Relative Outperformance: Low Quality Stocks

Yesterday, I briefly made mention of the relative outperformance of dreck. Let’s delve deeper into that this morning.

This year, stocks of companies with the strongest balance sheets have markedly lagged shares of firms with the weakest financials. In fact, the YTD performance numbers have not even been close.

According to Richard Moroney, editor of Dow Theory Forecasts, the worst decile of stocks as measured by "debt levels, interest coverage, and profit margins" have gained ~13%. Compare this with a less than 5% gain for the top ten percent of stocks (by those criteria).

Its not just the worst 10% of stocks ranked by debt, interest, and profits that are outperforming: Mark Hulbert notes a similar pattern exists when stocks are ranked according to "three- and five-year growth rates, along with return on equity, assets and investment." The 10% of stocks scoring the worst on these dimensions have gained nearly 11% so far this year, in contrast to a mere 1.4% for the 10% with the best scores on these dimensions.

Hmmmm, quite interesting . . . and there’s more:

Standard and Poor’s reported Monday that "stocks with average to low S&P Quality Rankings (B+, B, B-, and C) have continued to outperform those with high Quality Rankings in recent months." S&P’s Quality Rankings are based on dividends and "quality of earnings" measures.

Hulbert makes a very significant observation about this historical pattern of  low-quality issues outperforming high-quality issues: It occurs at two points in the market cycle: at the very beginning of a bull market — and at its tail end.

So that raises the very obvious question: Where are we int he present cycle? Is this the beginning, or (with apologies to Third Degree) is this the end?

You know my views.

Its not impossible for this to be the start of a new  multi-decade Bull market. However, for this to happen would require a historically unprecedented break from numerous other precedential factors:  the 4 year cycle, a P/E mean reversion, typical lengths of Bull and Bear Markets, P/E multiple expansion / contraction cycle, etc. It also means that all of the structural imbalances we have observed are utterly meaningless, and that irresponsible spending by both governments and consumers have no negative impact on the overall economy.


Incidentally, if this is the beginning of anew Bull run, I don’t mind being wrong — just so long as I can reposition before hand.


UPDATE March 22, 2006  1:55pm

In addition to the information above, consider these two charts below:

click either for larger graph

Contrahour points out that Nasdaq volume has been outpacing the NYSE volume:


and Sentiment Trader notes the big spike up in bulletin board stock volume:



Is this the end, or just the beginning?
Mark Hulbert
MarketWatch, 12:01 AM ET Mar 21, 2006

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