To the bulls, I say: I suppose one must take one's gains where they are to be found. However, you should be aware that the recent rally is built on shaky foundations; indeed, it is the poorer-quality companies that have experienced the largest gains. This has serious implications for all prudent investors.
Outing the "junk rally"
To show that this is a "junk rally," I split the companies in the S&P 500 into five ranked groups based on their Z score. Developed by Edward Altman, a bankruptcy expert at New York University, the Z score predicts bankruptcy risk using market and accounting data. The lower the Z score, the greater the risk of bankruptcy.
For each group, I calculated the average stock return from the end of June and from when the market hit a low on March 9. The following table summarizes some of the results:
Altman Z Score Quintile
Average % Return From June 30
Average % Return From March 9 Market Low
Top Quintile (lowest bankruptcy risk)
9%
50%
Bottom Quintile (highest bankruptcy risk)
15%
104%
S&P 500
8%
47%
Note that the interpretation of these results is subject to some caution, because Z scores were only available for approximately two-thirds of the companies in the S&P 500.
Source: Author's calculations based on data from Capital IQ, a division of Standard & Poor's.
As you can see, the companies with the highest bankruptcy risk have produced a much higher average return than those with the lowest risk -- on the order of 2 to 1. Here are some examples of that phenomenon:
% Return Since June 30
Z-Score Quintile (1: Lowest Risk; 5: Highest Risk)
Recent Market "Winners"
Caterpillar (NYSE: CAT)
40%
5
Ford Motor (NYSE: F)
29%
5
Freeport-McMoRan (NYSE: FCX)
23% Continued... |