Despite a long run of underperformance, the time may be at hand for value stocks to overtake growth stocks and reclaim market leadership. Over the last three years alone, the iShares Russell 1000 Growth ETF (NYSEMKT:IWF) has soared at a 21% annualized clip, while the iShares Russell 1000 Value ETF (NYSEMKT:IWD) has risen only 2.5% each year. That gap has grown even wider in 2020, with large cap growth stocks outperforming their value counterparts by 32 percentage points, while small cap growth has beaten small value by nearly 25 percentage points.

As an investor, you need to determine why growth has beaten value, and whether the tide will turn.

What's in an index?

Tech titans like Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) have been driving markets higher, with the Tech sector up 35% in 2020. Meanwhile, the Financials sector has fallen 6% year to date, while Energy has plummeted 33%.

Man looking at a glowing crystal ball to determine the future.

Image source: Getty Images

More than anything else, it is these sector differentials that have caused the performance gap between value and growth stocks. For instance, the top-performing Tech sector constitutes 44% of the iShares Russell 1000 Growth ETF,but only 9.5% of the iShares Russell 1000 Value ETF. Meanwhile, Financials stocks (at 19%) are the largest component of the Value Index. Beaten-down Energy and Real Estate stocks often fall under the value umbrella as well.

So, when deciding whether to rotate from growth to value, ask yourself: will Tech continue to lead the way? Or does a sector rotation lie ahead?

Sector rotation

Historically, different sectors have moved in and out of favor. The 1990's saw the dotcom boom as Tech and Telecomm soared to ridiculous heights. Not surprisingly, growth stocks trounced their value counterparts that decade. Things got so bad that famous value investors like hedge fund legend Julian Robertson threw in the towel on Tech. Even Warren Buffet's abilities were called into question, with some market watchers claiming his style was out of date.

That boom ended with a crash, and the tech-heavy NASDAQ 100 lost more than 75% of its value.As Tech stagnated, the 2000s saw Financials, Energy, and Real Estate companies soar on the back of record earnings. The result was a decade of outperformance for value.

But, as is so often the case, these leaders suffered disproportionally in the next bear market (the 2008 financial crisis), and market leadership shifted back to tech, which is where we are today.

Is it value's time to shine again?

Reversion to the mean is a powerful concept in financial markets, and it argues for a period of outperformance for value. Compelling valuations and a possible coronavirus vaccine make this argument even stronger.

By definition, value stocks should be less expensive than growth stocks, but the current differential is startling. The price-to-earnings ratio (P/E) of the iShares Russell 1000 Value ETF is 17, while the iShares Russell 1000 Growth ETF sports a hefty P/E of 40. Price-to-book ratios (12 for Growth, 2 for Value) and dividend yield (0.80% for Growth and 2.88% for Value) tell a similar story.

Given the challenges many value sectors face, it isn't surprising that relative valuations are compelling. However, there is even hope for improved performance.

  • Energy stocks have suffered with the decline in oil prices and fears of a world running on alternative fuel sources. But the reality is that the world needs fossil fuels for the foreseeable future. Plus, low oil prices mean fewer new projects have come online recently, bringing the balance of supply and demand into a more favorable range.
  • The Real Estate sector has seen the "death of retail" compounded by the coronavirus pandemic and the rise of remote working. But as a vaccine gets distributed, more workers will return to their offices, more consumers will shop at retail stores, and more diners will visit restaurants.
  • The sudden economic collapse last spring could have been catastrophic for the Financials industry, but government support prevented worst-case scenarios around loan losses. Banks are now fighting a headwind of ultra-low interest rates, so a return to normalcy could also benefit the Financials sector.

Ultimately, sector rotation probably depends upon economic improvement, which requires a widely distributed coronavirus vaccine. So, shifting from growth to value now is a bet on a return to a more normal world.

Last spring, savvy investors that looked at the pandemic's impact and shifted into growth stocks were well rewarded. It seems quite possible that those with the foresight to look around the bend and envision a post-pandemic world might be similarly rewarded now by making the move out of growth and back to value.