After a brief swoon in January and early February, the riskier end of the stock market is back in favor.
That includes small stocks, stocks badly hurt by the financial crisis and those most dependent on global economic growth. Safer stocks, including those that offer steady dividends, are out.
That wasn't the case between Jan. 19 and Feb. 8, when the Dow Jones Industrial Average fell 8% amid fears that the global recovery could stall.
Since then, the Dow is up 7%. And in most cases, investors are turning to the same stocks that led the market higher in last year's big rally.
"It seems like the lower-quality, smaller-sized names are taking the lead," says Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "We are getting a junk dominance again."
By a variety of measures, lower-quality stocks are out-gaining higher-quality stocks, says Paul Hickey, co-founder of Bespoke Investment Group in Harrison, N.Y.
"In the words of Oscar the Grouch," says Mr. Hickey, "the market 'loves trash.' "
He has ranked the quality of stocks in the Standard & Poor's 500-stock index based on their market size, price/earnings ratio and credit rating. He even sorted them based on which get the most attention from short sellers, the bearish investors who bet that stocks will decline by borrowing the stocks and selling them.
"No matter how you look at it, so-called low-quality stocks in the S&P 500 have outperformed high-quality stocks" since Feb. 8, Mr. Hickey says.
The 50 smallest S&P stocks have risen 13%, compared with a gain of 9% for the 50 largest stocks. Companies whose bonds are rated as junk have risen more than those with investment-grade ratings. The 50 stocks with the highest prices, compared with analysts' expectations for their 2010 profits, are up 16%. Those with the lowest price-to-earnings ratios are up 10%. The most heavily shorted are up 15%. The least-shorted are up 7%.
A total of 19 companies show up as lower-quality stocks by three or more of these criteria. They are up an average of 15%. Those include Office Depot, up 48% since Feb. 8, and U.S. Steel, up 39%. The 33 that are high quality by at least three criteria are up an average 6%.
One way to track the performance of risky stocks is to look at those that have had to be rescued by the U.S. government. Citigroup, down 11% from Jan. 19 through Feb. 8, has jumped 26% since then. American International Group fell 22% from Jan. 19 to Feb. 8, and has since rebounded 54%.
Financial stocks, among the most damaged during the bear market, have been among the strongest gainers. U.S. financials are up 13% since Feb. 8, based on financial stocks in the Dow Jones Total Stock Market Index.
They more than doubled during the rally from March 9, 2009, through Jan. 19, making them the second-strongest gainers. In the brief winter decline, they pulled back just over 8%.
The group with the biggest gains since the rally resumed on Feb. 9 is the same one that led the market ahead from March 9, 2009 through Jan. 19: producers of basic materials.
These companies are associated in investors' minds with hopes for the world economy because they make the most basic building blocks of global growth: copper, steel, chemicals and the like. The group rose 123% during the 10-month rally, then sagged 14% during the brief pullback and has rebounded 16% since.
As was the case last year, sectors perceived as safe have been the weakest performers since Feb. 8: Dividend-payers such as utilities and telephone companies, both of which have risen less than 5% since Feb. 8.
Even investors looking for yields appear to have migrated toward riskier areas such as junk bonds, whose performance compared with investment-grade bonds briefly dipped early this year and now has resumed its climb.
One classic way to bet on risky, more-volatile stocks is to shift to smaller stocks. Those companies tend to have the shallowest cash reserves and the biggest dependence on a strong economy. When the economy rebounds, small companies generally turn in bigger profit gains and faster sales growth; when the economy slumps, they suffer the most.
The Russell 2000 small-stock index jumped 89% from March 9, 2009 through Jan. 19, outpacing the Dow's 64% gain. The Russell then fell 10% over the next three weeks, more than the Dow's 8% pullback. Since then, the Russell is up 15%, more than double the 7% rise in the Dow.
Harris Private Bank is in the middle of a debate over whether to boost its small-stock exposure. The bank has decided to cut investments in Europe, Japan and Australia and increase U.S. holdings—but which U.S. holdings?
Harris's small-stock analyst is leery of the group, feeling it has become expensive, Harris's Mr. Ablin says. The Russell currently trades around 52 times its companies' profits for the past year, making it more than twice as expensive as the stocks in the S&P 500, according to Thomson Reuters.
But analysts are forecasting that small-company earnings could double this year, compared with growth of 10% to 12% at larger companies, Mr. Ablin says. He is tempted by the group's prospects and its stock momentum.
The problem: "There are enormous expectations built in, so room for disappointment is enormous," he says. "We may end up buying a little of both small and large stocks."
Some analysts warn that the trend toward risky stocks may be nearing its apex.
"We are taking some money out of the high fliers and reallocating a bit, thinking we might be near the high end" of the market's 2010 gains, says Jeffrey Kleintop, chief market strategist at brokerage firm LPL Financial in Boston, who has been bullish.
He worries that uneven economic performance could make stocks volatile and limit gains, especially if world-wide demand for Chinese goods proves uneven.
He isn't recommending that clients cut back on small stocks yet, but he thinks that time is nearing.
"Investors are embracing risk," Mr. Kleintop says. But "as the headwinds for growth re-emerge later this year, I think we will see small stocks give back most of their gains relative to large stocks."
