To keep riding the rally, follow the smart money

Catching a ride on the next leg of this historic 10-month stock market rally will mean following the smart money, mostly represented by institutional-class investors, toward a new concentration on quality and calculated risk.

While last year gave us a beta rally that rewarded the riskiest investments the most, the general thinking is that the market is now shifting toward favoring the names and categories that can be clearly justified on balance sheet terms.

Dividend-paying companies, some clean and green technology, domestic value and even Japanese equities are all examples of categories that are emerging as leaders in a market that will start requiring more-diligent analysis.

Some of that separation from the pack is illustrated by the performance of Japanese stocks, as measured by the iShares MSCI Japan Index exchange-traded fund (EWJ).

Last year, the index gained 2.6%, well behind the 26% gain by the S&P 500.

But over the first three weeks of 2010, the index was up 5%, while the S&P 500 was up 2%.

It’s a similar story for small-cap-value stocks as measured by the iShares Russell 2000 Value Index (IWN) and dividend-paying stocks as measured by PowerShares HighYield Dividend Achievers (PEY).

One of the best examples of the indiscriminate beta rally that unfolded last year was seen in the performance of Wal-Mart Stores Inc. (WMT).

The stock performance of the world’s largest retailer baffled a lot of analysts all year by the way it underperformed the broad equity markets, not to mention a lot of riskier investments.

Wal-Mart’s reputation and balance sheet helped hold shares steady at the start of last year when the S&P 500 fell by more than 25%. But for the full year, while the index rallied to gain more than 26%, Wal-Mart shares remained flat.

At this point, with the S&P 500 having gained more than 60% from the March bottom, the strategy again seems to favor the kind of companies that might hold up best in a less generous market environment.

“On a macro scale, last year’s laggards will become this year’s leaders,” said Sam Jones, president of All Season Financial Advisors Inc.

Of course, this doesn’t necessarily mean that every category that did well last year won’t continue to do well in 2010.

High-yield debt and emerging-markets stocks are both examples of categories expected to extend their rallies this year.

But money managers should be guarding against the pattern most often seen among the retail investor ranks of being too conservative at the wrong time and chasing last year’s hot categories.

“We think riskless assets are rewardless, and high-quality debt is probably the biggest losing sector,” said Scott Colyer, chief executive and chief investment officer with Advisors Asset Management Inc., which has more than $4 billion under supervision, mostly in fixed-income portfolios.

The connection between riskless and rewardless might seem obvious to a professional such as Mr. Colyer, but financial advisers earn their fees by steering less sophisticated investors away from old patterns and bad habits.

Last year, for example, when domestic-equity prices were climbing at a record pace, stock mutual funds experienced more than $25 billion worth of net outflows.

Bond funds, meanwhile, had more than $356 billion worth of net inflows last year.

That pattern has continued into 2010, according to Morningstar Inc.

“The stupid man’s response [to avoiding equities at this point] is that they were down big in 2008,” Mr. Colyer said.

Crude and antiquated as it might sound in this age of endless advice and impressive examples of market efficiency, the reality is that the dumb money can still be easily identified by its glaringly contrarian stumbles.

And sometimes the dumb money is the best place to start when searching for the smart money.

“Fighting last year’s war,” is how Morningstar analyst Russel Kinnel described some of the investment patterns he has seen unfold over the past few years.

“One of the biggest disconnects we’ve seen involves the flows into high-quality, low-yielding bond funds,” he said. “Even some of the bond fund managers are fairly wary at this point.”

With history as our guide, we can assume that those fund flows eventually will reverse in stride with more tangible evidence of an economic recovery.

And when the retail investors start flocking toward the highest-priced securities, we’ll know we’ve entered the next stage of the market cycle.

Of course, by that point, the smart money will already be somewhere else.

E-mail Jeff Benjamin at [email protected].

Related Topics: ING Group