Value Stocks Have Hit Their Stride. What They Need Next.

A scene from the floor of the New York Stock Exchange this month. (ANGELA WEISS / AFP via Getty Images)

Key Points

• The Russell 2000 Value Index has risen almost 12% since late November, outperforming the Nasdaq’s 6% recovery.
• Lower rates are expected to boost economic activity, supporting value stocks. Demand for the goods and services those companies make is sensitive to the strength of the economy.
• Analysts project 36% aggregate annual earnings growth for value stocks over the next two years, compared with 22% for the Nasdaq.

Value stocks, now finally trouncing growth stocks, need a few things to go in their favor for the outperformance to continue.

The Russell 2000 Value Index , home to companies with smaller market capitalizations that trade at relatively low valuations, has been a laggard for years. It is up only 45% over the past five years, compared with nearly 90% for the technology-heavy Nasdaq Composite .

The main reason is that earnings at the large tech companies that are powering the emergence of artificial intelligence have increased spectacularly, and investors expect AI will bring more of the same. The shares of many less innovative firms have suffered because investors are worried that the economy is slowing down.

Lately, the tide has appeared to turn. The Russell 2000 Value Index is up almost 12% from the low point it hit in late November, when the whole market briefly declined, beating the Nasdaq’s 6% recovery.

Expectations that the Federal Reserve would cut interest rates, as it did on Wednesday, are the biggest factor behind that outperformance. While the Fed has made it clear it will monitor changes in economic data before making decisions, it could easily cut more next year, as long as the recent tariff-driven inflation eases and the job market remains fairly weak.

Lower rates would support spending by both consumers and businesses, lending strength to corporate sales and earnings. That matters more for value stocks than growth stocks because demand for the goods and services the value companies provide is more sensitive to the strength of the overall economy.

If economic data are such that the Fed talks about keeping rates steady, the value trade could give back some of its strong performance. But if the Fed continues to angle its commentary toward more cuts, the foundation for value-stock outperformance is still in place.

“Lower interest rates could drive an uptick in economic activity, positioning cyclical value equities to participate in the uptrend, creating more opportunities for investors,” write analysts at Turning Point Market Research.

For value to continue its strong performance, the economy will ultimately have to improve. The market understands that growth will look weak in the near term, given recent jobs data and the fact that economists expect growth in U.S. real gross domestic product to slow to an annual rate of 1% in the fourth quarter.

But the lower rates, and the potential for them to fall even more, are partly why economists expect a mild reacceleration of growth into the 2% area next year, according to Evercore data showing consensus estimates. Add in mild inflation and it is easy to see that annual sales at many companies could rise by percentages in the low to mid single digits for a couple of years.

Sales growth estimates from analysts covering companies in the value index point to 3% annual gains, in aggregate, over the next two years, according to FactSet. A healthy economy could make that estimate look a smidgen too low.

The growth could be enough to nudge net profit margins higher. Wages and salaries are growing a little faster than sales, but companies also have costs such as depreciation and interest that don’t change much, so revenue can still rise faster than overall expenses. Plus, interest expenses can fall if companies refinance their debt at lower rates.

Given that picture, analysts expect aggregate annual earnings growth of 36% for companies in the value-stock index over the coming two years, according to FactSet. That compares with 22% for the Nasdaq.

That means that if the market sees more evidence pointing to outsize growth for value names, it will bid value stocks higher.

The value index trades at just under 18 times the earnings expected for the coming 12 months, compared with just over 28 times for the Nasdaq. That is a slightly larger discount than the average over the past five years, according to Barron’s calculations using FactSet data. So if the value index’s earnings move significantly higher, the stocks could easily appreciate—and beat the Nasdaq.

Meanwhile, the Nasdaq isn’t helping itself right now. Near midday on Thursday, it was down 0.9% as disappointing financial guidance from Oracle sent that stock lower and weighed on other shares exposed to artificial intelligence.

Growth stocks could drop more if threats to the AI growth story crop up, as the market fears. All the more reason to bet on value.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com