The junk rally
One year after the COVID crash, stock markets have moved from extreme fear to euphoria. In the March quarter, excitement reached new heights as defensive assets such as bonds and gold were dumped while riskier securities soared. The GameStop saga in the US stock market symbolises the market’s interest in stocks that are akin to buying lottery tickets, as its share price rallied more than 1,700% in January. The unbelievable behaviour of GameStop’s share price represents the undercurrent of what has been driving global equity markets since late 2020 – a surge in low quality stocks.
Low-quality companies typically have lower returns on equity, more financial leverage, more cyclical earnings and/or are unprofitable. In the long term, most companies with these ‘junk’ characteristics typically do not generate sustainable shareholder returns. With weak fundamentals these stocks are prone to collapsing in recessions, but also exhibit powerful rallies coming out of recessions if they survive. Because of poor fundamentals the share prices of junk stocks are typically more volatile (higher beta) than the average stock.
The following chart displays an index that tracks the rolling annual performance of junk stocks minus the performance of quality stocks in the US since the late 1990s. The chart also displays the rolling annual returns of high beta stocks in the S&P500 index. The current outperformance of junk stocks relative to quality stocks is on par with previous post-recession periods. Mirroring the junk rally, high beta stocks have performed even better, delivering their greatest one year rally on record.
Source: Bloomberg, AQR, Vertium
Lower quality stocks typically include most cyclical companies (e.g. banks and small caps), challenged businesses that requires a turnaround strategy (e.g. Hertz and GameStop), growth companies with negative earnings (e.g. many technology start-ups) and companies with fragile balance sheets. Hence, its no surprise that companies with weak balance sheets have also recorded their largest rally in history.
Due to the enormous rally in junk stocks, growth stocks are not the only ones pricing in strong earnings growth. Current valuations are not like the Dot-com boom where there was a huge disparity between technology stocks and the rest of the market. Today, most stock prices are elevated as reflected by the aggregate market PE being very similar to the median stock PE ratio.