Value stocks are at a crossroads after years of underperformance. Exchange-traded funds (ETFs) focused on stocks that historically have been underpriced relative to their fundamentals are seeing a resurgence of inflows while their higher-growth momentum counterparts start to lag, suggesting a major reversal in investor preferences is underway, according to a recent story in the Wall Street Journal

“We are trading what we think are the early stages of a reversal, and watching out for a bigger reversal that can last for many years,” said Hugo Rogers, who oversees $5 billion as chief investment strategist at Deltec International Group. 

What it Means for Investors

One of the biggest value-focused ETFs tracked by FactSet passed $50 billion in assets under management last month, a record, and gained 4.9% over the month of September. Meanwhile, the S&P 500 rose just 1.7% and one of the biggest momentum-focused ETFs fell 1.1% over the same period. Some of the big, momentum-driven technology stocks like Netflix Inc. (NFLX) and Facebook Inc. (FB) are showing signs of weakness having underperformed over the past month.

The divergence in performance between value and momentum reached its widest level since 2010 in September as value stocks outperformed momentum stocks, indicated head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch Savita Subramanian in a recent report. She added that since 1986, whenever the negative correlation between value and momentum has been as wide as it is now, value has outperformed 77% of the time over the following 250 days, according to Barron’s.

Key Takeaways

  • Value outperforms higher-growth momentum stocks in September.
  • Divergence in performance hit widest level in nearly 10 years.
  • PE-ratio spreads between value and growth at widest level since 2001.
  • Growth stocks suffering from overcrowding.

Lisa Shalett, chief investment office of Morgan Stanley Wealth Management, also sees “a massive rotation away from growth-style factors toward value-style” is underway. She believes part of the reason for the shift may be technical, with investors unwinding positions in overcrowded growth stocks.

The spread between the trailing price-to-earnings ratio (PE ratio) of growth and value stocks on the Russell 1000 Index has not been as wide as it is now since the dot-com crash of 2001, according to TCW Group Inc.’s Diane Jaffee, who oversees a $3.7 billion value-focused fund. The fund has received a spike in inquiries from pension and endowment funds.

Wolfe Research recently found that momentum stocks haven’t been this widely held since 2016. As a result, investors my have concluded these stocks are overcrowded and are rotating out of them before a chaotic selloff.

Looking Ahead

To be sure, Subramanian says that two key catalysts are needed for value outperformance to continue—a recovering economy and a acceleration of corporate profit growth. She and many bulls are optimistic that the economy and profits will start to pick up early next year. If that fails to happen, value stocks could return to their status as perennial losers.