Main Thesis & Background
The purpose of this article is to evaluate the Vanguard Growth ETF (NYSEARCA:VUG) – and the growth theme more broadly – as an investment option given the macro-climate. Specifically, VUG is a passive growth-oriented ETF with an objective that “seeks to track the performance of the CRSP US Large Cap Growth Index”. What this means in practice is that VUG is quite top-heavy with some of the largest US companies, namely those in the Tech sector.
This is an area I got very bullish on at the mid-point of the year. I saw a lot of merit in going “risk-on” at that time. Suffice to say, I was absolutely correct with this assessment:
With this outside gain, I figured it was time to do another review of VUG as we are about to enter a fresh calendar year. Simply put, this has been a winning play this year, but I have some concerns in the short-term. Growth in particular is getting quite pricey and I believe a downgrade to “hold” makes sense so that readers aren’t inclined to chase profits at these levels. I will explain why I feel this way in detail below.
High On Mag 7 Means Valuation High Too
Right off the bat the primary concern I have with VUG is the valuation. This should not come as a surprise given its run this year – and can be extended to other Tech-heavy indices (such as the NASDAQ 100 and the S&P 500 as well).
Much of this is driven by the “Mag Seven” includes NVIDIA (NVDA), Apple (AAPL), Alphabet (GOOGL), Microsoft (MSFT), Amazon (AMZN), Meta Platforms (META), and Tesla (TSLA). Readers are surely aware that this basket of stocks has greatly out-performed the rest of the market in 2023 and have been the source of much of the gains in the large-cap US index (the S&P 500). By extension, they have been a substantial reason for VUG’s “alpha”. These seven stocks represent a whooping of 50% VUG’s portfolio:
Clearly, what has been good for the “Mag 7” has been good for VUG. This has been great for holders of the fund and could easily be the case going in to 2024 as well. I will not deny that momentum plays like large-cap US stocks can out-perform for a while. Readers should be cognizant that remaining long these stocks (or VUG) could certainly bring about plenty of rewards in the new year. Remember, there is risk to being out of the market just as there is risk to being in it. So keep that in mind, as I am bringing this up to manage expectations. Just because I am downgrading my outlook – which I believe is prudent – does not mean I am an outright “bear” on this strategy.
That said, why do I believe in prudence here? As mentioned above, it is the valuation aspect. As the Mag 7 has soared, so too has the forward P/E for this category. The net result is the P/E is high in both isolation and compared to the rest of the large-cap US stock market:
I think it should be clear from this graphic why some moderation is required. I honestly couldn’t look at this type of divergence and say with a straight face that growth funds – which are heavy with the Mag 7 – need to be bought at these levels. Can VUG go higher from here? Of course. But nothing goes up in a straight line, not even U.S. growth stocks. This dynamic tells me that a better buying opportunity is likely to come along compared to where the market sits right now.
Are There Viable Alternatives? Yes
So growth stocks look expensive. That is clear to me and is probably fairly clear to most investors. It is just a matter if you are willing to pay the price based on your own personal forward outlook. That is a subjective decision and one where there is no true “right” or “wrong” – it is dependent on personal circumstances and risk tolerance.
But I believe VUG looks pricey at these levels. While an important consideration, the next question is – what can I buy instead? Are there are viable options out there that aren’t expensive?
Fortunately, the answer is yes. One place to start is dividend paying stocks. Those with a “high” dividend objective actually look particularly attractive by comparison at the moment. This is due to the growth/S&P 500’s out-performance in 2023, combined with above-average dividend payers getting hit by rising interest rates courtesy of the Federal Reserve. The net result is that the spread between the basket of high dividend payers versus the S&P 500 is historically very wide:
In my view this makes dividend payers – especially those with a “high” dividend objective – look attractive right now. While this category tends to usually be cheaper than the S&P 500 (which is both Tech and Growth heavy), the gap right now is tough to ignore. The bottom-line for me is that investors have options, so chasing the momentum in growth is not a requirement now.
