getting near the end..
ANNANDALE, Va. (MarketWatch) -- A couple of investment newsletters in recent days have drawn readers' attention to a subsurface pattern in the market that has very curious implications for where we are in the market's cycle.
It seems that in recent months, stocks of companies with the strongest balance sheets have markedly lagged shares of firms with the weakest financials. In fact, it has not even been close.
Late last week, for example, Richard Moroney, editor of Dow Theory Forecasts, reported that, so far in 2006, the ten percent of stocks scoring the worst according to measures of "debt levels, interest coverage, and profit margins" have gained nearly 13%, versus a less than 5% gain for the ten percent of stocks at the opposite end of the spectrum.
Moroney reported a similar pattern 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 1.4% for the 10% with the best scores on these dimensions.
In a similar vein, 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 the quality of earnings.
What does this mean? As best as I can determine, the historical pattern is for low-quality issues to outperform the high-quality issues both at the beginning of a bull market and at its end.
Take your pick.
Consider first what happens at the beginnings of bull markets. That's typically when the economy is just emerging from a recession and economic growth is beginning to pick up momentum. Such growth will have the most dramatic impact on companies living at or close to the financial margin, since they are the ones whose very survival was most in question during the recession.
To be sure, it takes a while for this revived economic strength to filter its way down to companies' bottom lines. But the stock market is a discounting mechanism, and it doesn't wait for those balance sheets to improve before bidding these companies' stock prices strongly higher.
Hence the strong relative strength at the beginning of bull markets of stocks of companies with the lowest financial quality.
At the other end of the spectrum, consider that bull markets often come to an end in a speculative blow-off. Ironically, the companies that typically are the beneficiary, temporarily, of such speculative excesses are the lowest-quality companies. There no doubt are many reasons for this, but one is that higher-quality companies cannot possibly satisfy the demands for earnings and revenue growth demanded by an increasingly greedy investment public at that stage of the market's cycle.
By way of example, I need only remind readers of the Internet bubble of the late 1990s and early 2000.
Which of these two extremes is more likely to apply to today's markets? It would seem difficult to argue that we today are at the beginning of a new bull market, since by almost all counts we are in the fourth year of the bull market that began in October 2002. So by process of elimination we are left to conclude that we must be close to the end of a bull market.
If so, then the best that the bulls can hope for right now is that the outperformance so far this year of the lowest quality issues is merely temporary and doesn't represent a meaningful trend. I interpret this to be Moroney's meaning when he writes in his latest issue: "In our view, strength in high-quality blue chips is exactly what the broad market needs."
Are there any signs of a high quality revival? Richard Tortoriello, a quantitative equity analyst at S&P, thinks there are. He notes that the "rate of [the lowest quality issues'] outperformance has [recently] slowed."
In other words, though the lowest quality issues are still beating the highest quality ones, they aren't beating them by as much as they were before.
To be sure, this is not much more than a glimmer of hope at this point. But, when interpreting the marked relative strength recently of the lowest quality issues, this glimmer is about all that the bulls can point to.
It seems that in recent months, stocks of companies with the strongest balance sheets have markedly lagged shares of firms with the weakest financials. In fact, it has not even been close.
Late last week, for example, Richard Moroney, editor of Dow Theory Forecasts, reported that, so far in 2006, the ten percent of stocks scoring the worst according to measures of "debt levels, interest coverage, and profit margins" have gained nearly 13%, versus a less than 5% gain for the ten percent of stocks at the opposite end of the spectrum.
Moroney reported a similar pattern 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 1.4% for the 10% with the best scores on these dimensions.
In a similar vein, 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 the quality of earnings.
What does this mean? As best as I can determine, the historical pattern is for low-quality issues to outperform the high-quality issues both at the beginning of a bull market and at its end.
Take your pick.
Consider first what happens at the beginnings of bull markets. That's typically when the economy is just emerging from a recession and economic growth is beginning to pick up momentum. Such growth will have the most dramatic impact on companies living at or close to the financial margin, since they are the ones whose very survival was most in question during the recession.
To be sure, it takes a while for this revived economic strength to filter its way down to companies' bottom lines. But the stock market is a discounting mechanism, and it doesn't wait for those balance sheets to improve before bidding these companies' stock prices strongly higher.
Hence the strong relative strength at the beginning of bull markets of stocks of companies with the lowest financial quality.
At the other end of the spectrum, consider that bull markets often come to an end in a speculative blow-off. Ironically, the companies that typically are the beneficiary, temporarily, of such speculative excesses are the lowest-quality companies. There no doubt are many reasons for this, but one is that higher-quality companies cannot possibly satisfy the demands for earnings and revenue growth demanded by an increasingly greedy investment public at that stage of the market's cycle.
By way of example, I need only remind readers of the Internet bubble of the late 1990s and early 2000.
Which of these two extremes is more likely to apply to today's markets? It would seem difficult to argue that we today are at the beginning of a new bull market, since by almost all counts we are in the fourth year of the bull market that began in October 2002. So by process of elimination we are left to conclude that we must be close to the end of a bull market.
If so, then the best that the bulls can hope for right now is that the outperformance so far this year of the lowest quality issues is merely temporary and doesn't represent a meaningful trend. I interpret this to be Moroney's meaning when he writes in his latest issue: "In our view, strength in high-quality blue chips is exactly what the broad market needs."
Are there any signs of a high quality revival? Richard Tortoriello, a quantitative equity analyst at S&P, thinks there are. He notes that the "rate of [the lowest quality issues'] outperformance has [recently] slowed."
In other words, though the lowest quality issues are still beating the highest quality ones, they aren't beating them by as much as they were before.
To be sure, this is not much more than a glimmer of hope at this point. But, when interpreting the marked relative strength recently of the lowest quality issues, this glimmer is about all that the bulls can point to.