Surprise: The Weakest Companies Are Leading the Rally

Fed Chairman Ben Bernanke believes the green shoots of economic recovery are sprouting, and the market seems to agree: The S&P 500 is up 36 percent since March.

But a closer look reveals plenty of crabgrass on U.S. balance sheets —
enough to choke the rally before long. Balance sheets are the best snapshot of a company’s health. And for about 90 percent of the S&P 500 stocks outside the financial sector, the picture is still worse than a year ago.

So far, that hasn’t dampened the optimism. Bernanke has spoken about a
“return to prosperity.” And nearly three-quarters of economists expect
the recession to end by the third quarter.

A heap of cheery financial news hit the market in recent weeks. Top
newsletter writers are bullish. Earnings estimates are rising.
Financial fear gauges are at their lowest levels since the credit
crisis began in August 2007. Even the latest consumer survey showed a
big improvement. All that helped fuel one of the strongest 90-day
rallies in a half-century.

Still, those gauges only measure people’s sentiment. They’re
essentially financial opinion polls. The balance sheet fundamentals
are the facts. And right now, those facts still show that business is
going south — with no signs of turning around.

For proof, just look at the Altman Z-scores for the companies in the
S&P 500. The Z-score, invented by New York University professor Edward
Altman, uses balance sheet data to measure a companies’ strength — and
the likelihood they’ll become insolvent. For more than a quarter of
the companies in the index, Z-scores suggest that bankruptcy is a
strong possibility within the next two years. That’s a higher number
than at any point in four decades.

Surprisingly, it’s the stocks with the poorest Z-scores that have led
the market rally. Investors’ growing appetite for risk, the federal
stimulus plan and increased liquidity appear to lifting all boats —
starting with the rustiest hulls of the S&P.

The Z-score is considered one of the best forward-looking measures of
a company’s health. Eighty-two percent of the time it correctly
forecasts that a business will become insolvent, Altman says. In fact,
he used the Z-score in September 2008 to predict that General Motors
would go under.

Goodyear Tire is a good example of a company with a rising stock price
and a poor Z-score. It’s grappling with tighter credit, cash-burning
operations, and sluggish demand for new cars.

Another case is Advanced Micro Devices (AMD), which lost more book value
than any other S&P 500 company last quarter. Its sales continue to
sag, while the chipmaker piles up debt. Networking equipment-maker JDS
Uniphase (JDSU), meanwhile, has the worst Z-score of any S&P 500 firm.

All three stocks have more than doubled since their March lows, far
outpacing the market. In fact, the S&P stocks with the 20 worst
Z-scores are up 69% over the past 90 days, versus a total index gain
of 26%.

Z-scores don’t work as a gauge for financial firms, since several of
the score’s underlying ratios don’t apply to banks. Still, it’s safe
to say that the financial sector is far from healthy. The list of
troubled banks rose in the first quarter to its highest level since
1994, and FDIC Chair Sheila Bair said last week that asset quality for
the group remains a “major concern.” The era of big bank write-offs
also may not be over, judging from analysts’ estimates.

But it’s the same story: Banks have outpaced the overall rally twofold
since March.

Can the surge in stocks keep going if it’s fueled by the weakest
companies? And what happens when other Z-score laggards follow GM into
bankruptcy? Rising treasury yields also could hurt the rally by making
bonds more attractive than equities.

It’s hard to say which S&P 500 company might falter next. There are
131 stocks in the S&P 500 with Z-scores in the “distress” zone. If
only a fifth of those become insolvent by mid-2011, that’s more than
two dozen companies poised to wipe out investors. As GM and Lehman
Brothers showed, no one wants to be left holding stock in a bankrupt
company.

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
dilutes stock value for existing shareholders. In the past, many
companies have announce those types of offerings after a few months of
strong gains.

Z-score critics dismiss the measurement, saying it can’t predict the
future. They compare the scores to earnings and revenue results, which
tend to lag an economic recovery. But tracking the changes in a
balance sheet is a time-tested way to assess future sales and profit,
and ultimately, a company’s stock price. So until we start to see
rising Z-scores, the “green-shoots” rally is at risk of browning out.

Mike Tarsala