The daredevils are winning big this year.
Investors who bought the riskiest stocks when the economic recovery was in doubt this year are clocking the biggest gains. Among them: stocks from companies at risk of defaulting on their debt, ones already priced high and those that other investors bet would drop fast. Returns from this dicey lot are as much as double the gains in the broad market.
"Greed is increasing, and people are going to risky stocks for higher return," says Paul Hickey, co-founder of stock researcher Bespoke Investment Group.
Consider shares of companies that rating agencies think could stiff lenders. Stocks of so-called junk-rated companies rose 19 percent from the start of the year through Dec. 16, according to Bespoke. By comparison, those of stable and flush companies with ratings of AA or higher returned six percent.
One possible reason risky stocks are booming: the stop-and-go economic recovery. The idea is that some investors who buy risky shares in recoveries held back earlier this year out of fear this one would stall. Now they are jumping in and that is extending the rally. Typically, riskier stocks rise the most early in recoveries because they fall the most in the recessions preceding them. During a recession, investors figure high-risk companies won't churn out profits or even stay in business. But then bargain hunters pounce on the survivors in anticipation of better times and the stocks climb fast — for a while at least. Eventually, investors shift money into bigger, more stable companies called blue chips as the recovery gathers steam.
But this time, 21 months into the rally, investors still prefer the dangerous over the dull.
"We spent most of the year worried about earnings and a double dip," says Mark Bronzo, manager of Security Global's big company fund. But then "earnings came in better than expected and people are playing catch-up."
The danger now is that small investors who are edging back into stocks will buy these high flyers just as the trend breaks and prices fall.
Investors are "pulling money out of bond funds but where is the money going?" says Steven Ricchiuto, chief economist at Mizuho Securities. "We've had a huge run. I'd get more defensive now."
Conventional wisdom says that at this point in the bull, investors should avoid stocks priced high compared with their earnings. A low price-earnings ratio suggests a stock is a bargain. But if you followed that strategy, you would have missed out on big returns this year. The 10 percent of stocks in the Standard & Poor's 500 index with the highest price-earnings ratios at the start of the year returned 23 percent through Dec. 16, according to Bespoke. That was eight percentage points higher than the return for stocks with the lowest price-earnings ratios.
Likewise, stocks that Wall Street traders targeted for so-called short sales have shot up. In a short sale, an investor bets against a stock by borrowing shares and selling them. If the stock falls, the investor can buy back the shares and return them to the original owner, pocketing the difference. But the 10 percent of stocks in the S&P 500 that attracted the most short sales at the start of the year are up 26 percent, according to data provider FactSet. Those with the least short sales rose 17 percent.
Another winner in the stop-and-go economy: stocks of so-called cyclical companies whose profits are bound up tightly with economic cycles. Consumer discretionary companies like toy maker Mattel Inc., for instance, gained 90 percent last year from their lows as investors anticipated that people would spend more on non-essentials. Then prices kept rising, up another 25 percent this year. What's more, they've trounced stocks of non-cyclicals whose sales are steadier and should be outperforming now. Stocks of consumer staple providers like Campbell Soup Co. have returned 11 percent.
Stocks of small firms are beating stocks of big companies, too. Big companies are thought safer because they sell many products and services in many countries and can tap various sources to finance themselves. Yet the S&P Small Cap 600 index, after returning 85 percent last year from its March low, is up another 24 percent in 2010. That's more than double the 11 percent gain in the S&P 500, a large-company index.
"These things go in cycles," says USAA stock manager Arnold Espe of the small-stock outperformance. "We think we're at an inflection point."
Alas, some experts were saying the same thing 10 months into the rally a year ago.
Pioneer Investments' John Carey owns Pfizer Inc. and Eli Lilly & Co., drug makers with fat dividends but whose stocks have been hurt by fears that President Barack Obama's health care plan will eat into profits. A shift by investors into blue chips, which he figures is already six months overdue, would have helped lift those stocks. No dice. Pfizer is down 2.1 percent so far this year while Eli Lilly is up 4 percent, a third of the S&P 500's gain.
"During the course of a bull market, people start focusing more on dividends and earnings" but that hasn't happened, Carey says. But he adds, "I'm a patient investor."