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What's Causing Growth Stocks to Yield the Lead

May 09, 1999|TOM PETRUNO

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.

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