Does relative strength favor low or high P/E stocks? Today, we answer that question while looking at the performance of different P/E groups over the last decade.
The debate between value and growth is an ever-important dynamic within markets, and investors have shown a clear preference towards growth areas in the last 2.5 years. Since the start of 2023, the Vanguard Growth ETF (VUG) is up 108% while the Vanguard Value ETF (VTV) is up only 27%. This dynamic has continued in 2025, as VUG is up 8% compared to 5.4% for VTV. The growth versus value debate is often looked at by fundamental analysts through the lens of price to earnings (P/E) ratios. While NDW usually approaches markets from a relative strength perspective, we don’t discount the validity of fundamentals. We like to say that using both fundamental and technical analysis is like playing a piano with both hands, as the result will hopefully be better than using just one alone. Higher valuations typically imply better growth prospects while lower valuations could be viewed as trading at a potential discount. To see the interaction between relative strength and valuations, we split the S&P 500 into five baskets (quintiles) depending on their forward P/E ratio entering each year since 2015 (excluding companies acquired intra-year).
Currently, stocks in the highest P/E ratio group are up an average of 4.18% this year, outpacing the lowest P/E group average by just under 1%. However, the two groups have taken an interesting path to get where they are. January and February saw relatively balanced returns between the groups before low P/E stocks outperformed by a wider margin in March. The second quarter saw a rebound in favor of high P/E stocks, driven largely by the 6.7% outperformance over the lowest P/E stocks in April. Interestingly, low P/E stocks have outperformed in both June and July even with the market setting new all-time highs.
In addition to looking at the group’s performance, we can use relative strength to quantify which areas are most in favor. The market is currently showing a preference for higher valuation stocks, especially at the ends of the spectrum. The high valuation group has an average TA score of 3.33, which is 60% higher than the 2.05 average score for the lowest valuation stocks. Long-term participation is also notably stronger for the most expensive valuation group, with 80% of names trading in a positive trend compared to 51% for the lowest P/E group. Broadly speaking, relative strength supports the notion that buyers prefer high valuation stocks for the time being. Although, shorter-term indicators such as the percent on a buy signal (BP) or above their 10-week moving average (TW) are relatively even among the groups.
While looking at the strength of different valuations may assist with determining favorable stock characteristics, it can also shed light on what type of market environment we’re in. In theory, higher P/E stocks outperform in a rising market with a strong economic outlook. Meanwhile, lower P/E stocks should outperform more in a defensive environment. The last decade has followed that dynamic in some regards, as 2020 and 2023 were strong years for all stocks, but especially for those with high P/Es. Meanwhile, the 2022 bear market saw high P/E stocks plummet while low valuation stocks held up much better than the rest of the market. However, some years don’t necessarily align with the trend, as down years like 2015 and 2018 saw some underperformance from low P/E stocks. The relative performance of higher P/E stocks matches with the performance of growth names that year, as VUG outperformed VTV in both 2015 and 2018.
Given that high P/E stocks currently hold the most relative strength on average, we can take that as a potential sign of confidence in domestic equities, especially within growth areas. This aligns with many of the risk-on relative strength developments in the last several months, as well as domestic equities’ return to #1 in DALI and a core percentile rank above 99 percent.
While it may be tempting to take the discount on low P/E stocks, doing so has been a losing strategy in recent history, underperforming even in two of the three down years studied. Value seeking is just one approach to investing, and it will go through periods of both underperformance and outperformance. Most of the last decade was not kind to the approach but there’s always the possibility it comes back into favor over the next decade. The benefit of using a relative strength approach is that it systematically identifies what is most in favor, allowing investors to take advantage of both growth and value environments.
