Big Debt and Big Returns Could Be Spurring This Rally

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 |  Includes: AIG, AMD, AN, BAC, C, CBG, CIEN, CTX, ETFC, F, GM, GNW, GT, HIG, HOG, IP, JAVA, JCP, JNS, KBH, LEN, MAS, MBI, ROH, SNDK, TMK, VIAV, WFM, WHR, XL
by: Alan Brochstein, CFA

I shared an observation yesterday regarding the rally in March: A lot of the performance in the S&P 500 is being driven by mean-reversion, with some of the biggest losers over the past year showing the strongest returns in the rally. I demonstrated that there was generally a correlation for companies with better balance sheets (measured by net debt to capital) to show better performance with the strange exception of some of the best performance to have come from stocks with among the worst balance sheets.

In this follow-up, I want to dig a little deeper on that front. As you can see in the chart below (click to enlarge), I sorted the entire S&P 500 by net debt to capital using StockVal, dividing it into deciles. I then plotted the returns of each of the 50 members of each of the deciles, with the lowest decile (on the left) representing the strongest balance sheets:

Sp500returnsVSnetdebttocap

Looking from this perspective, we arrive at the same conclusion: The highest decile (the worst balance sheets) produced some of the highest returns (as did the second decile). Otherwise, there was generally a tendency for most of the returns in a decile to be higher as we move to the left (towards better balance sheets).

Here are the stocks with returns >40% so far in March by decile:

  • Worst Decile: Bank of America (NYSE:BAC), Citigroup (NYSE:C), E*Trade (NASDAQ:ETFC), General Motors (NYSE:GM), Advanced Micro Devices (NASDAQ:AMD), CB Richard Ellis (NYSE:CBG) and Ford (NYSE:F)
  • 2nd Worst Decile: American International Group (NYSE:AIG), MBIA (NYSE:MBI), and International Paper (NYSE:IP)
  • 3rd Worst Decile: Goodyear (NASDAQ:GT)
  • 4th Worst Decile: Rohm & Haas (ROH), Whirlpool (NYSE:WHR), Masco (NYSE:MAS), and Harley-Davidson (NYSE:HOG)
  • 5th Worst Decile: Hartford (NYSE:HIG), Centex (CTX) and AutoNation (NYSE:AN)
  • 5th Best Decile: KB Homes (NYSE:KBH), Janus (NYSE:JNS), Lennar (NYSE:LEN) and JC Penney (NYSE:JCP)
  • 4th Best Decile: Whole Foods (WFMI) and Torchmark (NYSE:TMK)
  • 3rd Best Decile: Genworth (NYSE:GNW)
  • 2nd Best Decile: XL Capital (NYSE:XL), Ciena (NYSE:CIEN), Sandisk (NASDAQ:SNDK) and JDS Uniphase (JDSU)
  • Best Decile: Sun Micro (JAVA)

As I review these names, I have to be careful and not say them out loud. If I do, I am sure my beagle will howl as she tends to do when she sees other dogs. In many cases, these stocks were very oversold no doubt, but I don't believe that we can count on a repeat of this type of performance from this cast of characters. To reiterate my conclusion yesterday: Use this rally to improve the quality of your portfolio by paring companies with strained financials.

Disclosure: None