GARP stocks may outperform value stocks.
An excellent example fitting this description is Netflix (NFLX). Not only is the company witnessing increased international streaming adoption, but it’s also exploring advertising within its subscription plans. As sales increase, Netflix is expected to expand its profit margins. Analysts forecast an annual earnings per share growth of approximately 23% over the next three years. With a valuation of just under five times sales estimates for the next 12 months, Netflix offers promising potential.
Another tech giant worth mentioning is Alphabet (GOOGL). With the rise of artificial intelligence, Alphabet is experiencing increased adoption of its cloud services. Additionally, it leverages AI in advertising to drive better outcomes for brands, potentially leading to higher ad rates. Analysts anticipate a 10% annual sales growth over the next three years, accompanied by low double-digit EPS growth. Alphabet trades at around five times sales.
Both Netflix and Alphabet have seen remarkable growth of over 20% since early March.
Navigating the current market is challenging, but these stocks possess strong potential for impressive performance in the coming years.