Growth stocks aren’t selling off

Growth stocks aren’t selling off, but there’s a lot of misinformation out there that suggests they are. The misinformation stems from the performance of a small basket of stocks that are not doing well. We touched on this very group last month when he pointed out that a different kind of tech bubble had just burst. What we didn’t do in that article is proclaim that tech stocks would collapse, or that growth stocks were doomed. In fact, since we published that article, many indices that track growth stocks are either higher or flat.

So what’s going on? In a nutshell, here is what happened: software as a service (SaaS) became the hottest sub-sector in the broader tech market. This is quantified by the performance of PSJ & IGV, two ETFs that track the SaaS sector. Both ETFs rose 41% and 33%, respectively, from January 2019-July 2019. This compares to a 27% gain over the same period for QQQ, the ETF that tracks the NASDAQ 100. QQQ is generally regarded as the most well-known growth index because of its concentration in technology stocks.

Growth stocks are a segment, not a sector

Here is the key, SaaS happens to be classified as a growth sector. But this is because SaaS is a small part of the larger technology sector. And overall, the segment of the market that’s referred to as “growth” is made up largely of tech stocks. Said another way, all SaaS stocks are classified as technology stocks. But the majority of technology stocks are not classified as SaaS stocks. That’s why specialized sector funds like PSJ exist in the first place: to get niche exposure to a small slice of a larger market. Notice that QQQ, the largest technology fund by AUM in the world, and PSJ, own very few of the same stocks:

We should note here that PSJ only contains 31 stocks. The broader-based SaaS ETF, IGV, owns 94. However, even when comparing a more diversified SaaS ETF like IGV to our broader tech index, QQQ, we still see very few shared holdings:

What our critics say

At this point, critics of our argument will likely point to QQQ’s top-heavy structure as a flaw in our analysis. They will say that stocks like Apple and Google, along with a few others, make up more than 50% of the fund. And that this overweighting into just a handful of stocks is not a good representative of the technology sector as a whole. We agree with this argument against us, so instead let’s look at QQQE, an equal-weighted fund version of QQQ.

QQQE owns the exact same stocks as QQQ, but with one exception: all stocks are weighted the same. For example, Apple stock, which makes up 11% of QQQ, only makes up 1% in QQQE. This makes QQQE more diversified by weighting, and thus, is a better representative of the broader technology market as a whole.

Look at QQQ’s performance vs QQQE

We can compare QQQE’s performance to QQQ’s to see if perhaps the largest weighted stocks are covering up the weakness in smaller weighted stocks. For if that is the case, QQQE will underperform QQQ. From that underperformance, one could accurately make the blanket statement that “growth stocks” are selling off.

Yet the performance above shows very little difference between the two. Year to date, QQQ is up 24.26% versus 23.57% for QQQE. And since October started, when everyone is saying the sell-off in growth stocks accelerated, both QQQ and QQQE are higher. The truth is, growth stocks are not selling off. Better yet, growth stocks are actually rallying recently as measured by QQQ or QQQE. Even if we go back to July when SaaS stocks topped out, growth stocks as a whole have held up very well:

Software stocks are selling off

Since July, QQQ is flat and QQQE is down 1.75%. If that feels like a sell-off in growth stocks to you, then you either shouldn’t be in growth stocks or you’re not in a diversified group of growth stocks. Software stocks, as shown by IGV and PSJ, are down close to 10%. Moreover, IGV and PSJ have both fallen 5% in the last week, while QQQ and QQQE have rallied. So it is accurate to say that software stocks are selling off.

But you have to realize that the growth stock definition does not start and end with software stocks. In fact, it’s just the opposite. Software stocks make up a small portion of the growth stock market segment. And as we showed with the QQQ example, growth stocks as a whole are actually not doing much of anything recently. They had a great first six months of the year, and have essentially been flat since mid-July. Even if you run a comparison with a broader growth index like the Russell Mid-Cap Growth Index, you’ll see our point is still valid.

The role of allocation

Ultimately, what investors must be sure of, is that when they invest in growth stocks, they do so in a diversified manner. The growth stock market segment spans across multiple market caps and various sectors. ETFs like IGV and PSJ should be treated as niche allocations and not assume more than 2-4% of portfolio allocation. To get more efficient exposure to a more accurate definition of growth stocks, investors should consider funds like QQQ, QQQE, VBK, MDYG, IVF, IVW, and IWP. Investing in specialized sectors involves increased risks. And if that risk goes against you, it might feel like the whole market has turned. When in fact, it hasn’t.