Why I'm Not So Worried About This "Junk" Rally

Posted At 9:30 AM EST

Good Monday morning...We begin the day with some buying interest in the futures as the weekend news flow was modestly positive and there is some optimism given the huge jump in Indian equities.

My apologies for the late (and brief) comment this morning - I'm having to deal with some of the cleanup from my accident before Mother's Day.

Probably the biggest theme that we've seen bandied about regarding this rally is that it's being led by "junk" stocks.  We took a look at this in one respect in late April in terms of small caps versus large caps, but that didn't really get to the point of the matter.

The concern many are expressing lately is that the "worst" stocks have rallied the most off the March low, and unless that changes, then this rally is doomed to failure.

I thought it would be enlightening if we looked at all bear-market rallies since 2000 and compared how different types of companies fared during the rallies to see how it stacks up against our current recovery.

To determine what company is healthy is what is not, I used a formula called the Health Grade.  This calculation combines the Standard & Poor's credit rating of the company with something called Altman's Z-Score.  The Z-Score measures the financial situation of a firm and predicts its chances for bankruptcy.  You can read more about it here.

Like most of us are familiar with from school, the best companies based on this combined formula get an "A" grade.  The worst get an "F".

The chart below shows the return of each grade of company relative to the S&P 500 itself for each bear market rally.  So if the return was 30%, then that means that that grade of company out-performed the S&P 500 itself by +30% during the rally.

Data by Bloomberg

From the chart, we can quickly see how the current rally (the group on the far right, labeled "Mar 09") is being led by the worst firms, graded F.  They beat the S&P by an average of +62% from March 9th through May 8th.  The best companies, graded A, only beat the S&P by +5%.

Looking at the chart, it might seem like Lake Wobegon, where all the children are above average...all the bars are above 0%, meaning every group has beat the average.  The reason that's possible is because the S&P itself is cap-weighted, while the performance of the health grades are not.  I did do some preliminary work to correct for that, but found that it did not materially impact the results.

Anyway, if we look at the rallies since 2007, the current one is fairly different in that there was a very clear pattern of the worst companies doing the best, with each lower grade doing better than the one before it.  The other rallies did not share this characteristic.

Looking at the rallies during the prior bear market from 2000 - 2003, the current rally looks strikingly similar to the one that began in October 2002, the end of the last bear market (some would consider March 2003 the end, so it depends on your definition).

In October 2002, unlike each of the other rallies, we also saw a clear trend of each successively lower tier doing better than the one before it, just like now.  And even the magnitude of over-performance against the S&P 500 was pretty similar to what we're seeing now.

Based on this type of analysis, I don't think we should be scared away from the "junk-led" rally that is getting so much attention.  We've been here before, and the market's future wasn't so bleak as virtually every article would have us believe because of it.

Bottom line - Intermediate-term Outlook:  Neutral  (since April 9)

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration.  Some of those studies were even more positive, and suggested not just a rally, but possibly a new bull market.

After a 20%+ rally, several of our measures like the Indicator Score and Dumb Money Confidence reached levels during mid-April that usually result in either a flattening out of the price rally, or an outright decline...especially during a bear market.

But the market held up extremely well in spite of some of these overbought types of indications.  This is very rare during an ongoing bear market, and is important to keep in mind especially given many of the "this time is different" kinds of studies we reiterated last Friday.

The S&P 500 broke out over 875 and held well, another good sign.  Shorter-term, there were some early signs with the Nasdaq 100 that were troubling (particularly with the Dumb Money Confidence recently spiking over 70%), and we're testing the breakout levels in several indices as a result.

Such strong trend persistency as we've seen tends to continue longer-term, so as we get a pullback, the first set of solid oversold readings and/or approach towards 875-880 should provide a decent bounce, and we saw some initial signs of that last week.  We'll know a lot more about this over the next few days.

Bottom line - Short-term Outlook:   Neutral  (since April 20)

Last week some of our most sensitive indicators (like the STEM.MR Model, Down Pressure, Short-term Indicator Score and Rydex Beta Chase Index) hit oversold readings as many indices were approaching support levels.  We didn't quite make it to the 875 area I had as an initial target, but we hit that exact level pre-market this morning in the futures which marked the low so far.

Our short-term guides are no longer oversold, and the move off support this morning is occurring once again pre-market, which seems like a more and more common occurrence.  Unless one is trading at 3am, it's hard to take advantage of moves off of widely-accepted technical levels.

The market still has done nothing wrong - it was a little dicey there last week as we didn't bounce all that well off short-term oversold conditions, and some uptrend lines from the March lows have been broken in some of the indexes, but so far we're still seeing stocks and the market in general respond to "oversold on support in an uptrend' kind of behavior.

My concern would rise if we either break last week's lows (still using that general 875-880 area on the S&P as a line in the sand) or if we get a weak rally towards possible resistance (I'm using 910ish as a guide there) that fails.

All the best,