After a period of recent gains, there is evidence investor sentiment is turning bullish on growth stocks again. But should you be or with economic data looking grim, were the last couple of months little more than a bear market rally before another drop?
Of course, nothing is set in stone and the relatively unique nature of current economic headwinds, which are not structural as is usually the case when stock markets crash, makes predictions dangerous. But as investors, we have to make some kind of attempt to keep likely scenarios in mind, even if it is simply to hedge against them.
Let’s examine the evidence around the question of whether it’s time for investors to get bullish again or not.
The first half of 2022 was a blood bath for growth stocks but has the storm broken?
It was an appalling first half of the year for equities investors, especially those most exposed to the kind of growth stocks that had powered the record bull market’s gains for over a decade. Inflation was already rising dangerously quickly as the global economy started to uncoiled itself out of pandemic conditions. It was then turbocharged by Russia’s invasion of Ukraine, which sent commodity prices, especially energy and food commodities, into a price spiral.
With inflation since hitting levels last seen in the 1970s, central banks were belatedly forced into responding with interest rate rises that many believe still have some way to go. Recent forecasts have suggested the BoE and Fed’s base rates could hit 4% next year with no obvious sign of inflation easing in the near term. The economic consensus is also for many of the world’s major economies, including the UK, USA and Europe, to slip into recession either towards the end of this year or next.
For now, a deep, prolonged recession is not expected. There are hopes that the geopolitical crisis in Ukraine might ease and if it doesn’t, the production of oil and gas increased elsewhere and supply lines adapted to get it where it needs to go in the world. Lower energy prices would take the edge off inflation even if grain prices remain high due to the disruption of exports out of Ukraine and Russia, which are both usually major suppliers to international markets.
Why are some investors bullish on growth stocks again?
This week it was reported that levels of bullishness among the subset of active, often shorter-term investors most focused on the growth-centric Nasdaq index canvassed by the Hulbert Nasdaq Newsletter Sentiment Index are high. Sentiment among the investor group tracked by the index, compiled by US analyst Mark Hulbert,  is not just bullish; it’s the most bullish it has ever been.
That particular group of adventurous investors are buying growth stocks again, confident the market has already turned a corner and is ready to head in a general upwards direction again.
Are bullish investors buying back into growth stocks jumping the gun?
However, the consensus view of mainstream analysts and investors, of the breed that usually has a 5-10 year investment horizon, is that the current bear market still has some distance to run. They are not yet ready to buy back into growth stocks with enthusiasm.
What can history tell us about if the recent rally can be sustained or is more likely to run out of steam and fall back into a bear trend?
The first obvious warning sign this 2022 summer bull market will prove a blip and give way to further declines is that rallies during a bear market are far from unusual. The last major stock market slump, in 2007-2009, featured seven major rallies. The dotcom crash of 2000-2003 featured six. Even a technical return to a bull market, defined as a gain of at least 20%, can be a temporary bear market rally.
In that context, it might well be optimistic to hope the second rally since the start of the 2022 bear market, with the first short-lived, marks a sustained return to a bull market environment. That’s especially the case when we consider how recently the market hit a long-term peak and that the evidence suggests inflation will not ease significantly in the near term or even this year.
Another indicator that it may well be too early for investors to fire up their bullish instincts is the history of valuation cycles, especially in the U.S. where most big growth stocks are listed. Over the last century or so, broad market cycles, referred to as secular cycles, have typically lasted around a decade or longer.
That’s put down to human psychology, which leads us into over-optimism when the going is good but equally means we can become overly pessimistic when things go wrong. The outcome for the stock market is long secular bull markets that drive prices to unsustainable levels followed by equally long bear markets when investors become overly cautious after being burnt.
In the early 1980s, at the start of the bull market that culminated in the dotcom crash of 2000, the average CAPE (cyclically adjusted price/earnings ratio) of S&P 500 consitituents was around 6. It peaked in 2000 at 43. Between 2009 and 2022, the longest bull market in history which recently ended, the average CAPE of S&P 500 companies rose from 12 to 38.
Right now the figure is around 28. If a similar pattern to previous bear markets plays out, the CAPE of growth stocks would be expected to fall by a good deal more before valuations become cheap enough to allow for a long-term upwards trend.
So should I wait before investing in growth stocks again?
Historical patterns offer investors invaluable information about how a current trend or cycle might play out. The stock market is famously cyclical. However, investing would be simple if it was as easy as spotting a cycle and playing it as an identical re-run of previous cycles.
There are always some differences between cycles and there are also always new patterns that haven’t been seen before or play out with variations in timing. And there are some unique factors influencing what is happening now.
The first is that we’ve seen a period of extended quantitative easing by central banks that stretches back two decades and has no obvious historical precedent. The second is that it’s difficult to tell how much the 2022 bear market is down to the hangover from the Covid-19 pandemic and a major war in Europe.
Inflation was already rising and may have become a serious problem anyway but we don’t know to what extent. It would have almost certainly been lower without a global pandemic followed by a war but guessing by how much is speculation.
We also don’t know exactly how long it will take for supply chains to be reset efficiently and for the war to stop driving up commodity prices.
Don’t try to time the market
All-in-all, investing with the assumption the worst of the 2022 bear market has already run its course seems a risky approach. But that doesn’t mean you shouldn’t be buying growth stocks at all. Even if stock markets fall further in the wake of recent gains, the smart money would be on them being considerably higher than current levels a few years from now.
That means that buying growth stocks now because you expect them to finish the year, or even next year, higher, would be a very risky bet. But buying them, or the growth stock-centric Nasdaq index for more diversified exposure, with the expectation that you will have realised a healthy return on investment several years from now, would be a perfectly reasonable approach.
Trying to time the market perfectly is usually an ill-advised approach. It is cyclical and patterns reoccur with impressive regularity but rarely with timing that is similar enough to bet on. Especially when this bear market has, as discussed, several unique qualities.
If your investment portfolio has a long-term horizon of around ten years or more, taking on exposure to growth stocks now may well work out even if they lose value in the short term. But with lower volatility a plus for long-term gains, it may not be a good idea to sell off defensive holdings just yet. And you don’t need to.
Dripping money into the growth sector rather than going all in on it offers a hedge against a faster return to a bull market than recent bear markets have managed. And if you have plenty of time to wait is relatively low risk. But doing so in anticipation of an imminent return to a sustained bull market would seem high risk.
