A Rally Led by 'Junk Stocks'

Conservative investors have fallen behind in the past three months as risky, financially troubled stocks beat the rest of the market

By Ben Steverman

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."

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