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Value stocks tend to beat growth stocks when inflation accelerates — but the usual explanation is completely flawed


There’s no way of knowing for sure why value stocks have suddenly built such a huge lead over growth stocks.

But we can fairly confidently say what was not the cause: Higher inflation.

This likely will come as a surprise, since the almost universally held belief is that higher inflation helps value stocks relative to growth stocks.

The rationale is that growth stocks’ valuations are disproportionately dependent on earnings further into the future. So when a higher inflation rate leads to higher interest and discount rates, the present value of future earnings correspondingly declines, and growth stocks suffer more than value stocks.

Recent data certainly appear to support this rationale. In the two months since late November, during which the CPI inflation gauge has soared to a 40-year high, the S&P 500 Value ETF VOOV, +1.53% has outperformed the S&P 500 Growth ETF VOOG, +3.35% by more than 13 percentage points. That’s an extraordinary spread for such a short period.

Richard Warr, a finance professor at North Carolina State University, doesn’t buy this rationale. In an interview, he said the argument is guilty of a fundamental mistake in economics known as “inflation illusion” — confusing nominal with real, or inflation-adjusted, values.

It’s important to pinpoint the precise source of this mistake. It’s not wrong, when inflation and interest rates rise, for investors to increase the discount rate used to calculate the present value of companies’ future years’ earnings. Instead, the error traces to the assumption that, at the same time, those future years’ earnings won’t themselves be higher in the higher-inflation environment.

That assumption is wrong, Warr said he has found from his research. In this regard I draw your attention to an otherwise inscrutable comment that Dow Inc.’s CEO, Jim Fitterling, made earlier this week. In commenting on Dow’s profit and sales coming in higher than Wall Street’s expectations, Fitterling said that investors should actually welcome inflation and interest rate increases. “Honestly, inflation has always been a positive for our business,” he said.

Note that inflation’s impact on nominal earnings and the discount rate at least somewhat cancel each other out: Earnings are likely to grow faster when inflation is higher, but they will be more heavily discounted when calculating their present value.

Warr’s analysis is of more than just academic interest. If higher inflation and interest rates aren’t the source of value’s opening up a big lead over growth, then you will need to focus on other factors when deciding whether to more heavily weight your portfolio to growth or value.

What might those other factors be? One possibility might be that investors are no longer counting on the Federal Reserve coming to their rescue in the event the stock market collapses. Though that guarantee has never been explicit, it was widely assumed to exist — known colloquially on Wall Street as the “Fed Put.” As my colleague Bill Watts pointed out earlier this week, investors recently have come to the conclusion that they can no longer count on the Fed Put.

That, in turn, has caused a market-wide reassessment of stocks’ risks, several money managers told me. One possible consequence of this reassessment, they furthermore argued, is that growth stocks will disproportionately suffer.

In any case, it’s worth remembering that value stocks on balance have hugely lagged growth stocks over the past 15 years. There have been other short-term stretches during this 15-year period in which value nevertheless outperformed growth, leading many value managers to prematurely declare victory. Whether or not the last two months will end up being another such stretch is an open question, the answer to which will come from elsewhere than the inflation data.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at

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