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It’s Official: The Fed Manufactured a Rally in ‘Garbage’ Stocks

Last Updated September 23, 2020 2:00 PM
Andrew Packer
Last Updated September 23, 2020 2:00 PM
  • The recent market rally has been fueled by retail investors, who have targeted some of the worst-performing stocks.
  • Those stocks, with high credit default swap rates, are at high bankruptcy risk.
  • But those companies have been the best performers in recent weeks with no end in sight.

Yes, it’s no secret that retail traders have been beating the pants off professional money managers since the Fed cut interest rates to zero.

And that those traders are riding high on a wave of euphoria, even now claiming to be better than those who have been doing it full time for decades.

But there are a lot of warning signs out there that the recent rally won’t end well, even with Fed support.

Data Show Fed Fueled a “Garbage” Buying Frenzy

The latest? Data are showing that the best-performing stocks are those with the highest credit risks as measured by default swaps.

Garbage stocks outperform the overall market
Companies with high credit risk, or the “garbage” plays, have been driving the stock market higher. | Source: Twitter 

Companies with credit default swaps over 1,000 basis points—that’s 10% for you wunderkind retail traders—have been the best-performing niche of the market.

It’s not just one company in bankruptcy, it’s a lot of companies that are, financially speaking, garbage.

There’s a perverse logic in this, after all. The stocks with the highest credit risks tend to perform the worst during a market downturn . Why? Because their odds of a credit default rise.

And when markets turn up again, these stocks tend to perform better as a rebound trade. If the companies run into trouble later, a healthy bull market can enable a company to sell more shares or find a buyer at a better price.

But credit default swaps exist for a reason. Credit investors are safety-oriented. They think a lot more about a company’s operations and cash flows than those looking for a high return on a company’s share price.

Fed’s Rush to Liquidity Created a Reach for Yield

There’s another factor at play here. In fact, it’s the opposite side of the retail investor coin here. It’s the Federal Reserve.

By pushing interest rates back to zero, the Fed hoped to keep the economic shutdown from being too severe.

But when rates on ultra-safe assets like U.S. Treasuries are zero or near zero, investors need to go higher up on the risk scale for yield .

While some may move into junk bonds, it’s easy to see investors with higher risk tolerance head toward some of the most beaten-down stocks as a rebound trade. The reach for yield has become a reach for returns.

Retail investors have dramatically simplified this complex phenomenon.

Those with the “money printer go brrr ” mentality have a point when they rationalize that stocks only go up. And they have that point thanks to the Fed.

The problem is that the Fed’s moves have obstructed real price discovery. They’ve prevented capital from moving from the weakest companies to the strongest ones.

And in so doing, they’re creating zombie companies that have just enough capital to stave off bankruptcy, but can’t really thrive .

And it hasn’t been enough to stave off a drop in the yield curve. That measure indicates the strong probability of a lasting recession.

Yield Curve with 200-week moving average
The yield curve dropped under its 200-week moving average for the fourth time this century. Historically, that event has been bearish for stocks. | Source: Man Institute 

This kind of financial atrophy can’t last forever. But with unlimited financial backing, it can last long enough for stocks to keep hitting new all-time highs.

The Fed has overreached and created a speculative spectacle in the stock market. Typically, the Fed fuels bubbles rather than stop them. That makes the final burst worse than it would have been otherwise.

And it may yet go far higher before reality kicks in. Thanks, Jerome.

Disclaimer: This article represents the author’s opinions and should not be considered investment or trading advice from CCN.com.