Growth stocks, neglected at the start of the year, are starting to get a bit of love from investors again.
The best returns in the Standard & Poor’s 500 index over the past month have been posted by technology companies. Industrial companies, as well as banks and insurers, are also performing better. By contrast, gains for utilities and consumer staples companies – safe-play stocks that had been investor favorites in the first three months of this year – have stalled.
It’s a change in tone in the rally that has pushed the market to record highs this year. Investors are getting more comfortable owning riskier stocks.
The gains for stocks early this year were driven by investors looking for so-called defensive stocks: big companies in steady industries which pay large dividends and aren’t as volatile as the overall market. Now, investors are favoring companies that have the best chance of increasing their profits as the economy expands.
After a period of subdued growth, investors are more optimistic that the economy is set to revive. If the economy is poised for an upturn, companies whose fortunes are more closely linked to growth should do better.
Technology stocks have gained 6.6 percent in the past month, the best performance of all the industry groups that make up the S&P 500. Utilities did the worst, falling 5.7 percent. The index as a whole rose 4.8 percent.
Here are some of the reasons behind the shift in investor sentiment:
It’s the Economy
Earlier this month, the government said that unemployment fell to a four-year low as hiring picked up. That was another piece of evidence pointing to better growth.
If investors believe that the economy will carry on improving, it makes sense for them to load up on the stocks of companies that will benefit most from accelerating growth.
Banks tend to perform better in a strong economy because demand for loans increases as companies borrow more to expand. Technology stocks and industrial companies also do better when other companies start to invest in new equipment. Airplane maker Boeing has gained 10.1 percent over the past month to $100.
“The thing that you want to buy in this economy is growth – wherever you can find it,” says Ron Sloan, a senior portfolio manager at Invesco.
High-Dividend Stocks Are Getting Pricey
After a long run-up, stocks that pay rich dividends have become expensive.
The price-earnings ratio, a measure used by investors to value stocks, has surged for utilities and consumer staples companies.
Investors were paying more than 19 times next year’s earnings over the past twelve months for utilities stocks at the end of April, the highest ratio in at least 10 years, according to FactSet data. The ratio for consumer staples companies, such as Proctor & Gamble and Wal-Mart Stores, rose as high as 18.
Those ratios compare with an average price-earnings ratio for S&P 500 companies of 15.7, which is slightly above the 10-year average for the index of 15.1.
While those valuations have fallen back slightly over the past month, they’re still higher than for companies that would benefit if the economy picks up. Investors are currently paying just 14.2 times earnings to buy financial stocks and 14.7 times earnings for technology stocks.
“The savvy investors that are doing this looked at valuations,” says Ron Florance, managing director of investment strategy at Wells Fargo Private Bank. “How much am I paying for economic opportunity?”
It’s better to invest in a company that has the potential to earn more money, and in turn increase its dividends, than to overpay for established dividend-payers, says Jim Morrow, a portfolio manager of Fidelity’s Equity Income Fund.
Financial and technology companies may not pay the biggest dividends right now, but they have large amounts of cash on their balance sheets. That means they are in a position to pay more money to shareholders.
Technology companies in the S&P 500 have $419 billion of cash on their balance sheets, accounting for about 40 percent of all cash held by S&P 500 companies, according to S&P Capital IQ Data.
“Give me a balance sheet that’s full of cash,” says Morrow.
Take Apple. The technology giant said April 23 that it would distribute $100 billion to its shareholders by 2015, some of it in the form of higher dividends.
Technology companies haven’t been the biggest dividend payers in the past. Currently, they pay average dividends of just 1.4 percent, but the trend is for higher payouts.
In 2004, tech companies in the S&P 500 paid just 0.3 percent. That trend is likely to continue as income-hungry investors put more pressure on companies to pay dividends.
Bond Yields Are Edging Higher
Rising interest rates are bad for stocks that pay big dividends. When long-term interest rates start to rise, bonds start looking attractive again to investors who are looking for income. That diminishes the appeal of defensive stocks.
Bond yields have risen this month on speculation that the Federal Reserve is considering easing back on its stimulus program as the economy improves. The Fed is currently spending $85 billion a month on buying bonds to push down interest rates.
The yield on the 10-year Treasury note rose to 2.03 percent on Wednesday, close to its highest level of the year, after minutes of the Fed’s meeting earlier this month showed that some policymakers favored cutting back on stimulus soon. The yield has climbed from 1.63 percent on May 3, its lowest of the year, before the April jobs report was published.
As yields have risen, the big dividend-paying stocks, utilities and telecommunication companies have fallen.
Hopeful Signs on Earnings
Another reason investors are starting to take a shine to technology stocks is that their earnings are showing signs of picking up.
Microsoft delivered solid results last month from its Office, software tools and Xbox divisions.
Google, the leader in internet search, raised prices for ads distributed to smartphones and tablet computers. The company’s stock climbed above $900 for the first time May 15.
Even the outlook for Hewlett-Packard is improving. The company’s stock surged 17 percent Wednesday after the struggling PC maker reported quarterly earnings that weren’t as bad as analysts had been expecting. That encouraged investors to believe that HP’s turnaround strategy may succeed.
The nascent rally in growth stocks may be short-lived if the economy fails to build on its performance in the first quarter, says Barry Knapp, head of equity strategy at Barclays Capital.
Barclays predicts that U.S. growth will slow to 1.5 percent in the second quarter, from 2.5 percent in the first quarter, as the economy is held back by government spending cuts.
“If it becomes clear that we’re growing at that sort of a rate in the second quarter, and we don’t see much of a pickup in the third quarter, I don’t really see how the cyclical names could continue their current bounce,” says Knapp.