Is a Growth Stock Crash Imminent?

For the past 13.5 months, investors have been witness to history on Wall Street. Following the fastest bear-market decline of at least 30% on record, investors have had a front-row seat to the greatest bounce-back rally of all time.

Since the iconic Dow Jones Industrial Average, benchmark S&P 500 (SNPINDEX: ^GSPC), and tech-focused Nasdaq Composite bottomed out on March 23, 2020, they’ve respectively gained 84%, 86%, and 95%. In all three instances, growth stocks have led the charge.

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The market owes a significant portion of its gains to growth stocks

The environment has been perfect for growth stocks to thrive for more than a decade. For one, lending rates have been heading lower for years, which has rolled out the red carpet for fast-paced companies to borrow at cheap rates. Taking on debt has allowed fast-paced companies to hire, innovate, or make acquisitions. In Apple‘s case, it allowed the company to buy back a boatload of its own stock.

The nation’s central bank has remained especially accommodative, too. The Federal Reserve has pledged to keep its federal funds target rate at or near historic lows through at least next year, and it’s continued its ongoing bond-buying program for the time being. Since bond prices and bond yields have an inverse relationship, buying long-term Treasury bonds should weigh on yields, thus keeping borrowing rates well below historic norms.

Nowadays, even Capitol Hill is viewed as a positive for growth stocks. Putting aside the possibility of higher corporate tax rates, the Biden administration’s multiple trillion-dollar spending packages designed to buoy workers and the U.S. economy are an open invitation for growth stocks to thrive.

Yet, despite all of this good news, we could be on the verge of an imminent crash in growth stocks.

Image source: Getty Images.

Get ready for the great growth stock crash of 2021

Over the long run, history is one of the greatest allies for investors. It tells us that if we buy great companies and hang on to them for long periods of time, we have a very good chance at building wealth. That’s because the broader market indexes all eventually erase crashes and corrections and head higher.

However, history can also be the enemy of the major indexes, as well as growth stocks.

Back in 2016, Bank of America/Merrill Lynch released a report that compared the average annual performance of growth stocks to value stocks over the very long term (1926-2015). Over this 90-year period, BofA/Merrill Lynch found that value outperformed growth in nearly three out of every five years. Whereas growth stocks averaged a perfectly respectable annual return of 12.6% over nine decades, value stocks generated an even more impressive 17% average annual return.

What’s more, value stocks have a knack for performing best during the early stages of an economic recovery, which is where we are right now.

More concerning data can be found in the S&P 500’s Shiller price-to-earnings (P/E) ratio. The Shiller P/E ratio takes into account inflation-adjusted earnings over the previous 10 years.

As of May 11, the Shiller P/E for the benchmark S&P 500 was north of 37, or well over double the 150-year average. What’s more concerning is that in the previous four instances where the Shiller P/E ratio has crossed above 30 and sustained that level, the index has subsequently declined by a minimum of 20%. Growth stocks are most definitely responsible for these lofty valuation ratios.

Image source: Getty Images.

Go shopping, but temper your expectations

To reiterate, history is the friend of the investment community. If your goal is to buy into innovative businesses to hold for a long period of time, a potential crash in growth stocks is nothing to fear. If anything, it could be the perfect opportunity to go shopping. However, with history telling us that value stocks are the long-term outperformer and the clear winner during economic recoveries, it’d be best to temper your return expectations.

As a perfect example, take a closer look at cloud data warehousing company Snowflake (NYSE: SNOW). Snowflake was an exceptionally popular initial public offering that rocketed out of the gate well above its list price last year. It’s growing at a faster pace than most other software-as-a-service stocks, and it offers identifiable competitive advantages that make it attractive.

For instance, it shuns subscriptions in favor of a pay-as-you-go billing platform. Businesses are therefore able to pay for data storage based on how much they use. Being built atop the most popular cloud storage infrastructure services also allows its clients to easily share cloud-stored data, even when they’re housed on competing platforms.

Then again, Snowflake isn’t anywhere close to being profitable. What’s more, it’s been halved since hitting an all-time high, yet is still valued at a whopping 53 times forecast full-year sales for fiscal 2022. This is the type of company that can be a long-term winner for investors but is probably going to be a near-term underperformer.

There are a lot of “Snowflakes” out there right now, which means investors are going to have to keep their near-term expectations realistic and focus on winning the long game.

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Bank of America is an advertising partner of The Ascent, a Motley Fool company. Sean Williams owns shares of Bank of America. The Motley Fool owns shares of and recommends Apple and Snowflake Inc. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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