The Federal Reserve unveiled its interest rate tightening program earlier this month, prompting some investors to speculate that downside for equities is on the way.
That’s not necessarily the case, particularly if investors know how to allocate against rising rate backdrops. An idea to consider is value equities and the related exchange traded funds, including the Invesco S&P 500 Pure Value ETF (RPV).
“There is some evidence that value stocks perform well when interest rates and inflation are high. Value stocks outperformed their growth counterparts by almost 10 percentage points per year during the 1970s,” notes Morningstar analyst Daniel Sotiroff.
RPV, which follows the S&P 500® Pure Value Index, is living up to that billing. The Invesco ETF is higher by 7.63% year-to-date, trouncing broader equity benchmarks while residing near all-time highs. A major reason why value stocks are beating growth rivals this year is that the longer-dated cash flows of many growth companies become less appealing as rates rise.
Translation: When discount rates are low, growth stocks are more attractive. As discount rates trend higher, value stocks become more appealing.
Another reason is that dividends are more readily associated with value names than growth fare. RPV sports a dividend yield of 1.61%. Plenty of the fund’s 124 components yield in excess of that, and many offer sturdy payout growth potential.
“Dividends are pulled to the present by accounting for a stock’s discount rate, or its expected rate of return. Interest rates are an input into stocks’ discount rates, which are a combination of a risk-free interest rate and an equity risk premium,” adds Sotiroff.
An interest point about RPV’s recent bullishness is that many investors overestimate the impact of higher interest rates on financial services stocks. In fact, that sector often declines immediately following rate hikes. Those stocks represent 31.74% of RPV’s roster. For now, this time is proving to be different, as the S&P 500 Financial Services Index is higher by 5.71% over the past month.
Investors considering RPV today may want to ponder the point that rates, historically, aren’t the sole determinant of value’s fortunes.
“Th ere does not appear to be a link between interest-rate changes and the advantage conferred to value or growth. The Russell 1000 Value Index outperformed the Russell 1000 Growth Index when interest rates dropped between November 2000 and August 2003,” concludes Sotiroff. “It also outperformed in the rising interest-rate environment between June 2004 and July 2006. The growth index outperformed in the latter two periods, regardless of the direction interest rates moved.”
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.