The S&P 500 is commonly viewed as a benchmark for the broader U.S. stock market due to its diverse composition. It tracks value stocks and growth stocks that represent the largest companies from all 11 market sectors. Last year, the S&P 500 dropped into a bear market as investors panicked about a possible recession, and the benchmark index is still 18% off its high.
But many growth stocks have fallen more sharply. In fact, the S&P 500 Growth Index -- which tracks the growth stocks in the index -- is currently down 28%, while the S&P 500 Value Index is down just 8%. Clearly, growth stocks tend to be more sensitive to economic changes, and the drawdown might get worse if inflation remains elevated or interest rates continue to climb. Here's what investors should know.
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Why growth stocks have fallen so sharply
Stocks are often valued based on future cash flows. Specifically, investors discount future cash flows back to their present value to determine a fair price for the stock today. But that approach involves guesswork. The evaluator must estimate the cash flow's growth rate over a certain time period, and that is especially tricky where growth stocks are concerned.
Why? Growth stocks, by definition, have the capacity to grow cash flows more quickly than value stocks, so they typically trade at much higher valuation multiples. Investors are willing to pay a higher price today for larger cash flows tomorrow.
But high inflation and rising interest rates throw a wrench into the calculation. While economic headwinds result in a lower cash-flow growth rate for growth stocks and value stocks alike, the fallout is worse for growth stocks.
Consider this example: Imagine a value stock growing free cash flow (FCF) at 10% annually and a growth stock growing FCF at 30% annually. If economic headwinds cut those growth rates in half, the impact is more profound for the growth stock.
Specifically, the growth stock would nearly quadruple its FCF at 30% annual growth over five years, but its FCF would only double at 15% annual growth during that time. Meanwhile, the value stock would increase its FCF by a factor of 1.6 at 10% annual growth over five years, and its FCF would increase by a factor of 1.3 at 5% annual growth during that time.
In plain English, growth stocks have been hit especially hard during the bear market because their valuations place more weight on future growth, but economic headwinds have called that future growth into question.
So, is it safe to invest in growth stocks right now?
History says the stock market and the economy will recover
High inflation and rising interest rates have already caused a slowdown in economic growth, and those headwinds have already taken a toll on corporate cash flows. In fact, S&P 500 earnings have decelerated sharply since mid-2021, and they actually declined in the fourth quarter of 2022.
But investors can find confidence in one indisputable fact: The U.S. economy and the S&P 500 have grown in value over time despite numerous recessions and bear markets, and there is no reason those trends should change.
More to the point, the S&P 500 Growth Index has recouped its losses from every past drawdown, and it has easily outperformed the broader S&P 500 over the last decade. In fact, the S&P 500 Growth Index is up 204% over the last 10 years, while the S&P 500 is up just 155%.
So, is it safe to invest in growth stocks right now? Yes, but only for risk-tolerant investors willing to buy and hold high-quality growth stocks for at least five years.
Economic uncertainty will likely make the market volatile in the near term, and that is especially true for growth stocks. But investors can reasonably expect growth stocks to outperform the market over the long term, and with many growth stocks trading at discounts to their historic valuations, now is an excellent time to buy.
