Junk Stocks' Rally Ends Badly as Higher Quality Shares Prevail

The rally in "junk stocks" that characterized 2003 appears to be ending badly, as a clear difference has emerged between higher-quality shares and lower-quality stocks. The primary factor behind the decline of junk stocks - shares in companies with high leverage, lower-quality earnings, and greater profit volatility - is the looming specter of higher interest rates. While dividend-paying S&P 500 stocks outpaced non-dividend paying shares in January, the market has since turned, with dividend-paying stocks falling 1.3% between February 1 and May 20, and non-dividend paying shares dropping 9.5%. The weakness in lower-quality names can be attributed to the shifting stance of the US Federal Reserve on interest rates.

Key Takeaways:

• The rally in junk stocks that characterized 2003 is ending badly, with higher-quality shares outperforming lower-quality stocks.
• Higher interest rates are the primary factor behind the decline of junk stocks, which have high leverage, lower-quality earnings, and greater profit volatility.
• In January, S&P 500 dividend-paying stocks rose 1.3% on average, while non-dividend paying stocks returned 5.7%.
• Since February, dividend-paying S&P 500 stocks have fallen 1.3%, while non-dividend paying stocks have dropped 9.5%.
• Historically, when junk stocks peak, higher-quality stocks outperform the market by 22% on average over the next two years.
• A recent research report by Grantham Mayo entitled "The Case for Quality - the Danger of Junk" found many precedents to suggest fleeing from junk companies when they peak.
• Higher-quality companies can help shelter investors from losses in case of a financial catastrophe caused by increasing interest rates.

Statistics:

• January 2004: S&P 500 dividend-paying stocks rose by 1.3% on average, while non-dividend paying stocks returned 5.7%.
• February 1-May 20, 2004: Dividend-paying S&P 500 stocks fell 1.3%, while non-dividend paying stocks dropped 9.5%.
• 1999-2001: Higher-quality stocks outperformed the market by 22% on average over the next two years after junk stocks peaked.
• 2004: Grantham Mayo's research report predicts an average 22% outperformance by higher-quality stocks over the next two years.
• US companies are heavily leveraged, with a potential financial catastrophe caused by increasing interest rates.

Sources:

• Standard & Poor's - "S&P 500 Dividend Paying Stocks and Non-Dividend Paying Stocks"
• Howard Silverblatt, Standard & Poor's quantitative research group
• Edmund Choi, partner at Grantham Mayo Van Otterloo & Co.
• Grantham Mayo - "The Case for Quality - the Danger of Junk" research report