**Readers can find a host of ETFs (aside from individual securities) that pay “high” dividends. Some popular funds include the iShares Core High Dividend ETF (HDV), the SPDR Portfolio S&P 500 High Dividend ETF (SPYD), the Invesco S&P 500 High Dividend Low Volatility ETF (SPHD), and the iShares Select Dividend ETF (DVY).
Inflation Is A Key Risk
Another factor to consider is that much of VUG’s gains have come at a time when inflation has been cooling. This has led to a surge in “risk-on” stocks, while simultaneously boosting bond prices. The net result has been a win-win scenario for investors across both stocks and equities. While something we can all enjoy, it is not likely to last forever.
This brings me to a key risk facing growth investing at the present time. While inflation has cooled, so too has the Fed paused on interest rate hikes. Expanding on that, the Fed has even suggested the possibility of rate cuts in 2024. This is something the market has welcomed with open arms, and has been responsible for driving some of the gains in the short-term. This is because high growth stocks tend to perform while during a low inflation, low interest rate environment. So, for many investors, the forward outlook in 2024 looks bright for the underlying companies in VUG. This explains the double-digit gain since June.
This begs the question – why do I have any concerns? The main thing is I believe markets are now priced for perfection (or close enough to it!). But inflation’s decline has started to level-off and come to a more sustainable percentage, in my opinion. This is true for three different inflation gauges that are popular with investors and economists:
What I am driving at here is that inflation’s decline and the potential for a more dovish Fed in 2024 have begun to get priced in already. So there looks to be more downside than upside in my view if things don’t end up panning out as planned. For example, if inflation has leveled off, or even increases again, that exposes funds like VUG to some rapid volatility.
Similarly, this will prevent the Fed from cutting rates under most scenarios and likely cause the market to give back some of the gains we have seen to end the year. If that happens – and I reiterate that there is a chance it might not – then the strategies most prone to a sell-off would be the ones that rallied leading up to the hope for a Fed pivot. A fund like VUG is precisely the type that would be at risk. This is a central concern I have that balances out some of the otherwise bullish indicators that I see in the market today.
Index Levels Look Familiar
My final point has to do with the broader market as a whole, but it is still relevant to VUG because this ETF trends very closely with two major indices – the NASDAQ 100 and the S&P 500. Given that each index is top-heavy with the same stocks that VUG owns, this makes a lot of sense:
As you can see, while performance does differ, they all are fairly correlated in that they move up and down at roughly the same time. The difference is in the size of the move, which is important, but it still shows the impact of the Mag 7 in all three options.
My concern here is that “stocks” are simply expensive right now if we are buying large-cap growth or tech. Whether you are buying the NASDAQ 100, the S&P 500, or VUG, you are buying many of the same underlying companies and these companies are pushing these benchmarks towards all-time highs. While this can be positive for momentum traders, these levels are strikingly similar to where we ended 2021. In case you don’t remember, investing at that time wouldn’t have worked out too well:
I will say again I am not trying to be alarmist. I don’t see a short-term scenario where VUG drops by 20% like it did at one point in 2022. That would be a bold prediction to make and I don’t believe it is likely if the Fed does follow through on a dovish course of action.
However, when I see all-time highs getting hit, it makes logical sense to me to get more cautious. That’s what it comes down to with VUG at these levels. The recent run-up has been great, so why not sit back and enjoy those gains without chasing more for the time being? With the fund at historic levels and plenty of headwinds on the horizon (i.e. geo-political risks, inflation, Fed inaction, a recession) I see a lot of merit to holding steady rather than buying.
VUG has been a big winner in 2023 and I want to protect those gains. Rather than amplifying my risk-reward proposition here, I think being prudent will open up a better buy-in opportunity at some point in the beginning of the new year. While I could be wrong, that is a risk I am willing to take because markets seem priced for perfection right now. As a result, I am downgrading my rating to “hold” and I urge my followers to approach this fund very selectively going forward.