What’s Causing Growth Stocks to Yield the Lead
The simple analysis of Microsoft’s decision last week to invest $5 billion in AT&T; is that there is nothing Microsoft can’t buy, and no place its virtual tentacles can’t reach in search of more profit.
Which would seem to be all the justification Wall Street needs to continue paying an extraordinary price for Microsoft shares relative to underlying earnings.
If this isn’t a classic growth stock, what is?
Instead, Bill Gates’ paper wealth dwindled for the fourth straight week, as Microsoft ended at $79.06 on Nasdaq on Friday, down from $81.31 a week earlier and off 17% from its record high of $95.63 reached April 5.
The Dow Jones industrial average, by contrast, ended the week at yet another new high, rising 84.77 points Friday to close at 11,031.59.
The problem for Microsoft shareholders today is that they do own a growth stock--maybe the poster child for big growth stocks.
And growth stocks, suddenly, have an image problem with many of the same investors who couldn’t own enough of these shares for the last two to three years.
Exactly what turned the tide against the mega growth stocks is a matter of debate, but many Wall Street pros are pointing at an ancient nemesis: rising interest rates. And because the rate problem looks here to stay, so do growth stocks’ problems.
Some investors’ reaction may simply be, “It’s about time!” The growth-stock segment of the blue-chip Standard & Poor’s 500 index--that is, the stocks generally selling for the highest price-to-earnings (P/E) ratios--soared 34.7% in 1997 and 40.6% in 1998, as measured by the S&P; Barra Growth index.
It was truly a golden period for such high-growth companies as Microsoft, drug titan Pfizer and telecom giant MCI WorldCom.
By contrast, the S&P; Barra Value index, which tracks the S&P; shares generally selling for the lowest P/E ratios--typically slower-growing companies such as engine maker Briggs & Stratton and insurance firm Cigna--gained just 12.5% last year after rising 27.1% in 1997.
But in recent weeks the performance numbers have reversed: The S&P; growth index is up just 5.9% year-to-date and is down 6.2% from its record high reached April 12.
The S&P; value index, meanwhile, is up 13.3% year-to-date, and closed Friday just under its record high hit earlier in the week.
The damage overall to big growth stocks still seems modest, of course. Who’s to say this isn’t just a bit of profit-taking before another spectacular run-up in these shares? Who, indeed: How about Federal Reserve Chairman Alan Greenspan?
In a speech last Thursday, Greenspan repeated many of his long-standing concerns about the ebullient U.S. economy: Maybe growth is too rapid, maybe inflationary pressures are building, maybe stocks are overpriced.
He didn’t appear to break much new ground. Yet something in his tone rattled many investment pros.
Tad Rivelle, veteran bond fund manager at Metropolitan West Asset Management in Los Angeles, thought Greenspan wanted to send a clear message to Wall Street that “the Phillips curve has not been abolished,” in the Fed’s view.
The Phillips curve documents the historical relationship between employment and inflation. When employment is high--meaning the economy is running at a brisk pace (as it is now)--the risk also is high that inflation in wages and prices will begin to pick up.
In turn, that usually means interest rates will begin to pick up.
For many happy reasons, including tremendous productivity gains, a strong dollar and falling oil prices, the Phillips curve hasn’t rung true in this economic boom. Inflation remains benign.
But will that continue to be the case? Greenspan last week did not threaten to raise interest rates to reflect inflation risks. (The Fed meets on May 18.) But the bond market is already acting for him.
Longer-term Treasury bond yields last week hit their highest levels since last May. The yield on the 30-year T-bond ended Friday at 5.81%, up from 5.66% a week earlier and 5.10% on Jan. 1.
And what does that have to do with growth stocks? One of the few rules the stock market has continued to abide by in the 1990s is that highly valued stocks, as a group, can only become more so as long as interest rates are falling.
Lower rates mean lower borrowing costs for fast-growing companies and less competition for stocks from bonds. So it’s natural that investors should pay a higher premium for growth stocks.
On the flip side, if rates are rising, the premium that investors are paying for growth companies’ future earnings naturally should be adjusted downward, as companies’ borrowing costs rise and stocks face tougher investment competition.
That, in a nutshell, is the growth stocks’ problem, many money pros say. In Wall Street lingo, it’s the “long duration” assets--those for which the bulk of the “payoff” is expected well in the future--that suffer most when rates rise.
Hence, Internet-related stocks selling for stratospheric P/Es have been hit very hard. “Net stocks are the ultimate long-duration asset,” says Richard Bernstein, a market strategist at Merrill Lynch in New York. “There’s nothing upfront” with those stocks.
Bernstein, among others, is a believer that growth stocks are in trouble, because he sees no reason to think that the trend in interest rates will soon turn down.
Another Wall Street strategist with that view is Peter Canelo of Morgan Stanley Dean Witter.
“Growth managers feel betrayed” by the stocks’ sudden declines, Canelo says. But he argues that “many growth managers have been violating their disciplines for two years,” knowingly paying excessive prices for a relative handful of large growth stocks.
Now, Canelo says, growth managers are facing some unpleasant realities: They own overvalued stocks that typically don’t do well in periods of rising interest rates, and they don’t own the value stocks (industrial issues, transportation issues, etc.) that usually do perform well in such periods so long as the reason for rising rates is that the economy is growing at a good pace.
(That brings up a key point: Historically, the stock market overall has been able to rise amid higher interest rates, until such time as the rate rise becomes excessive.)
Certainly, the day will come again for the big growth stocks, Canelo acknowledges. But he sees the value stocks (including smaller stocks) powering the market until at least the fourth quarter.
Tom Petruno can be reached at tom.petruno@latimes.com. Petruno and other Times financial writers will be among the speakers at The Times’ third annual Investment Strategies Conference May 22-23 at the Los Angeles Convention Center. For more information, call (800) 350-3211 or go to https://www.latimes.com/isc.
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Hard Times for Growth Stocks
Rising interest rates have helped drive major growth stocks lower this year. Yet the price-to-earnings (P/E) ratios of many of the stocks still are high. A sampling:
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1999 Fri. Decline ’99 Stock high close from peak P/E Yahoo $244.00 $147.44 --40% 369 America Online $175.50 $118.19 --33% 219 Disney $42.75 $30.00 --30% 39 Dell Computer $55.00 $40.19 --27% 55 Pfizer $150.13 $116.94 --22% 48 Amgen $81.38 $63.63 --22% 34 Clorox $132.94 $106.81 --20% 29 Sun Microsystems $72.50 $58.06 --20% 35 Gap $77.38 $63.25 --18% 38 Microsoft $95.63 $79.06 --17% 51 Wal-Mart $53.38 $44.75 --16% 40 S&P; 500 $1,363 $1,345 --1% 29
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‘99 P/E based on analysts’ consensus earnings estimates
Source: Bloomberg News; Zacks Investment Research
