Excerpt from fund manager John Hussman's weekly essay on the U.S. market:
To offer an idea of how much the recent advance has represented a speculative run on "low quality," Bill Hester put together the following chart. It presents the performance of stocks rated "high quality" by Standard & Poor's, compared with the performance of all stocks with an S&P quality rating. Presently, the capitalizations being awarded to "garbage stocks" are very rich. Historically, these extremes haven't persisted.
The chart above is through the end of 2006. The same relative performance can be observed in the debt markets, where junk has clearly outperformed higher rated debt in recent years. It's notable that the "quality spread" in stocks has begun to reverse in recent weeks, along with risk spreads in the corporate bond market. Note that the yield spread on the CBOT's new credit default swap [CDS] index has just moved to a fresh high. A credit default swap is a way of transferring credit risk from one holder to another -- a rising spread indicates increased concern about default risk. This will be important to monitor in the weeks ahead.
As I've often noted, the worst situation for an investor is when risk premiums are low and are being pressed higher. When that happens, stock and corporate bond prices can weaken significantly because the only way to get the yield (and risk premium) up is to drive down the price, and it takes a substantial amount of price decline to bring a low yield to higher levels.
A seasoned investment analyst once put it to me this way in an easy southern drawl. Suppose you've got a 100 pound sack of potatoes. Now, since there's a lot of water in a potato, suppose what you've really got is 1% pure potato, and 99% water. Now suppose you let that bag sit out in the hot sun, and finally you go get it, and now it's 2% pure potato, and 98% water. What do you guess that sack weighs?
That general principle is why speculating in a richly valued, overbought market with rising interest rates is typically a bad idea. This instance may turn out to be different, but the average outcomes are sufficiently poor to keep us fully hedged.