The Dash For Trash Goes Daffy: “Balance Sheet Bombs” Up 94% Since 2011

It was just last Friday when we updated our list of the most hated, i.e., most shorted, stocks which are so critical in the New Normal because as we have reported constantly since 2012, going long the most shorted names remains the best alpha-generating strategy, outperforming the broader market by orders of magnitude. Today, it is Bloomberg’s turn to recap just how broken the market is with an article that highlights the “balance sheet bombs” rallying by 94%. The lede: “In the U.S. equity market, the worse a company’s finances, the better it’s doing.” Because there is nothing like rewarding failure and capital misallocation to promote economic growth and employment recovery.

Here is what the outperformance of garbage companies looks like:

Regular readers will know the story but here it is once again because it somehow manages to get funnier with every read:

Stocks with the weakest balance sheets have climbed more than 8 percent in 2014 and 94 percent since the end of 2011, generating almost twice the gain in the Standard & Poor’s 500 Index (SPX) over that period, according to data compiled by Bloomberg and Goldman Sachs Group Inc. Shares in the category this year are beating those that most investors consider the bull market’s leaders, such as small caps and biotechnology, which tumbled in March.

Goldman, whose year end S&P price target is 1900 and which see the S&P at 1950 not on Friday but on June 30, 2015, adds the following value:

“Having a weaker balance sheet isn’t a liability or a drag on potential company performance at this point,” David Kostin, chief U.S. equity strategist at New York-based Goldman Sachs, said in a May 20 phone interview. “In an economy that’s getting better, you can operate perfectly fine with a little more leverage.”

And here is why we periodically update our list of 50 most shorted stocks:

A basket of 50 companies that rank lowest in measures comparing equity to total liabilities and earnings to assets, compiled in a gauge known as the Altman Z-Score, has increased 8.3 percent in 2014 after climbing 50 percent last year. The highest-rated group is up 3 percent since December after rallying 28 percent in 2013, according to data compiled by Goldman Sachs.

So what exactly are algos rewarding? Why the relentless releveraging of these companies with debt which once the rate cycle turns will promptly crush them all:

Junk-rated borrowers from Oklahoma City-based Chesapeake Energy Corp. to Netflix Inc. in Los Gatos, California, issued a record $380 billion of speculative-grade bonds in the U.S. last year, data compiled by Bloomberg show. While the pace has slowed in 2014, a monthly average of $29.5 billion is still 13 percent higher than during the previous four years.

But the real reason is simple: dash for trash, New Normal style, thanks to the Fed of course:

“There’s insatiable demand for high-yielding, lower-quality instruments, and companies are taking advantage of that to get money,” John Carey, a Boston-based fund manager at Pioneer Investment Management Inc., which oversees $220 billion worldwide, said in a May 22 phone interview. “The market is rewarding the kind of short-term behavior and earnings enhancement that this kind of financial strategy can provide in a low-interest-rate environment.”

Better returns from companies with the weakest balance sheets are also being aided by a shift in investor demand for stocks trading at lower valuations. Equities in the Goldman Sachs basket with the lowest Altman Z-scores, such as Natick, Massachusetts-based Boston Scientific Corp. and Time Warner Inc. in New York have an average price-earnings ratio of 21. That compares with 31 for the Facebook Inc.-led strong balance sheet category.

Not everyone is buying the Koolaid…

The outperformance of weak balance sheet companies “may be a head fake,” Mortimer, the Boston-based director of investment strategy for BNY Mellon Wealth Management, which oversees about $185 billion, said in a May 21 phone interview.

… But once the specter of losing out on his year end bonus rears its ugly head, because everyone else is outperforming BNY, it will be: Buy, Mortimer. Buy!

In the meantime, don’t expect the dash for trash to end any time soon:

Fed Chair Janet Yellen suggested on March 19 that the central bank might raise U.S. interest rates by the middle of next year, six months after bond purchases end.

Relaxed lending standards have led to a reduction in corporate defaults. Eight U.S. companies failed to meet debt obligations through April 24, compared with 19 over the same period in 2013, according to a S&P Ratings Services report.

Finally, what is the overarching objective of the central planners:

The Fed is “trying to allow otherwise shell-shocked or risk-avoidant investors to participate in this economic expansion,” Stephen Wood, the New York-based chief market strategist at Russell Investments, which oversees more than $259 billion, said in a May 21 phone interview. “We’re not approaching a credit-constrained environment, at least from a policy perspective.”

What expansion: that of the Fed’s balance sheet? But yes, the Fed would certainly want everyone to participate in this late stage ponzi scheme: after all the banks, which are the entities doing the bulk of the buying, need to sell to someone before even the most optimistic permabulls who confuse 5+ years of Fed intervention and micromanagement with actual sustainable growth pull a “nervous” Tepper and just admit the market is too manipulated and rigged even for them.

To summarize: the Old Normal had GARP – Growth At A Reasonable Price. The New Normal has CAAP: Crap At Any Price.

Published at Zerohedge.