What’s Working In This Rally

by Jon Markman | October 11, 2011 12:02 pm

Now that we’ve seen a big rally off the Oct. 4 low, we can study exactly what types of stocks investors wanted.  It helps us understand what to buy the next time the same setup occurs, as well as what might work best going forward in the next few weeks.

Bespoke Investment analysts have discovered that the average stock is up 9.6% since the Oct. 3 close. The analysts then ran a decile analysis on the S&P 500 to determine which factors have led the way.

To run the analysis, they break the index into deciles (10 groups of 50 stocks each) based on various categories (market cap, P/E ratio, short interest, etc.) and then calculate the average performance of stocks in each decile since the rally began.

It turns out that the 50 largest stocks in the S&P 500 are up an average of 7.4% since Oct. 3,  while the 50 smallest stocks are up 13%. It’s typical for smaller-cap stocks to outperform large-caps during rallies, and this rally has been no different.

In terms of valuations, the decile of the stocks with the lowest P/E ratios averaged the best returns, which means value stocks are beating growth stocks. Financials have low P/E ratios right now, and they have outperformed during this rally, so that helps to explain this development.

Stocks with high dividends have been significantly underperforming stocks with small or no dividends, the analysts report, so anyone who has recently gotten more invested in high-yielding names has done poorly relative to the market. But they may not care, because they want the dividend.

The short interest category helps to tell how much of this rally has been short-covering. As shown, the 50 stocks with the smallest amounts of short interest are up an average of 7.9%, while the 50 stocks with the highest short interest are up an average of 12.2%. The difference between the two is wide, the analysts report, but it’s not as wide as seen in the past during rallies. Short-covering has definitely had an impact, they surmise, but based on this they don’t believe it’s the defining factor.

In terms of institutional ownership, the stocks most heavily owned by institutions have outperformed the stocks least owned by institutions, the analysis shows, indicating that the so-called smart money has been participating.

And finally, it’s the performance of stocks during the correction that preceded the rally that has affected performance the most during the rally, the analysts discovered. The S&P 500 fell 9.6% from Sept. 16 through Oct. 3, and the stocks that were down the most during this correction have bounced back the most during the current rally.

Meanwhile, the 50 stocks that held up the best during the correction have averaged a gain of just 3.7% since Oct. 3, the worst of any decile, while the 50 stocks that were crushed the most during the correction are up an average of 17%, the best of any decile.  Bespoke surmises that investors thought that the selloff became overdone and rushed to buy stocks that were beat up the most.

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