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Cyclical stocks are considered riskier than defensive names because they react much more dramatically to economic data points . But the difference could be diminishing. Investment strategists use a measure called “beta” to measure the market sensitivity of stocks and stock sectors. A ‘beta’ of 1.0 for any stock or sector means that those stocks mirrored exactly the percentage move in the overall market (i.e. the TSX Index in Canada or S&P500 in the U.S.). A ‘beta’ of less than 1.0 means the stocks move less than the overall index in either direction (i.e. they are less volatile) while a ‘beta’ of more than 1.0 means that stocks move more than the index in either direction (i.e. a stock with a beta of 1.2 would typically rise 12% if the market gained 10%). Defensive groups such as utilities, consumer staples, and health care saw their beta rise last year, going from 0.5 to 0.7, while the beta for industrials, materials, and consumer-discretionary stocks slipped to 1.05 from 1.15. In a way, we might say “risk isn’t as risky, and safe isn’t as safe” as they were a year ago.
Also, it isn’t earnings growth alone that could move stocks higher. It could be, instead, investors’ willingness to pay more for each dollar companies earn. Companies are expected to earn 32% more this year than in 2007, says Thomson Reuters. Yet the S&P500 index is merely at 2007 levels, which suggests price-to-earnings multiples have become compressed during this expansion. That could reverse if stocks’ new highs begin to win over sidelined skeptics. It is too soon to hail a great bond-to-stock rotation, but after pulling $391 billion from U.S. stock mutual funds during this bull market, investors have steered $16.1 billion back recently. If this keeps up, cyclical stocks should see their valuations improve even more quickly.
We hear much lately about the potential ‘great rotation’ from bonds to stocks. Since the stock market peak in 2007 in the U.S. we have seen over US$1.2 trillion of new money flow into bond mutual funds while equity (stock) mutual funds saw an outflow of over US$400 billion in the same period (see chart below). While much of the stock outflow was captured by stock ETFs (exchange traded funds), which have become a popular alternative to mutual funds due to lower costs and reduced risks. Despite that, there has clearly been a substantial switch from stocks to bonds.
Given that interest rates are now at all-time lows and have little ability to generate positive returns from current levels, it seems logical that the money will start flowing back to stocks once investors have some comfort that the economic background has stabilized and growth has returned. It doesn’t hurt that many stocks also have dividend yields which are well in excess of the current return on bonds, meaning that you are getting all the growth potential for free!