It's time to rotate.
After a year of strong gains for small-cap stocks with low-quality earnings and no dividends, analysts are starting to urge investors to take profits and move into other areas.
"I think there will be somewhat of a change in leadership, and there will be more reliance on fundamentals as opposed to momentum," said Brett Gallagher, head of U.S. equities at Julius Baer Investment management. "Larger companies are probably going to do better relative to small-caps, just as a rule of thumb."
Small-cap stocks, as measured by the S&P 600, have climbed almost 33% this year, compared with a 20% rise for the
. Meanwhile, nondividend-paying stocks have surged almost 51% compared with an almost 26% rise for stocks that pay a dividend.
Howard Silverblatt, a quantitative strategist at Standard & Poor's, said this trend has started to shift recently, and he expects the disparity between dividend-paying and nondividend-paying stocks to moderate next year.
"Nondividend-payers have gone up because they have been rebounding after doing so poorly in the previous two years," he said.
, which plunged 99% from its bubble high, has risen 565% in 2003, even though it pays no dividend.
has also been a huge winner for the year, even though it's been losing money.
"These issues tend to do better at the start of a recovery cycle, and I expect them to cool down next year," Silverblatt said.
Ed Yardeni, chief economist at Deutsche Bank Securities, is expecting well-capitalized, stable earners with a dividend payout to outperform in 2004. "I sense that sentiment is moving in this direction among institutional investors," he said.
Although small-cap stocks are expected to post earnings growth of 26.3% next year, compared with 12.2% for the large-caps and 19.6% for mid-caps, small-cap valuations are also higher. Yardeni said valuations in the small-cap group have increased sharply this year, with the forward multiple rising to 18.4 from 13 in mid-March.
"If stock prices continue to move higher in 2004, with most participating in the rally, then the importance of making the correct rotation decision on a timing basis is reduced somewhat," he said. "Still, I agree that companies with higher-quality earnings should outperform in the coming year."
Jeffrey Kleintop, chief investment strategist at PNC Advisors, believes higher-quality stocks are better positioned to capitalize on the continued economic improvement going forward. Since 1985, stocks with solid earnings and dividends have outperformed lower-quality names 70% of the time, he said. "Price momentum and speculation
should fade as key drivers of the market."
Kleintop advises investors to overweight financials and industrials and underweight noncyclical sectors such as telecom, consumer staples and utilities.
While many analysts expect the
to hike rates sometime next year, Kleintop said financials could do well, thanks to a revival in the capital markets, which would spark more initial public offerings and a round of merger and acquisition activity. He also notes that the group trades at a discount to the overall market.
Yardeni also likes the finance group, because earnings momentum remains strong. In addition, he recommends homebuilders, home improvement retailers, casinos and brewers. The homebuilding sector has been crushed in recent days, as the Fed took another step toward tightening rates, but Yardeni thinks the profit outlook still looks encouraging. Like Kleintop, he is less enthusiastic about utilities and telecom services.
Even though demand for electricity is growing, analysts say utilization rates are low and earnings are likely to lag. As for the telecom group, pundits say weak pricing power will keep that group under pressure.
Gallagher expects the industrial sector to perform solidly in 2004, because the continued weakness in the dollar should help to boost earnings. But he said investors should steer clear of consumer-related stocks, which will be hurt by a slowdown in mortgage refinancing and a reduction in government stimulus.
"With tax cuts disappearing, it's going to be very difficult for consumers to increase spending, and these stocks' valuations are predicated on continued strong growth," he said.