The Starting Gun Just Fired

Steve's note: We want to profit from today's Melt Up... and prepare for the Melt Down. In fact, my colleagues Dan Ferris and Mike Barrett say we're on the verge of a profound shift in the markets, where a specific group of stocks will see incredible outperformance for the first time in years. Read on to make sure you're ready...


The starting gun just fired for the new "Golden Age of Value"...

As my good friend and Extreme Value editor Dan Ferris noted on Saturday in DailyWealth, the key turning point happened last month. From the issue...

Earlier this week, the folks at The Market Ear – a blog about the markets – published a series of charts labeled "reversal in everything." The feeling of carnage was palpable...

Value stocks – as measured by the Russell 1000 Value Index – gained 3.3% in September. Meanwhile, growth stocks – as measured by the Russell 1000 Growth Index – were essentially flat in that span.

In other words, fresh investment capital is finally flowing out of growth stocks – the best performers over the past decade – and into value stocks. As a result, "boring" businesses that investors have long neglected will offer some of the best investment opportunities over the next year.

Today, I will explain why the rotation from growth to value is happening – and how you can profit...

Before I get into the details, I must be clear about what I mean by "growth" and "value."

In this essay, I'll use two exchange-traded funds ("ETFs") to represent the two groups of stocks – the Vanguard Mega Cap Growth Fund (MGK), and the Vanguard Mega Cap Value Fund (MGV).

Well-known companies like online-retail king Amazon (AMZN), streaming company Netflix (NFLX), and mobile-payments leader PayPal (PYPL) are all growth stocks. The growth-stock universe includes businesses that grow their earnings per share ("EPS") at breakneck speed... Often, their EPS growth is between 20% to 50% per year.

When companies grow earnings at such high rates, it means they're enjoying strong demand for their products and services. So they keep the pedal to the metal, reinvesting rising earnings back into the business to grow further.

On the other hand, the value-stock universe includes businesses that grow their earnings at or near the rate of the broader U.S. economy. Today, MGV's EPS growth rate is just 2.3%... in line with the broader U.S. economy during the second quarter of this year.

MGV's top holdings include consumer-goods titan Procter & Gamble (PG), telecom giant Verizon (VZ), and beverage icon Coca-Cola (KO).

These companies have fewer growth opportunities to reinvest in, so they typically use their free cash flow ("FCF") to pay higher dividends. (Regular readers know FCF is the money left over after a company pays its operating expenses and capital expenditures.) That's why MGV's 2.8% dividend yield is two and a half times more than MGK's 1.1% yield.

Growth stocks have outperformed value stocks over the past decade, but the gap is closing...

You can see what I mean when you compare the total returns of MGK and MGV. Take a look at their performances over four different time periods...

No one reading this essay should be surprised that growth stocks trounced value stocks over the past decade... After all, big-cap technology darlings Amazon and Netflix are up roughly 2,000% and 4,000%, respectively, in that span.

But if you look closer at the previous table, you'll notice that MGK hasn't outperformed MGV by as much in recent years.

Most of MGK's outperformance happened at the beginning of this cycle. Over the past year, the returns of MGK and MGV have been essentially the same.

Capital is moving back into value stocks for a good reason...

We've seen a period of slowing earnings growth across the market so far this year. The EPS for all the companies in the benchmark S&P 500 Index has declined in each of the past two quarters.

Market-data firm FactSet estimates that the S&P 500 could see a year-over-year EPS decline of 3.8% in the third quarter. That's much worse than the 0.6% decline in the second quarter.

And as you can see in the following chart, this deceleration is even more pronounced with some of the market's top growth stocks. Take a look...

Despite this, growth-stock valuations remain stubbornly high today. Investors continue to give these stocks the benefit of the doubt.

However, if the shift toward lower EPS growth continues, know this... It's only a matter of time before investors abruptly adjust those sky-high valuations downward.

That means massive declines could be in the cards for many over-loved, over-owned growth stocks.

A stock trading at 100 times earnings can fall a lot further than one trading at 15 times. Many high-flying growth stocks – like Pets.com and eToys.com – didn't survive the dot-com collapse from 2000 to 2002. Others made it through, but have yet to return to their 2000 highs.

On the other hand, value stocks like manufacturer 3M (MMM) and consumer-goods giant Johnson & Johnson (JNJ) quickly recovered. Today, these stocks have returned about 315% and 280%, respectively, from their lows in October 2002. (In Extreme Value, Dan and I recommended Johnson & Johnson about nine years ago. Our position is up 159% since then.)

Now, that doesn't mean you should load up on shares of 3M and Johnson & Johnson to protect yourself from the next big bear market.

But owning slower-growing, boring value stocks can help you outperform when growth is broadly decelerating.

Tomorrow, I'll show you why even if EPS growth bounces back from the current downtrend, value will still outperform growth in the coming years...

Good investing,

Mike Barrett

Editor's note: As the "Golden Age of Value" takes hold, some of the most popular stocks out there could suffer terrible declines. But thanks to the huge change that took place in September, you can ride out the volatility, and even profit. Best of all, Mike and Dan have found the top three stocks that are poised to win big in the shift to value... Get the full details here.

Further Reading

"It's the 'Fear Factor IPO' market, where investors have to buy into crazy new stocks," Dan writes. "Those who require profits are labeled cowards." Learn more about this craze – and what it means for the future of the market – right here.

"I believe it's high time we turned back to the long-term investment strategies that have lagged lately," Dan says. Get the details on his plan for investing in today's market here: Two Investing Strategies for the 'Swift, Strong, and Wise.'

Market Notes
A CLASSIC 'BAD TO LESS BAD' RALLY FROM THIS ELECTRONICS GIANT

Today’s chart shows a big-name company that moved past some bad news…

As regular readers know, you can make impressive gains when the market unfairly punishes a stock. Savvy investors can make big gains even if shares only return to normal. Steve calls this approach “bad to less bad” trading. Today, we have a perfect example…

With a market cap above $1 trillion, Apple (AAPL) is one of the world’s most valuable companies. And many folks love its Mac computers… its iPad tablets… and, most of all, its iPhone smartphones. So when iPhone sales missed expectations last year, investors quickly fled. But the latest model’s lower starting price and new features have brought customers flocking back… And recent reports say Apple will increase its iPhone production by as much as 10% as a result.

Investors are quickly returning to Apple as well… Shares are up about 60% from their January lows, recovering to a new 52-week high. While they’re still below their all-time highs, folks who bought early this year have seen massive gains as Apple got “less bad”…