Risk Appetite Making a Comeback

Stocks just wrapped up another positive week to close at their best level in over a month. It’s still unclear whether the lows set on June 16 will turn out to be the bottom of this bear market, but some investors are clearly betting that’s the case. Risk appetite is attempting a comeback.

If the value of a stock is the present value of all its future cash flows, then the stock of a company that will grow future cash flows at an above-average rate should be worth more. That’s the essence of investing’s growth factor – it focuses on stocks that are expected to rapidly grow earnings, but those stocks tend to be expensive. If above-average growth rates fail to materialize, though, the higher price is no longer justified, presenting investors with considerable downside risk as valuation multiples correct. Value stocks, on the other hand, tend to be viewed as the ‘safer’ option – their earnings may not be growing rapidly, but they do have less variability. The value factor is one bird in the hand versus growth’s two in the bush.

During times of economic stress, growth companies’ earnings targets come under pressure, and the group tends to lag. That’s what’s happened in 2022. Since November, value stocks have outperformed growth by more than 15% as investors have shunned expensive stocks with lofty expectations in favor of cheaper ones whose futures offer more certainty.

Now growth is coming back into fashion. Relative to Value, the S&P 500 Growth index is back above its spring 2021 lows, an important level of support that was broken earlier this year.

The relationship between Consumer Discretionary and Consumer Staples has similar characteristics. Earnings trajectories for Discretionary companies are tied to economic strength, Staples less so – you’re probably not getting a new car during a recession, but you’re still going to the grocery store and buying toothpaste.

So when macro headwinds appear on the horizon, it’s not uncommon to see the Consumer Discretionary sector underperform and Staples outperform like has happened this year.

Those trends are trying to reverse. Compared to the S&P 500 index, Discretionary stocks had been consolidating below resistance for months. With the ratio clearly in a downtrend, the consolidation should have resolved lower. Discretionary railed instead.

And while Discretionary was breaking through resistance, Staples was getting rejected by it. How’s that for risk appetite?

Some of the biggest and growthiest stocks in the world are set to report second quarter earnings this week (along with roughly a third of all large cap stocks). Their results might reverse the recent strength.

Or perhaps they’ll be gasoline on the fire that is risk appetite.

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