Where Are We in This Rally's Lifecycle?

 |  Includes: AIG, AMBC, FMCC, FNMA, GE
by: Dr. Hugh Akston

With the stock market rally approaching its six month anniversary, a rally that currently has the S&P 500 up +54% from the intraday low set on March 6th, it is a good time to take a closer look at the internals of this rally and see what they suggest for the future. While a rising tide certainly lifts all ships, it is important to take note of which types of stocks moved and when.

I compiled total return data for the largest 3,000 US stocks as measured by market cap which serves as a good proxy for the overall US stock market. I then sorted these stocks by “quality” to see how the different “quality” levels have participated in the rally. I will be the first to admit that the “quality” of a stock is very subjective. After all, every stock has a certain price that makes it a good investment and conversely a certain price that would make it a bad investment. A very savvy colleague of mine told me that low-quality stocks are what people call the stocks they don’t own. In any event I think there are several quantifiable characteristics that can serve as a proxy for “quality”.

For this analysis I used financial distress risk, short interest ratio, and Wall Street analyst rating. The risk of financial distress is measured by total debt divided by enterprise value which is a good measure of the liquidity profile of a company, lower quality stocks have a higher risk of financial distress. The second metric is short interest ratio (shares sold short divided by total shares outstanding). Here we are assuming that the majority of short sellers are professional investors that have done their research and on average are shorting lower quality companies. The final metric, analyst rating, is probably the biggest leap of faith given my cynicism of Wall Street analysts but here we assume that on average analysts will have lower ratings on lower quality companies. Remember that we are looking at 3,000 stocks so these metrics should reflect a level of quality when taken in aggregate. Without further ado:
Click to enlarge This analysis paints a clear picture of how high quality stocks led the way at the beginning of the rally whereas lower quality stocks have recently done much better than their higher quality counterparts. From a behavioral finance standpoint this makes perfect sense. At the beginning of the rally investors saw true value opportunities in high quality stocks that had been oversold to unwarranted levels. Investors bought up these stocks and bid away the valuation anomalies. Without these compelling opportunities, investors are now being forced to go downstream into the lower quality speculative stocks. Investors are now stretching for return and in the process taking on much more risk, how much risk was there really in GE at $6?

As the market has exhausted all of the true value opportunities investors need to consider how much gas is left in the tank of this rally. I am hard pressed to find four stocks of lower quality than FNM, FRE, ABK, and AIG yet look how these have traded over the past 5 days.

Click to enlarge

The most appropriate analogy is to think of an apple tree. If a group of people stumble upon an untouched apple tree they will firs pick off the best and easiest low-hanging fruit. As more and more people pick from the tree the easiest apples will disappear and people will have to reach higher and higher to get the apples. The current state of the market feels like we are at the point where people are picking the apples at the top of the tree while on stilts standing atop a ladder.

Disclosure: No positions