Scary bear markets generally end with a reversal to the upside that catches most investors by surprise and creates a feeling of disbelief and doubt that the move higher can be sustained. Investors commonly look to headline news items like high unemployment and other systemic troubles and wonder why the market can move higher when the news still isn’t good.
2009 has been no different, with a stock market rally of historic proportions beginning in the spring when the common opinion leaned more toward the possibility of a financial system collapse than to a dramatic rise in stock and bond prices.
Inside this trend, another sub-plot has been occurring pretty much in line with the historical precedents of the transition periods from significant stock market declines to new bull markets. The trend I refer to is one in which we observe lower quality companies dramatically outperforming companies which have better balance sheets, higher levels of profit and pay dividends to the owners of the shares.
The reason these junk stocks tend to move much higher at the beginning of a new bull market is not difficult to understand. First, these tend to be the companies which declined the most during the preceding market correction and once investors realize the world is not going to end, they tend to buy shares in the most beaten up companies to obtain the most bang for the buck during the recovery.
The second reason is that these lower quality companies are generally the target of short-sellers during the decline phase. Short-selling is a technique used to profit from the decline in a company’s stock price and the lower quality companies are the favored target of short-sellers because they anticipate larger price declines. However, to lock in his/her profit, a short-seller must buy back the shares, and this buying pressure now drives share prices upward along with the buying pressure described in the preceding paragraph.
The junk rally historically lasts six months months or so and tends to be followed by a period where higher quality companies with real profits, solid balance sheets and that pay dividends tend to start to outperform the junkie segment of the market. We may have transitioned into this phase in recent weeks. With the stock market bottom occurring last March, the 6- to 7-month junk rally took us into the September/October time frame, and since the beginning of October, we have observed larger, more established companies outperform the average smaller company by a significant margin.
If historical precedent holds, we may see these higher quality companies continue to provide superior results for the next 6 to 12 months.
The data used to write this article is contained in a white paper research article from Pioneer Investments titled “After the Turn.” We have a copy posted on our Web site at www.breitercapital.com if you are interested in reading in further detail. Just click on the Newsletter/Research tab on the homepage.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing.