Morgan Stanley's Credit Analyst Lends Weight To Equity Fears (MS, DFS, RGS, KLIC, AAI)

An appetite for risky assets that has sent small-cap and emerging market stocks and junk bonds flying since March now is getting more scrutiny from a market heavyweight.  Greg Peters, head of credit strategy at Morgan Stanley, (NYSE: MS) is the latest to question the rallying assets of debt-laden companies. In an interview with Bloomberg, he calls the market incredibly dangerous, noting that average debt relative to earnings among high-yield offerings is at an 11-year high. And the strong rally is happening despite rising default rates. How long can any rally last when it’s being driven by the worst assets?

Turning to the equity market, we made a similar argument about the quality of strongly rallying assets last month, using Altman Z-scores, a measure of balance sheet health. As of last month, there were 131 stocks in the S&P 500 with Z-scores in the “distress” zone. If only one fifth of those become insolvent by mid-2011, that’s more than two dozen companies that could potentially wipe out investors.  As GM and Lehman Brothers showed, no one wants to be left holding stock in a bankrupt company.  The trouble is, those are the Z-scores for supposedly top companies. the Z scores are even worse among the small-cap and emerging market stocks from many of the same companies that are issuing junk bonds.

Even if Z-scores are too pessimistic in forecasting bankruptcies, the news isn’t good. Companies that pull through with weak balance sheets often have to raise funds using secondary or convertible offerings that dilute stock value for existing shareholders. In the past, many companies have announce those types of offerings after a few months of strong gains.

We’re seeing a wave of secondary offerings such as the ones so far this week from Discover Financial Services Inc. (NYSE: DFS), Regis Corp. (NYSE: RGS), Kulicke & Soffa Industries Inc. (Nasdaq: KLIC) and Air Tran Holdings Inc. (NYSE: AAI).  It just so happens that every company that just posted a secondary this week has a Z score that’s in the danger zone of potentially going bankrupt, with the exception of Discover. But Discover is an exception because Z scores don’t work with financial companies.

There are times when the worlds of credit and equity move in tandem. With quality in question, this might be one of them. It’s why equity investors to heed what the credit guy is saying.

Mike Tarsala