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.

Reflation theme

The high beta, junk rally has occurred with a reflation backdrop as economic activity is expected to improve. In recent months, US Government long term bond prices experienced a correction of more than 20% as yields rose from 2020 lows to 1.7% at the end of the March. The rise in bond yield is approaching its highest ever percentage point increase in one year.

Source: Iress, Vertium

While historical context provides an idea of how much the current rally could persist, there is a fundamental reason why the high beta, junk rally is not sustainable. High interest rates would severely impact companies with weak fundamentals when corporate debt is very high.

In a typical recession highly indebted companies are purged from the economy. This allows room for interest rates to rise when the economy improves and healthy companies can afford to pay higher interest payments. However, the COVID recession was unique because the forbearance programs have kept businesses from defaulting on their debt. Hence, unlike other recessions bad debts have not been purged and still remains high.

Source: Bank of International Settlements

The area of the economy where the financial impact from rising rates will be the greatest are small businesses and small cap stocks. Currently, small cap stocks have the highest leverage ratio (net debt to EBITDA) relative to its history since the late 1990s.

Small increases in interest rates will have an amplified affect on companies with high leverage ratios as more cashflows are required to service higher interest payments. Increasing debt without increasing productive capacity lowers long term growth prospects. Because debt has not been purged, the underbelly of the US economy is a lot weaker than it was before the COVID pandemic. The real recession is still to yet to come.

Australian experience

In Australia, the junk rally has echoed the United States. The rally in junk relative to quality companies has even surpassed the post GFC rally in Australia.

Source: AQR, Vertium

Highly cyclical sectors have significantly outperformed from their March 2020 lows. For example, over the last year the ASX300 Resources, Financials, and Small cap accumulation indices have recorded a return of +55%, +47% and +52% respectively. In contrast, the higher quality sectors with more predictable earnings such as the Consumer Staples, Healthcare and Utilities have lagged recording +9%, +0.5%, and -9% return respectively over the same period.

While the March quarter marked one of the biggest junk rallies in history, there are cracks beginning to appear. The bubble-like interest in technology stocks with no earnings may have popped. Many of the recent US technology IPOs have crashed from their recent highs. For example, Snowflake and DoorDash peak to trough returns are -47% and -42% respectively. In Australia, the best technology IPO last year, Nuix, also collapsed with a peak to trough return of -58%. More mature tech companies with minimal earnings have also fallen from grace including Tesla and Afterpay, both with peak to trough returns of -36%. Is this a pause in the junk bubble or are the best days behind it?

Conclusion

The father of value investing, Benjamin Graham, had a great description of the stock market, which sums up the current euphoria in junk stocks perfectly. He stated “In the short run, the market is like a voting machine” where public opinion chase the popular narrative, which makes high beta, junk rallies fleeting in nature. However, he stated “In the long run, the market is like a weighing machine” where fundamentals eventually matter and stocks deliver a similar return to the business that underlies it. In the long term, quality businesses always generate far more sustainable shareholder returns than junk stocks.

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