Investors rotate into cheaper stocks in erratic market

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Some market watchers think there is a good reason the stock market has been jolting recently between rally-euphoria and correction-dread: Investors are rotating out of the flashy big winners and into cheaper, less-loved stocks.

It's a comforting thought as more nervous types look for evidence that the bull market is sputtering after five years of gains and an overall move of 180 per cent.

After all, rotation implies a shifting of the guard rather than a change in direction.

The S&P 500 certainly looks directionless. After rallying 30 per cent last year, it is close to flat in 2014, despite some remarkable ups and downs.

In March alone, the benchmark index has experienced eight days in which it has either risen or fallen by 10 points, including a 22-point dip on March 13 and a 28-point surge on March 4.

The moves could be due to shifting interpretations of Russia's incursions into Ukraine, China's slowing economic activity and recent monetary policy from the U.S. Federal Reserve, which is tapering its bond purchases and signalling that interest rate hikes will follow.

But the rotation thesis is an attempt to dig a little deeper than the broader market moves and see what is actually causing most of the mayhem.

Ed Yardeni, president and chief investment strategist at Yardeni Research, pointed out that stocks with high valuation multiples are suffering at the expense of stocks with low valuations.

In particular, stocks in industry groups such as biotechnology, Internet retailing and Internet software and services – defined by companies like Facebook Inc., Google Inc., Amazon.com Inc., Netflix Inc. and Gilead Sciences Inc. – are taking the brunt of the damage.

On average, the three industry groups have declined more than 10 per cent from their highs earlier this year, conforming to the popular definition of a correction.

Even with the declines, the price-to-earnings ratios are very high, ranging from the low 30s in the case of biotech and Internet software, to the mid-80s in the case of Internet retailing. That's well above the S&P 500's P/E of 17.

Meanwhile, far cheaper telecommunications, energy stocks, utilities and consumer staples, with price-to-earnings ratios ranging between 15 and 19, have been rebounding over the past two months.

What does it mean? Mr. Yardeni believes the adjustments are nothing more serious than an "internal correction," where money periodically flows out of "risk-on" stocks and into "risk-off" stocks.

He thinks the adjustment is likely to be temporary: "My hunch is that the high-flyers that have lost a bit of altitude recently will be back at record highs soon," Mr. Yardeni said in a note.

Michael Hartnett, chief investment strategist at Bank of America, isn't so sure about that.

He thinks the current bout of volatility is largely due to the unwinding of Fed stimulus – in particular, the prospect of interest rate increases as soon as next year.

As he explains, Fed stimulus created a situation in which a lot of money chased after a limited number of companies that were capable of impressive earnings growth. This implies that reduced stimulus will reverse the trend: As economic growth improves and bond yields rise, money will flow elsewhere.

"Higher yields and higher growth should put pressure on 'growth' stocks," Mr. Hartnett said in a note.

That doesn't mean the bull market is nearing an end. Indeed, the strategist is maintaining a year-end target of 2000 for the S&P 500, or about 8 per cent higher than Thursday's close.

But it does suggest the market jolts are likely to continue.