SmartInMoney

 

 

 

After seventeenth months of cruel bear market, stock markets have rallied since the early spring and gained steam over the summer. The markets closed the third quarter with huge gain.

 

The Dow Jones Industrial Average index is up 48% from its March 9 low and up 11% this year, although still down 31% from its October 2007 record.

 

The Standard & Poor's 500-stock index is up 17% for the year and up 56% from its March low but off 32% from its October 2007 high.

 

The big gains followed a brutal bear market that hit hardest those companies with the shakiest balance sheets, heavy debt loads and high fixed costs. The Fed responded by cutting interest rates essentially to zero and flooded the credit markets with additional money, buying up Treasurys, government-backed mortgage securities and agency debt.

 

For the past seven months, it has been a beta-driven rally. As investors took advantage of the easy money and moved back into riskier assets, many of the biggest decliners during the crisis posted the largest gains. Buying volatile stocks is known as a beta trade. A financial statistic called beta is a measure of an individual stock's moves in relation to the market. A stock with a beta of two, it historically moves twice as much as the market.

 

A basket of the 20 highest beta stocks in the Russell 1000, as ranked by Nomura Securities International, gained 141% year to date after a 75% decline in 2008.

 

After seven months of big gains for stocks, investors are concerned about the underlying strength of those risky companies. The powerful rally came as the economy overall showed signs of stabilization. Corporate profits have come in above reduced expectations, in large part due to cost cutting. It steamrolled concerns that consumers remain suffered by debt, high unemployment and depressed home prices.

 

Last week, Fed governor Kevin Warsh cautioned that Fed policy could begin normalization. As the timing of the Fed's next steps become clearer, the best-performing stocks may move from more-speculative companies to those with better earnings quality.