The market has rallied dramatically since the March 9 low, with the biggest beneficiary of this rally being low-quality companies.
This intuitively makes sense, given that companies with the most troubled outlooks are the ones most likely to have a strong recovery when the dire outcomes predicted at the bottom of the crisis failed to transpire.
Quality may have different meanings to different investors, but in a recent research piece, Citigroup ranked performance based on multiple definitions of quality. S&P earnings quality ranking, debt-to-capitalization ratio and return on equity were used as proxies for quality. The research universe was the small-cap Russell 2000 Index, but I believe broader market conclusions can be drawn as well.
Based on S&P earnings quality rankings, companies with C or D (the two lowest categories) ratings returned about 55 percent over the past six months, while the highest-rated stocks returned about 11 percent. As a whole, the Russell 2000 universe returned 30 percent over that time period.
This trend is also broadly true for the other measures of quality. Generally speaking, companies with higher debt burdens outperformed companies carrying low debt, and companies with negative return on equity outperformed the broader market as well as the companies with the highest return on equity.
Morgan Stanley also recently released a research report that looked at low-priced stocks as a proxy for low-quality and found that S&P 500 stocks trading below $5 dramatically outperformed. The same analysis was conducted on the MSCI Europe Index with very similar results, indicating a broad-based global phenomenon.
Morgan Stanley highlighted that the recovery so far has been driven by multiple expansion – the valuation that investors are willing to pay has increased, but that has not been supported by an increase in earnings in the current period. But we are now potentially at an inflection point at which the junk rally has more or less run its course and the market is beginning to focus on earnings growth.
The business cycle plays a significant role in market valuations in the sense that the market anticipates a recovery and pays up for the anticipated earnings stream. Once the recovery takes hold, however, investors focus on actual earnings power as the primary driver of valuations.
One persuasive indicator that the recovery has indeed taken hold can be seen in the ISM Manufacturing Index, which moved above 50 about six weeks ago, indicating that the economy is expanding.
What has worked so far in this stock market recovery will not likely carry us into 2010 and beyond, so the time could be right to reposition for the next leg of the recovery.