Monetary stimulus favors poor quality equities

Mark Hulbert argues that the monetary easing since January 2009 has caused low quality stocks to outperform high quality stocks. This is illustrated in the first chart taken from his interesting article in the March 23rd Wall Street Journal.

Click here to read the WSJ article by Mark Hulbert, 3/23/13

Using Ford Equity Research data, he compared
the performance of the 20% lowest financial rated stocks to the highest. The 4 year gains are +273% vs +171% respectively, a very substantial divergence in favor of 'junk'.  I calculate the difference in performance to be +37.1 % per annum  vs +27.0%.

I would argue that the monetary easing more likely facilitated the rise in poorer quality stocks rather than causing it.

Core Equity Valuations has been keeping records of the valuation of over 500 equities monthly since September 2004.  In addition to our valuation data, we have also retained in our database some Value Line data included their Safety Rank. Using that as our measure of financial quality, we get very similar results as those based on the Ford data.

However, looking at the same two series in the years leading up the recession and the recession itself, we get a more complete picture.

Between the end of 2004 to October 2007, below average Safety Rank stocks outperformed the highest Safety.  However, from Oct '07 to Jan '09, something very dramatic occurs.  The lowest ranked stocks declined an average of 76% while the highest ranked  declined by only about 45%.

The next question to ask is: was the decline in low Safety stocks attributable to overvaluation in October '07?

The answer is not particularly.  Using Valuation Return/Risk (VR)*, the median was -4% for the lowest ranked and 0% for the highest ranked stocks at the start of the major downturn.

But after the decline, in Dec '08, those VR numbers are +73% and -17% respectively.  The former is an exceedingly high median number for any group of stocks, at any time.

Therefore, the conclusion is that the poorer quality stocks have done well in the recovery due primarily to their massive  undervaluation at the beginning. 

The monetary easing probably facilitated their recovery but it doesn't look like it caused it.

Finally the question is where are we today in terms of valuation.  The answer is pretty neutral.  The median VR for below average Safety Rank is +1% and +4% for the highest ranked.

Robert L. Colby

* Valuation Return/Risk is the price projection relative to the market based on the history of the each stock's history of relative valuation to the market and their return from growth and yield, both actual and projected.

Volume 6

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Volume 5

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Caterpillar, a good example of an undervalued Industrial stock

A good example of the undervalued Industrial Sector (see below) is Caterpillar (CAT $87) -

As with any cyclical company (and CAT is very), any useful valuation analysis will start with a calculation of what 'normalized' earnings are, based on past and estimated earnings.  The normalized earnings are calculated using the RoE without the benefit of future knowledge with the exception of including the estimated earnings.

This graph shows the EPS including estimates as well as the normalized MPEPS (green dots). This model discounts for cyclical change but cannot predict secular change.

This graph shows the history of CAT's relative Payback using normalized earnings.  In the last 25 years, CAT has traded between 75 and 125% of the market's Payback.

This graph shows the calculated price range vs the actual Hi Lo Close on an annual basis.  The projected price range for 2014 leaves the stock undervalued by  70%

Volume 4

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Volume 3

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Industrieal Sector - exceptional values

The Industrial Sector has some of the best values in the market today.  Green indicates good value and orange, poor.

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A good example is Caterpiller (CAT $87) - see above