The economic worm is turning. A February 6th report from Goldman Sachs Portfolio Strategy Research highlights that growth stocks, which have been strong performers for some time now, are likely to slow down if not reverse in the near future.

GA analysts David J. Kostin and colleagues explain their perspective in the introduction to their report. “Investor preference for growth is also evident using our Revenue growth and ROE growth thematic baskets. Disappointing US economic data and tumbling sales and EPS growth estimates have led investors to perceive “growth” as scarce and bid for growth equities. High-growth stocks perform best when growth expectations are falling. Historical experience coupled with our above-trend 2015 US GDP growth forecast suggest the recent rally in growth stocks will soon reverse.”

Growth stocks have been rising on “wall of worry”

Growth Stocks

The GS report argues that the recent strong performance of growth stocks is related to investor concerns regarding the economy and profit growth. Kostin et al. note that some recent U.S. economic data, such as the fourth quarter GDP and the ISM manufacturing survey, have been downside surprises. They also point out that their U.S. MAP index of economic data surprises is currently at its lowest level since March 2014. The analysts say that as well as disappointing U.S. economic data, clients are worried about U.S. growth prospects because of uncertain GDP growth in Europe and Asia, very low oil prices, reduced capex from energy firms, and the strength of the dollar.

Growth Stocks

Kostin and team also highlight that analyst consensus is now calling for 0% S&P 500 sales growth in 2015, and that analysts have reduced revenue forecasts by 5% since October. Very low oil prices together with foreign exchange headwinds as well as pension charges have hurt fourth quarter earnings and blunted expectations for 2015.

Of note, downward sales growth revisions are led by energy (-23%) and materials (-5%). Ex-energy, S&P 500 sales growth expectations came down from 5% to 4%. The GS report notes: “For the first time since 2009, our GS top-down EPS growth forecast is above bottom-up consensus ($122 vs. $120). Consensus expects 5% EPS growth in 2015 due to a rise in margins compared with our 7% EPS growth forecast that assumes flat margins.”

Growth Stocks

Rally in growth stocks unlikely to continue

Historical data shows that high growth stocks lag the market over longer time periods. For example, the report notes that since 1980, “the average annualized return of the fastest-growing 20% of S&P 500 stocks is 12% vs. 15% for the equal-weighted S&P 500. High growth stocks have outpaced the S&P 500 in only 32% of 12-month periods.”

The GS analysts also note that in most cases high growth is accompanied by high valuation, which limits the  upside potential as an investment. Earlier GS research shows that most stocks ranking in the top 10% of EV/sales ratios lag the S&P 500 over 1-, 3-, and 5-year horizons, no matter what their realized growth (US Weekly Kickstart, March 7, 2014).

Growth Stocks

One rule of thumb is that growth stocks perform best when growth expectations are dropping. For example, the big freeze polar vortex held down economic growth during the first few months of 2014, and the GS Current Activity Indicator showed growth dropping off. At the same time, high growth stocks went on a tear, handily topping low growth by 750 bp between November and February.

Growth Stocks

However, history also shows that growth stock outperformance tends to stop after economic growth stabilizes. For example, in late February 2014, economic data and growth expectations were looking up, and high growth stocks fell off a cliff, lagging low growth peers by 650 bp in four weeks. Moreover, growth stocks did not recover these losses throughout the rest of the year.

Growth Stocks