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Easy money may already be out of the markets

The stock market rally is aging, and the surest sign is that investors are migrating to stocks that missed out on 2009's big run.
/ Source: The Associated Press

The stock market rally is aging, and the surest sign is that investors are migrating to stocks that missed out on 2009's big run.

The Standard & Poor's 500 index is up 69 percent since March 9. The stocks hit hardest during the bear market, including financials and small-caps, led the rally during its first seven months. Now, however, investors are favoring utilities, telecommunication, health care and large-cap stocks.

The shift is a natural progression in a bull market and suggests that most of its gains have already been realized.

"The easy money is made the first year of a bull market," says Sam Stovall, chief investment strategist with Standard & Poor's. Based on historical trends, about a third of a bull market's gains occur in its first year. In its second year, it tends to rise about 12 percent.

This bull market, like others, began with the first signs of the economy's recovery and quickly picked up momentum as investors went after the cheapest stocks. Investors bought financials, small-caps and companies with hard-to-predict earnings and high debt loads. Profits and sales at these companies were badly hurt by the recession and their shares had the furthest to bounce.

The S&P 500 Financials index soared 153 percent before reaching an Oct. 14 peak. That's more than double the broader S&P 500's gains. A similar trend occurred in 2002, when shattered technology stocks bounced and heralded the start of a new bull market.

Small-caps and shares of cyclical companies such as chemical makers and miners that rely on a healthy economy for profits were also primed for a rapid recovery. The Russell 2000 index of small-caps climbed 82 percent from March through mid-October, beating large-caps by 20 percent. A Morgan Stanley index of cyclical companies rose 176 percent.

Stocks known as low-quality shares were also early gainers. The category is loosely defined, but analysts agree these companies tend to have high debt loads, hard-to-predict earnings and few competitive advantages compared with rivals. While these are often smaller-sized companies, Morningstar considers large-cap names like Alcatel-Lucent and Ford Motor Co. to be low-quality. Analyst Paul Larson says an internal Morningstar index of low-quality stocks rose 176 percent from March to mid-October.

Now financials, small-caps and low-quality stocks are lagging the S&P 500.

The best-performing categories for the past two months were utilities, telecom, health care and high-quality stocks such as Procter & Gamble Co. and AT&T Inc. These categories usually perform solidly in any economy and often offer good dividends, characteristics that are especially important in the current market because the recovery is still uncertain. Investors see these companies as safer bets than the riskier ones that initially led the rally.

Historically, high-quality stocks have tended to perform well as a bull market matures, having been left behind in the early phase of the rally. In the second year of the last bull market, an index of the most reliable dividend payers, the Dow Jones U.S. Select Dividend index, beat the gains of the broader Dow Jones industrials by 20 percentage points.

Channing Smith, co-manager of Capital Advisors Growth Fund, said he's buying stocks like Wal-Mart Stores Inc. and Abbott Laboratories on the cheap. They are currently trading at price-to-earnings ratios of 15.5 and 15.2, respectively.

Investors watch P/E ratios, calculated by dividing the company's market value per share by its earnings per share, to get a sense of whether a stock is undervalued or overvalued. The P/E ratios for the stocks Smith is watching are below their historical averages and well below the current price-to-earnings ratio of 18.6 for the S&P 500 index.

"Many investors think they missed this huge bull market. They did in small-caps and mid-caps," says Smith. "But the market right now is offering investors the opportunity to pick up some of the highest-quality blue-chip names."