Credit Risk in Stocks Using the Fed Definition of Speculative Grade Stocks Shows Elevated Risk Today

  • The chart shows that the weakest quintile of stocks is as vulnerable today as they were in 2000
  • Vulnerability is measured by ICR, or EBIT/Interest Expense, and associated criteria as explained in the Federal Reserve’s 2020 paper
  • As documented in our last quick take, these financially weak firms that may not be able to make their interest payments should a correction take place, were rocked in the Covid crash as Junk Bond yield spreads exploded

Financially Fragile Stocks at risk of default: Should High Yield spreads widen from record lows today, these firms may suffer tremendous losses over both the short term and long term.

Vulnerability of the Weakest 20 of Companies

In our last Quick Take, Junk Stocks Funded by Junk Bonds, we showed that junk bond yield spreads are at record lows. We went on to demonstrate what the last spike in yield spreads during the Covid crash meant to financially weak firms that ranked poorly in KCRs Rankings Engine. We found that 70% of these firms suffered losses far worse than the S&P500.

Even absent the KCR screen, the 97 Financially Fragile firms that make up the chart above, suffered crushing losses in 23 trading days during the Covid Crash. As we noted in the prior quick take, the Fed’s latest findings note that financial fragility has become more severe in the post-Covid-19 pandemic era. In our view, the Fed methodology is a great cross-check on the credit rating of corporate bonds. During a crisis, firms that lack the resources to cover emergency expenses suffer inordinate losses.

KCR believes the confluence of irrational bond prices, interest rate risk, an influx of stimulus checks pumped into the market and inflation could be especially harmful to these Financially Fragile firms’ balance sheets in a market correction. Please click here for the full list of Financially Fragile firms identified using the Fed’s ICR ratio.

Today so many of America’s biggest companies and most promising “TAM” stories rest on the foundations of ever-increasing globalization. The valuations and expectations are higher than in 2000. The backdrop of current events looks particularly challenging. Maybe we are reading too much into it but is anyone pricing in this video?

As always, our working papers compare historical precedence of market risks and opportunities with today’s landscape. The higher interest rate spreads in Junk Bonds we saw during the Covid Crash could easily rear their ugly heads again and lead to real-time risk for investors. Whether it be another financial crisis, a continuation of inflation or a simple pricing correction, some of our work below may be of particular interest to KCR’s readers.

KCR views today’s speculative environment as one of the most precarious in history. As we have documented, today’s market appears to combine the most dangerous traits of the Nifty Fifty era with the Dot.Com bubble. If you are interested in the Nifty Fifty, please read The Collision of Arithmetic & Over-Optimism – Why Today’s Larger Cap Growth is More Precarious than the Nifty Fifty. For some of our research on the speculative Dot.Com risks we see in markets today, please see High-Quality Midcap Value: The Case for Common Sense and What Does Volume Mean in Stocks?

Disclaimer
The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2020 Kailash Capital, LLC – All rights reserved.