Global stock markets have transformed significantly over the last six weeks.
- The year started amidst fears of slowing global growth and markets quickly entered correction territory for the second time in seven months.
- Global stock markets have staged a strong relief rally from oversold market conditions, which reflected excessive but not materializing fears.
- The rally has favored low quality, high-risk companies, especially stocks with large short positions.
- Some market observers note that the relief rally now has run its course. Future market activity, they argue, once again will favor the stocks of high quality companies able to produce attractive revenues and earnings in slow growth international and U.S. economies.
Following a dismal start to the New Year, global stock markets have risen in recent weeks and key benchmarks have moved into positive territory for the year through March 21. The S&P 500 Index, which on February 11 was down 10.5%, was up 0.4%. The MSCI All-County World ex-U.S. Index (ACWX) was down only -0.1% after bottoming -12.0% on Feb. 11. The EEM (the iShares emerging market ETF), off 12.2% in mid-January, rocketed 20.7% for a year to date gain of 5.9%.
We are not surprised that global markets have recovered. We noted in a January 14 blog (Global Stock Market Turbulence: An Excess of Anxiety) that investor fears of a slowing global economy, which would ultimately lead to recession, disappointing corporate earnings, and bear markets in many countries including the U.S., were overly alarmist and unjustified. In particular, fears of an imminent collapse in the Chinese economy, aggressive interest rate hikes by the Federal Reserve, a resurgent dollar, and/or a further plunge in commodity prices (especially oil) – these conditions have not materialized. From this perspective, global equity markets overreacted and a relief rally was warranted.
As global markets rebounded from the start of year correction, leadership swung to favor what are generally considered to be low quality, high risk equities. In contrast, high-quality, low risk equities which we characterize by consistently high profitability, steady earnings, and low leverage. Barron’s recently emphasized this development:
The rally has been led by the worst of the worst: shares of companies with weak balance sheets, poor profit trends, and the wildest price swings. Through Thursday’s close, the stocks of companies with the lowest returns on equity – a measure of profitability – had gained a startling 41% since the market bottomed, far outpacing both a 12% rise in the broad index and a 16% increase in stocks with the highest returns on equity. (March 19, 2016)
Strategas, a highly regarded research firm, observed on March 15 that the quintile of stocks within the S&P 500 Index with the highest short interest surged 20% while the benchmark Index as a whole rose 10.6%. The posterchild of high-risk performance is Chesapeake Energy Corporation (ticker symbol CHK). The company’s stock rocketed 174% from Feb. 11 through March 21 on expectations that the company might avoid bankruptcy, thereby reducing its trailing 12 month loss to a mere -65%.
A key question at this point is whether the market will continue to rise and, if so, whether it will continue to be led by low quality, high risk stocks. Some observers, such as Barron’s, argue that the relief rally has exhausted itself. Their conclusion is, “current conditions, however, are just about perfect for high-quality stocks.” We agree. We think that high quality, growth-oriented companies capable of providing attractive revenues and earnings will once again lead the market in the anticipated slowly expanding global economy.