Small vs. Large Stocks

We've commented a few times about the rather shocking disparity in gains between the "weakest" and "strongest" stocks since the March lows, but I don't remember seeing it quantified quite as clearly as in this article from Sunday's New York Times:

Ford Equity Research, an independent research firm based in San Diego, rates stocks' financial quality based on a number of factors, including a company's size, debt level, earnings history and industry stability. All told, Ford Equity follows more than 4,000 stocks. Those in the bottom fifth of its ratings - including Sanmina-SCI - produced an average stock market return of 152 percent from the beginning of March to the end of November, according to an analysis conducted for The New York Times.

The stocks in the highest quintile for quality - including Wal-Mart - produced an average gain of 66 percent over the same period, or roughly 85 percentage points less. That is the biggest disparity over the first nine months of any bull market since 1970, which is the first year for which Ford Equity has quality ratings.

The article's author, Mark Hulbert, considers this to be somewhat concerning, given that only once since 1926 has this disparity been greater within the first nine months of a new bull market - 1933 - in the middle of the Great Depression. (Though it's worth noting that while there was quite a bit of economic pain still ahead at that point, the stock market rallied for four years from that February 1933 low. So it wasn't particularly bad news for stocks the last time this happened.)

Hulbert ends his article asking why this disparity has been so large, and turning to Jeremy Grantham for a possible answer:

Mr. Grantham said in an interview that by temporarily reducing the danger of incurring risk, the government had effectively encouraged huge amounts of risk-taking in financial markets. "The sizable disparity of junk over quality should not have come as a big surprise," he said, "given how massive the government's stimulus has been."

As an unintended consequence, Mr. Grantham said, high-quality stocks today are about as cheap as they have ever been relative to shares of firms with weaker finances.

"It's almost a certain bet that high-quality blue chips will outperform lower-quality stocks over the longer term," he said.

That's a take-away we'll be considering as we craft our 2010 asset allocations.
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Mark Biller is Sound Mind Investing's Executive Editor. Visit www.soundmindinvesting.com to learn more.