A Rally Led by 'Junk Stocks'

It doesn't seem fair: For two years, the stock market favored careful companies that avoided debt, while punishing firms that took big risks. Now, suddenly, the stock market's stars are companies that are, by most objective measures, in terrible shape.

Since the market low of Mar. 9, the Standard & Poor's 500-stock index is up more than 35%. It's natural that as investor appetite for risk has returned, some of the market's most beaten-down equities would rebound. But investors' unbridled enthusiasm for the weakest of stocks still has been surprising.

The market's rally was led by stocks like Office Depot (ODP), up 742%; Genworth Financial (GNW), up 628%; Fifth Third Bancorp (FITB), up 383%; American International Group (AIG), up 345%; and hotel chain Wyndham Worldwide (WYN), up 304%.

Debt-Laden? Not a Problem

The contrast is striking if, using data from Capital IQ (like BusinessWeek, a unit of The McGraw-Hill Companies (MHP)), one compares the 100 top-performing stocks in the S&P 500 since Mar. 9 with the 100 worst-performing stocks. The 100 top stocks saw an average advance of 163%, while the worst 100 rose an average of just 11.2%.

However, those top 100 stocks have a total debt load of more than $4 trillion, compared with $746 billion for the 100 worst-performers.

On Mar. 9, at the start of the rally, 70 of the top 100 stocks had debt loads that actually exceeded their market value, while just 19 of the worst 100 stocks had total debt levels higher than their market capitalization.

For years, Jeremy Grantham, co-founder of investment manager GMO, was a bearish, pessimistic investor, but in early March he suggested stocks could be at their bottom.

Like many investors, however, Grantham was surprised by how disproportionately the rally came from low-quality stocks, he said in a recent speech at the Morningstar Investment Conference. "It's a junk rally," Grantham said.

Rutherford Investment Management president William Rutherford agrees, calling the past three months a "dash to trash." Rutherford's funds had stuck with high-quality stocks that he was sure would make it through the financial crisis and recession. As a result, he says, "We missed out on a lot of [the] increase."

Rewarding Risky Bets

Independent market strategist Doug Peta notes the rally is the reverse of the previous year, when the low-quality, debt-laden stocks were decimated by worries that the recession and financial crisis could drive them to bankruptcy.

As the financial crisis has eased and economists hope for an economic recovery, the markets have begun to reward what were once considered risky bets.

The recent rally "is a necessary consequence after the real beating that equity markets have taken," Peta says. He notes that Fifth Third stock at one point hit $1 per share, a sure sign the bank's survival was in doubt. But, after the Federal Reserve completed its so-called stress test of major banks, worries about Fifth Third eased and the stock jumped above $8. "Now, [investors believe] Fifth Third is going to survive—the government has said so," Peta says. "It's getting to trade on more traditional metrics."

A strategy that produced better-than-average performance in 2007 or 2008—by sticking to stocks with solid balance sheets—has probably hurt returns in 2009. Thus, the rally has penalized many portfolio managers who have been careful and conservative with their clients' investments. "It was very hard if you were a responsible investment manager to participate," Rutherford says.

"It's everybody who was left behind trying desperately to catch up," Grantham said.

This creates perverse incentives for investment managers, who are graded on their performance not just over the long term but quarter by quarter and year by year. Many investors and mutual funds are judged against the S&P 500: The rally in weak, financially troubled stocks has boosted this broad index, while the financially secure issues have lagged. "That really does put a portfolio manager in a dilemma," Peta says. "There is strong pressure on them to follow the prevailing winds," and abandon their previous strategy, he adds.

Junk Stocks Could Stumble

For long-term investors, the key question is whether the rally, and especially the huge gains for risky equities, is sustainable. "We had this wonderful period in the last few weeks [when] all our problems seemed to go away," says James King, president and chief investment officer of National Penn Investors Trust. "While we think we've hit bottom and the trend is more positive, the road to recovery is going to have plenty of obstacles."

Investors must chose carefully, he says, because some low-quality names may falter, while others could actually benefit from the recovery.

The recent rally raises a troubling question: Wasn't it excessive risk-taking that got us in all this trouble to begin with? Are investors forgetting the lessons of the financial crisis?

King prides himself on avoiding the "poster children" of the financial crisis and sticking to "top-quality securities" over the past couple of years.

He says, however, that the problem wasn't necessarily too much risk, but not understanding that risk. "The problem was that we didn't have a good handle on the level of risk embedded in the market," he says.

"We are in the business of taking risk," King says. "That's what investors do."

Whether you believe this rally is sustainable, risk is an unavoidable part of investing. The key is being smart about how and when to take those risks so they pay off over the long term. For better or worse, a lot of market players are taking those risks on shakier stocks.

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