What’s behind the collapse of “growth stocks”
The term "growth stocks" is a bit of Wall Street jargon describing the companies getting clobbered the most in the markets this year.
Why it matters: We're not the language police — but using Wall Street's preferred nomenclature obscures some of what's actually happening in the markets.
- Basically, companies that soared during the pandemic rally, when interest rates plunged, have returned to Earth with a thud.
- And just as their huge surge didn't always have a heckuva a lot to do with a sudden change in their long-term prospects, their current collapse doesn't mean these kinds of companies are doomed either.
State of play: Tech-centric "growth" shares have gotten killed this year.
- The Nasdaq composite index is down 26%, versus the S&P 500's 18% loss.
- The Russell 1000 growth stock index is down 25%.
- Goldman Sachs' custom basket of "growth" stocks is down about 28%.
So, what exactly are growth stocks?
- Like many terms thrown around on Wall Street, there's no textbook definition, and the moniker is just as much marketing as anything else.
- "Growth stocks" is a catch-all covering a disparate group of shares, often tech- or health care-related, whose prices are far higher than you might expect based on the profits they produce. (They typically have high price-to-earnings ratios, in other words.)
The "growth" in growth stocks refers to revenue growth — which is usually higher than 20% per year — as opposed to profit growth.
- The idea is that investors are willing to pay a premium for "growth," meaning rapidly increasing sales numbers, on the expectation that, someday in the future, these sales turn into big profits.
- Translation: Many growth stocks are unprofitable.
But, but, but: Some of the most profitable companies — like Apple, Microsoft and Amazon — are also often categorized as growth stocks.
Flashback: Broadly speaking, all these stocks did incredibly well during the pandemic shock.
- For example, between March 2020 — when stocks hit their pandemic low — and the end of last year, the Russell 1000 growth index was up roughly 130%, as was the Nasdaq composite.
- Sometimes, this was for good reason. As the pandemic hit, investors rushed to snap up shares of Amazon and Microsoft, whose massive web services businesses appeared tailor-made for the COVID era.
- Other smaller companies such as Zoom Video, Fastly and Shopify, benefited from being well positioned in the work-from-home economy. Simply put, they were trendy.
Zoom out: An underappreciated driver of the surge in growth stocks was the plunge in long-term interest rates that resulted from the government's reaction to the COVID crisis.
- Stocks with high price-to-earnings ratios — you might call those overvalued stocks, though Wall Street, again, prefers to call them "growth" — tend to be very sensitive to moves in interest rates.
- They soar when interest rates fall, and nosedive when rates rise — and this year we've had a massive move higher in rates.
- This year we've had a massive move in interest rates, as the 10-year Treasury note rose from about 1.50% to nearly 3.50%.
The bottom line: While there's nothing wrong with calling these kinds of companies "growth stocks," you could just as easily call them "overvalued stocks," "trendy stocks," or "stocks that go up when interest rates go down."
- That probably wouldn't make it easier for Wall Street to sell 'em to investors, though.