What a month it has been, with the S&P 500 up a stunning 11%. As everyone grapples with the question of sustainability of the rally or the possibility of the end of the bear (here is my view), I wanted to see what was driving this move. While the number of factors to analyze is daunting and beyond my capabilities, I wanted to come at it a few different ways. So, the first thing I did was to sort the S&P 500 members' returns for March so far and compare them to the returns of the past year. I put them into deciles. This is what it looks like:
In case it isn't clear, the very best returns came from the groups with still the very worst 52-week returns. The only exceptions are at the other extreme, where the two worst groups over the past month did have worse 52-week returns than the balance of the S&P 500. For the most part, though, the better a stock has been over the past year, the worse it has been in March. If you are interested in the actual numbers, here is a table:
So, it sure looks like the rally has been a "reversion to the mean", at least when it comes to ferocity of the worst stocks in doing the best. As you can see in the table, I wanted to see if perhaps I could find another factor to confirm that the rally is being led by potentially troubled companies, and I think that I did. As you can see, the first decile, which is driving a great deal of the performance in the market (a median return of 4X the overall market for March), has a worse debt to capital ratio than the typical stock as well as most of the other deciles. I find it extremely interesting, though, that the three worst deciles also have weaker balance sheets by this measure, especially the worst decile. Here it is graphically:
As many readers may be aware, I have been focused on a different balance sheet metric: Total Liabilities to trailing EBITDA. The picture looks quite similar, with some lower quality apparent again in the highest decile but otherwise a rather obvious low return for more leveraged companies (in the bottom 3 deciles again):
Here's my take: The top decile, which is a bunch of dogs for the most part based upon their returns over the past year AFTER soaring this month and a higher debt to capital ratio, had astronomical returns. They currently represent 10% of the stocks but only 4% of the market value of the S&P 500. Even the second decile was just 7% of the market. The last decile, which is a really scary place (very high debt and couldn't rally in the mother of all rallies) is just 6% of the value of the market. I would guess that a lot of short-covering drove the top decile performance. The group is very overbought now.
Looking at the 10 GICS sectors, perhaps there is evidence of a low-quality nature of the rally,as Financials are leading the way. Industrials, which include a lot of captive finance companies (think GE) are well ahead of the market for the month as well. At the end of the pack are Utilities, Staples and Health (traditional safe havens, at least before this year!). Maybe investors overdid it on the way down for Financials and Industrials.
I am sure that there are other factors to explain the wide divergence in stock returns besides returns over the past year, balance sheet quality and sectors. Reading between the lines, absent the exaggerated returns of the top decile and perhaps the 3rd decile, it looks to me like investors are starting to pay more attention to balance sheets, with the weaker balance sheets for the most part lagging the market. By my calculation, had the top decile performed in line with its debt to cap ratio, the overall market advance would have declined by a little over 1%, while the larger 3rd decile increased the S&P 500 return by about another percentage point. For those curious, here is one last piece of data - the top three stocks in each decile in terms of market cap:
- SGP, BAC, MET
- GE, WFC, BK
- JPM, AAPL, INTC
- CSCO, ORCL, QCOM
- MSFT, CVX, PFE
- T, KO, OXY
- WMT, VZ, PEP
- XOM, JNJ, GOOG
- PG, IBM, GILD
- ABT, MDT, EXC
I would be very careful chasing the top decile stocks, and I would continue to focus on better balance sheets over the coming months. Use this rally to upgrade unless you are expecting a "V" recovery. It was apparent to me in breaking down the deciles, except for at the extreme, that investors are definitely paying attention to balance sheet quality already.
A final observation: I did this same analysis to the Russell 2000 (Small-Cap), and the effects were similar but more extreme, especially on the balance sheet. In general, the worse the returns have been over the past year, the better March was, with the notable exception of the bottom three deciles. On the March returns relative to net debt to cap, a picture is worth a thousand words:
Well, I won't use a thousand words, but something is wrong with this picture. The very best and very worst returns in March came from the deciles having the highest median net debt. I find it interesting that the top decile has a median price of 3.35 and an average of about 5. The average Russell 2000 stock has a price of 12.69. Clearly there is some low-quality grabbing going on!
Tying it all together, it is quite clear to me that many of the stocks that have soared don't deserve to have done so well. This last table separates the S&P 500 and the R2000 each into quintiles by Net Debt to Capital. What we find is that generally, the more debt, the lower the returns for March. In both cases, however, the worst balance sheets actually produced returns that were better than the 2nd worst quintiles. Note, though, that the dispersion of returns (measured by standard deviation) was extremely high. What this means is that the bad balance sheet stocks were often hammered, but almost as often soared.
In the coming days or weeks, I expect that we will find the market fixes this anomaly. Short-covering is most likely at play here. So, while I thought that this was a "low quality rally" potentially, I have found it to be generally a high quality rally to some degree, but with the very weakest stocks (as measured by balance sheet) skewing the overall results quite significantly. As I said before, use this opportunity to upgrade.
Disclosure: No position in any stocks mentioned, though CVX, CSCO and JNJ are in one or more of my model portfolios.
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