Time To Shift Away From Junk Stocks?

The Federal Reserve’s quantitative easing and loose monetary policy continues to rule the day, allowing “junk” stocks to continue to outperform higher-quality shares. But that won’t last forever, says MarketWatch’s Mark Hulbert, and investors should start preparing their portfolios for a reversal.

Junk stocks, which tend to have the most inconsistent earnings and highest risk of bankruptcy, Hulbert says, have benefited most from the Fed’s policies, which “have distorted the markets because they encourage risk-taking.” Because of that, this bull market has differed from others in a key way. “The typical pattern, according to data going back to the 1920s compiled by Eugene Fama and Ken French, finance professors at the University of Chicago and Dartmouth College respectively, is for junk to outperform quality for no more than the first year of a bull market,” Hulbert says. “Thereafter, market leadership shifts to the stocks of the highest-quality companies. Thanks in large part to the Fed’s easy-money policies, however, this shift hasn’t taken place.”

Hulbert offers some data showing how junk has outperformed quality since 2009, and how the trend hasn’t stopped in recent months. And, he adds, “When the Fed’s quantitative-easing programs were fully in force, junk handily won — turning in an average monthly gain of 5.6%, versus 3.4% for quality. During all other months, the average junk stock actually incurred a slight loss, versus a 0.7% monthly gain for the average quality stock.”

That, Hulbert says, “offers a glimpse into how the stock market is likely to behave when the Fed finally does bring quantitative easing to an end and begins to increase interest rates. Not only will the market as a whole face stiffer headwinds, but previously highflying junk stocks could be big casualties. Banking stocks, and the financial sector generally, could be particularly hard hit.”

Hulbert’s advice: He says conservative investors might want to start shifting their portfolios toward higher-quality names now, even though the Fed hasn’t yet tightened. The market discounts the future, he says, so it’s likely the shift toward quality will occur before the tightening begins.