In our last post we discussed how we at The Macro Trader think that risk is vastly under-priced. We looked at several different volatility indexes as well as Bill Luby and VixandMore.com’s JunkDEX. The JunkDEX shows how well stocks like AIG, Fannie Mae (FNM), Citigroup (C), CIT, and Bank of America (BAC) are doing. As you can see in our previous post “Volatility Indexes, Risk Appetite, Mispriced Risk, And Where We Think We Are Headed” the JunkDEX has had a monster rally. Usually this would signal at least a short term top as speculative fever burns out. Obviously the rally was not done and we are up since then.
To more quantitatively show the huge run up in risky assets we went looking for some factor based indexes that would show the performance of “good” and “bad” companies. In our search we came across some custom stock baskets from Goldman Sachs (GS) that use Edward Altman’s famous Z-score to separate stocks into strong and weak balance sheet indexes.
The Altman Z-score uses 5 financial ratios. Altman took the 5 ratios and using statistical techniques was able to build the Z-score which predicts a companies probability of failure. The higher the score the safer the business is and the lower the score the more danger there is of insolvency.
As was to be expected, the performance between the weak and the strong balance sheet stocks has been drastic over the last 6-months. As you can see in the chart below the low Z-score basket has vastly outperformed the high Z-score basket. In fact the weak balance sheet basket has done almost twice as good as the strong balance sheet basket of stocks. (click on chart to enlarge)
Goldman Sachs SP500 Strong and Weak Balance Sheet Baskets 6-Months
While the result is not too surprising it is an example of bad investor behavior. Academics as well as practitioners have found time and time again that safe low volatility stocks outperform risky volatile stocks over a full market cycle. In fact if you look at the chart below you can see how the roles between the strong and the weak balance sheet baskets are totally reversed. The strong balance sheet stocks are positive for the last five years while the weak balance sheet stocks are still very negative. Another thing to notice is that the junk stocks went down a lot faster and more consistently then the quality stocks when the market tanked over the last two years. (click on chart to enlarge)
Goldman Sachs SP500 Strong and Weak Balance Sheet Baskets 5-Years
So what are we to take from all of this? We think that the market is far too speculative given the current economic backdrop. Earnings while “better then expected” are at record lows, unemployment is at highs not seen since the depression, we are experiencing deflation for the first time in several decades, the consumer is retrenching and not consuming, and really the only true “green shoot” was that it is not yet the end of the world.
Yes, we can go higher from here but the odds do not favor being heavily long right now. Our basic forecast at The Macro Trader is that in the not too distant future we will have a correction if not worse and we will be able to buy stocks at a better price then where they are currently sitting.
Disclosure: We are short some QQQQ-NASDAQ 100 ETFs.