Is the economy growing or slowing? Amid the uncertainty, income stocks are outperforming the broader market.

Slow growth, strong growth. Low inflation, high inflation. Measured interest rate increases, aggressive interest rate increases. With shifting expectations regarding these three key economic fronts, stocks swung wildly during the first two weeks of May. 

Is the economy growing or slowing? On one hand, we're seeing high energy prices eroding consumer and business spending and dimming the outlook for corporate profit growth. Wal-Mart (WMT), for example, recently reported weak April sales and lowered its earnings guidance for the current quarter, stating that higher fuel costs are crimping consumer spending. Along the same lines, the University of Michigan reported that consumer sentiment has now dropped for five straight months, falling in April to its lowest level in two years. 

Yet, we're also seeing the tell-tale inflationary signs of robust economic growth. The latest non-farm payrolls report showed that the economy generated 100,000 more jobs than expected in April. Furthermore, retail sales grew +1.4% last month -- the strongest reading in six months. Meanwhile, the consumer price index (CPI), a key inflation gauge, rose +2.2% during the first quarter, the fastest pace in over three years. 

Even the Federal Reserve seems uncertain about the direction of the economy. On May 3rd, the Fed raised its benchmark interest rate a quarter-point in a continuing effort to nip inflation in the bud. Nearly two hours later, though, it posted a revised statement acknowledging "the solid pace of spending growth has slowed somewhat." 

What does all this have to do with income investing? A great deal, actually, considering that prices of high-yielding income stocks -- such as real estate investment trusts (REITs)-- typically move inversely to interest rates. 

Income-oriented investors are often forced to choose between high-yield stocks or low-risk fixed income alternatives pegged to short-term interest rates, such as treasury bills. When investors believe the economy is slowing and interest rates are likely to level off, dividend-paying stocks may look more attractive than their fixed-income counterparts. On the other hand, when the economy is speeding up and investors anticipate that future rate hikes will be needed to reign in inflationary pressures, yields on low-risk investments are likely to rise, thereby making income stocks less appealing by comparison.

Lately, dividend-paying stocks have reaped the benefit of mixed economic news. The broad-based S&P 500 Index (GSPC, 1154.1) has lost nearly -5% year-to-date. Over the same time span, the Dow Jones Select Dividend Index (DJJ, 702.5), a group of 100 solid dividend-paying stocks, has shed just -2.5% -- half as much as the S&P. Better yet, major real estate investment trusts, as measured by the Morgan Stanley REIT Index (RMS, 757.6), have lost just -1.6% for the year. Despite much volatility, all three indices remain largely unchanged so far for this month, losing about -3 points each. 

With an uncertain economic outlook, investors are holding on to their dividend-paying stocks. Thus far in 2005, dividend stock indexes (RMS, DJJ) are outperforming the broader market (GSPC). 

Outlook

Stocks in the S&P 500 Index are now expected to post a modest +2.7% gain over last year.

Despite the economy sending mixed messages, corporate earnings are still growing at a healthy pace. By now, most S&P 500 companies have released first-quarter earnings reports, and almost half have topped analyst expectations. Early tallies show that on average, earnings grew about +12% over a year ago, extending an impressive string of double-digit quarterly gains that began three years ago. 

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Investors may be able to profit from the disconnect between earnings growth and share prices. Many analysts are forecasting second-quarter and full-year earnings growth of about +7%, but the S&P itself is now expected to eke out just a tepid +2.7% gain for the year, down from an earlier +7% target. Assuming these projections pan out, the good news is that the Price/Earnings multiples for many S&P companies should contract. This could set the stage for solid gains in 2006. 

Important Note: The above article was merely a small excerpt from a recent News Flash we sent to subscribers of our premium, income-oriented investing newsletter -- High-Yield Investing. In each issue of that newsletter, editor Carla Pasternak delivers a host of other investing ideas and tips designed to help you earn steady gains and above-average income from your portfolio. To receive your copy of our most recent High-Yield Investing newsletter, as well as other guidance similar to this every month, you'll need to register for this separate publication. Please visit one of the following links to continue...

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