Growth Begins to Outshine Value

11/09/2010 12:00 pm EST

Focus: MARKETS

Janet Brown

Editor, NoLoad Fund*X

Janet Brown, editor of NoLoad Fund*X, says growth companies have quietly been doing well, and their shares are starting to outperform value stocks.

September and October have historically been among the worst months for stocks, but there were no meltdowns this year. Instead, a powerful rally from the end of August lifted the broad Standard & Poor’s 500 and Dow Jones Industrial Average about 12%, and the tech-heavy Nasdaq Composite index surged 18%.

As the rally continued, the S&P 500 and the Dow enjoyed their best October since 2003, gaining 3.8% and 3.3%, respectively. For the month, the small-cap Russell 2000 rallied 4.1%, and the tech-oriented Nasdaq Composite, 5.9%. The DJ World Index, excluding the US, gained 3.4%.

Strong corporate earnings, expectation of continued [Federal Reserve] support, and good valuations have propelled stock indexes to near this year’s highs. The much anticipated QE2 is a second round of quantitative easing from the Federal Reserve. The Fed buying large amounts of US government debt (an estimated $600 billion—Editor) should hold down interest rates and may boost growth.

The economy is growing slowly, and consumer spending in the third quarter was the strongest in four years. Unfortunately, an economy growing at 2% isn’t strong enough to reduce unemployment.

Realistically, the challenges of slow growth and high unemployment will likely persist for some time regardless of election outcomes, but both positives (QE2) and negatives (weak economy and high unemployment) are already priced into stocks.

There are many good companies around the world that are doing well, and not all of them are growing profits merely from cost cutting. Innovation continues, and low borrowing costs have led to strong balance sheets for many companies.

The resurgence of growth could be a sign that investors’ appetite for risk has returned, or maybe investors simply find the challenges facing distressed companies less attractive.

As company earnings recover, part of the gains in distressed companies will need to go towards stabilizing balance sheets, while stronger companies are positioned to pass along earnings to shareholders.

Among core funds, several large-cap growth funds have muscled past value funds that had been dominant for the past three years. Technology, energy, and industrial companies were among the winning sectors last month.

Interest rates have started to rise a bit, but remain near historic lows. Bonds continue to hold an important position in most investors’ portfolios, but current low yields pose significant threats to investors who may have taken their fixed income allocation to an extreme.

With cash yielding zero and bond yields near historic lows, even investors [who] are still shell-shocked from the meltdown of 2008 and the dismal returns over the last decade must realize growth prospects. Regardless of near-term market direction, long-term investments should be at least partly invested in stocks, buffered by a diversified, flexible bond portfolio.

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