Rate Regime and Value Rotation

Quick definition: The inverse relationship between interest rate levels and the relative performance of value versus growth stocks—a mechanical repricing effect where higher rates favor value stocks with near-term earnings while lower rates favor growth stocks with distant future earnings.

Key Takeaways

• Higher rates mechanically favor value. In a 5% rate environment, a dollar earned today is worth far more relative to a dollar earned in ten years than in a 1% rate environment. This mathematical repricing favors value stocks.
• Lower rates mechanically favor growth. As rates decline, distant future cash flows become more valuable. A growth stock's year-15 earnings become increasingly valuable in relative terms. This favors growth.
• This is not about fundamentals; it's pure math. The value outperformance in 2022 was not primarily because value company earnings improved; it was because the discount rate increased, repricing all cash flows.
• The regime is more important than stock selection. Picking individual cheap stocks matters far less than correctly forecasting the interest rate environment. An exceptional growth stock picks in a 1% rate world beats excellent value picks every time.
• Regime reversals are brutal for bet-sizing. A value investor confident in 4% rates building a concentrated portfolio will be decimated if rates fall to 2%. The mechanical repricing overwhelms fundamental strength.

The Present Value Formula

The foundation of this relationship is the present value of a future cash flow:

Present Value = Cash Flow / (1 + r)^n

Where r is the discount rate (related to the risk-free rate/interest rates) and n is the number of years in the future.

This formula explains everything about value/growth performance cycles. Consider two companies:

Value Co.: Expects to earn $10 per share next year and $11 per share five years from now. Most earnings are near-term.

Growth Co.: Expects to earn $1 per share next year but $15 per share five years from now. Most earnings are distant.

In a 1% interest rate regime:

• Value Co.'s near-term $10 earning is worth nearly as much in today's dollars as Growth Co.'s future $15 earning. Actually, discounting at 1%: Value's $10 next year is $9.90 today; Growth's $15 in 5 years is $14.28 today. But Growth Co. also has earnings beyond year 5, so Growth dominates.
• A growth investor is comfortable paying 30x earnings for Growth Co. because the discount rate is so low that distant earnings are very valuable today.
• Value Co., despite earning more in near-term, might trade at only 12x earnings because the market is obsessed with distant growth.

In a 5% interest rate regime:

• Value Co.'s near-term $10 earning is worth significantly more in present value relative to Growth Co.'s future $15 earning. Value's $10 next year is $9.52 today; Growth's $15 in 5 years is $11.74 today. The gap is smaller.
• A value investor is now comfortable paying 15x earnings for Value Co. because near-term earnings are more valuable.
• Growth Co. might trade at only 18x earnings because the discount rate has risen, making future cash flows less valuable today.
• The relative valuation dramatically favors Value Co.

The math is inexorable. When interest rates rise, the denominator in the present value calculation increases, depressing the relative value of distant cash flows. When rates fall, distant cash flows become more valuable in relative terms.

The Regime Shift of 2010-2021

For most of the 2010s and early 2020s, the interest rate regime was declining or flat-to-low. The Fed Funds Rate fell from 5% in 2006 to near-zero by 2009 and stayed there until 2022.

Given this rate environment, the mathematical repricing heavily favored growth stocks. An investor who believed that interest rates would stay low forever (or fall further) would rationally overweight growth and pay up for earnings in year 10 and beyond.

This is exactly what happened. Growth stocks accumulated outsized valuations—Nasdaq 100 companies trading at 20x, 25x, 30x forward earnings. Value stocks accumulated discounted valuations—Energy companies at 5x, Financial stocks at 8x, Utilities at 12x.

From a value investor's perspective, the situation was frustrating: they were theoretically right (value is cheap!), but they kept losing because the rate regime kept repricing in favor of growth. A value investor who bought oil stocks in 2015 at 8x earnings was right that they were cheap, but wrong about the timeline. Rates fell further; oil stocks stayed cheap for years. The value investor lost money not because the earnings didn't materialize, but because the multiple contracted further as rates fell.

The Regime Shift of 2022

In 2022, the regime inverted. The Fed raised rates aggressively from near-zero to 4.5%. The mathematical repricing was immediate and devastating to growth stocks.

A growth stock trading at 25x earnings at 1% rates might be reasonably valued at 18x earnings at 4.5% rates. If the market reprices it from 25x to 18x while the underlying earnings stay constant, the stock price falls 28%, and it's purely a discount rate effect, not a fundamental deterioration.

Simultaneously, value stocks benefited from the repricing. A value stock at 8x earnings suddenly looks more attractive at 4.5% rates. The near-term earnings are more valuable in present value terms. Valuations multiple might expand to 12x, representing a 50% capital gain with no fundamental improvement.

This is why 2022 was so violent: not because growth stocks' earnings collapsed (they didn't, much) or value stocks' earnings surged (they didn't, much), but because the discount rate changed, repricing everything mechanically.

Regime Dependency and Forecasting Risk

The challenge for both growth and value investors is that interest rate regimes are not easily predictable. A value investor who correctly identified that growth stocks were overvalued at 1% rates was still wrong if rates fell further. The repricing worked against them.

Conversely, a growth investor who loaded up on high-multiple growth stocks in 2019-2021 was right to do so given the rate environment—but was spectacularly wrong to hold them through the 2022 repricing. The rate environment inverted, and the repricing was devastating.

This creates a meta-problem: timing the rate regime is often harder than picking individual stocks. A value investor might identify the perfect deep-value stock at 0.4x book value, but if interest rates are falling, the relative performance of value will collapse, making the trade a loser overall.

This is why many successful investors focus on macro before micro. George Soros's philosophy was always to identify the big macro trade (currency devaluation, rate regime change, inflation shock) and then execute it through stock picking. Ray Dalio built Bridgewater on macro regime identification as the primary investment process.

The Limits of Rate Regime Analysis

However, there are limits to how mechanical the rate/value relationship is. Several factors complicate the pure mathematical relationship:

Quality and durability of earnings. A value stock with earnings that collapse in a recession, versus a growth stock with defensible recurring revenue, may not trade purely on discount rate mechanics. In a rising-rate environment that also causes recession, the growth stock might decline less than the pure math suggests.

Inflation dynamics. A rising-rate regime driven by inflation might structurally favor value stocks with pricing power beyond just the discount rate effect. Energy and materials can raise prices in inflationary regimes. This is a fundamental, not mechanical, advantage.

Multiple expansion/contraction A value stock at 8x earnings might not expand to 12x earnings just because rates rose. Market psychology, sentiment, and capital flows matter. The multiple might stay at 8x even if the "justified" multiple (based on discount rates) is 12x.

Risk premium changes. The discount rate isn't just the risk-free rate; it includes a risk premium that varies with market sentiment. In a risk-off environment, both growth and value stocks suffer as risk premiums widen. The value advantage might be muted.

The moral is: the rate regime is a powerful driver of relative performance, but not the only driver. Value investors who understand the rate mechanics get an edge in timing, but still need to be right on fundamentals.

Next

Explore the opportunities in international markets where value investors continue to find deep discounts: International Value Still Looks Cheap.

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See also: The 2022 Value Comeback — How the rate regime shift of 2022 created a historic value outperformance.