By all accounts, the recovery in the US equity markets has been pretty remarkable over the past 7 months—however, I hesitate to take a breath of relief. Why? Because over the past quarter we have witnessed a phenomenon that often occurs late in recoveries…a flight to low quality stocks. During the bleakest months of the recent bear market, many companies teetered on the edge of collapse as credit facilities froze. The energy sector, particularly smaller, highly leveraged Exploration and Production companies have been beneficiaries of this process. E&Ps are not alone, manufacturing, industrial and materials have also seen big rebounds in equity prices. What is troublesome is that factor perversity is not a sustainable trend. Companies in distress will at times present very attractive investment opportunities, but not without risks. This has given rise to a large number of high frequency and distressed funds that have opened in the past year. While I cannot argue with the principal of “go where the money is,” I can reasonably predict that when the music ends there will not be enough chairs. In effect, a small number of investors will reap the lions share of profit from this flight to low quality.
Furthermore, if the bear market is over, then the tendency will be toward an inflationary environment. As rates rise, the cost of borrowed money will increase and the financial pressure will be back on the capital intensive companies. If the bear market is still in place and the magnitude of the ‘dead cat bounce,’ is amplified by the magnitude of the 2007-2008 decline, low quality, highly leveraged companies will also underperform. We may be at a tipping point in the markets, which is why it is important to securitize balance sheets and income statements before the music stops.
The opinions herein are those of Patrick Morris and do not necessarily reflect those of HAGIN Investment Management. This is not a solicitation to buy or sell securities.
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