What many don't realise is that sometimes in a stock market rally the quality of the stocks you own just doesn't matter. Indeed, when the whole market rallies there are times when it pays best to own junk. These periods have become known as a 'dash to trash' and understanding the phenomenon could just save you from an awful lot of pain when the music stops.
Over the last 15 months since we've been monitoring the performance of 65 stock screens and strategies in real time the market's preference for trash stocks in strong rallies has been obvious. If you navigate to the performance history page you can explore this phenomenon better. We've annotated the chart below to illustrate how the December-January rallies in both 2012 and 2013 have been characterised by the strong rebound of stocks we normally categorise as potential short sales.
Short selling screens are filled full of story stocks, glamour stocks and trash stocks. These are stocks on nosebleed valuations or those that have little or no profits, low or no dividends, little asset backing and high share price volatility. Why do these stocks rally so hard? Because there is a lot of implied optionality in these kinds of stocks. Some of them may have blue sky potential - intrepid drillers or high tech R&D stories while others may be glamorous 'market darlings' that itch to have another leg up. When the macro environment feels a bit safer, or money is easier to come by people are more willing to go swimming with these sharks.
The danger comes when the market turns
But cyclical market downturns can be absolutely devastating to shortable stocks (glamour and trash). You can see in the chart above that between April and December 2012, when the stock market steadied itself, long strategies (quality, growth and value) outperformed short strategies (glamour/trash) by a huge margin of 30% - a margin that the shortable stocks won't ever be able to make up again though they may seem hell bent on trying.
This phenomenon of value & quality outperforming during bearish market periods has been well observed. The famous academics turned hedge fund managers Lakonishok, Vishny and Shleifer studied this phenomenon and confirmed that across typical bear markets value stocks decline less and outperform the market as a whole. For those that have read our book "